SEC Proposes Landmark Climate Related-Disclosure Rules
On March 21, 2022, the Securities and Exchange Commission (SEC) announced a new set of rules on the “Enhancement and Standardization of Climate Related Disclosures” after months of discussions. The proposal is a notable victory for the Biden administration’s environmental policy agenda, and comes at a time of growing support for climate action and the standardization of climate related risks disclosures. The United Kingdom, New Zealand, Japan, Hong Kong, and the European Union are all moving forward with similar measures (Corb et al. 2022). If the proposal is passed, publicly traded companies will need to consider how the disclosed information will be used. Transparent climate disclosures will make public firms more attractive to customers, and put private companies at a competitive disadvantage. This may cause private companies to follow suit and publicize their carbon footprints as well, making the regulations in the proposal the new standard by which companies are evaluated. Forced disclosures may make companies change their behavior and reduce emissions. Therefore, the SEC proposal, if passed, will likely cause a shift in the behavior of both public and private companies towards sustainable and climate-friendly practices.
When the proposal was made public in March, the SEC received major pushback, collecting over 10,000 comments during the three-month comment period. The proposal was bound to face criticism, and was formulated with “political divide baked into it right from the start” (Soroosh 2022). Republicans argue that producing detailed emissions disclosures will raise costs for firms, and that it was created for the benefit of a few large index investors. Progressive Democrats find the proposal weak and believe it should call for further emissions disclosures. SEC Commissioner Hester Pierce, a conservative, said in her official statement, “We are not the Securities and Environment Commission—at least not yet” (Ho 2022). The SEC must navigate this strong criticism to pass this important proposal.
The SEC’s proposal has three major components. The plan calls for the disclosure of climate related risks that are likely to have a material impact on a public company’s business and financial conditions. Public companies must disclose information on Scope 1, Scope 2, and Scope 3 greenhouse gas (GHG) emissions, and filers must include climate related financial metrics (SEC 2022). The detailed disclosure requirements will combat greenwashing done by corporations to capitalize on the ESG investing movement. Greenwashing is the act of providing misleading information about the environmental impact of products and operations to investors and customers. The proposal defines climate-related risks as negative impacts from climate conditions and events on business operations and financial statements. A registrant is required to define short-term, medium-term, and long-term plans for how it assesses the usefulness of assets in the registrant’s planning processes and goals, and how climate risks will affect its business model and strategy (SEC 2022). In addition to usual financial metric reporting, registrants must discuss the impacts of climate change events over the long term, which is unusual for annual reports. Including long term climate impacts could lead to firms reporting unreliable information.
Public firms must disclose direct emissions, referred to as Scope 1 emissions, which is common for environmental disclosures. However, firms must also release figures for Scope 2 and Scope 3 emissions, which are indirect emissions, and are the respective upstream and downstream emissions from the entire lifecycle of a product. Scope 2 emissions often come from a company purchasing energy for heating and cooling. Scope 3 emissions are more difficult to provide estimations for, and require approximations from a firm's suppliers and customers. One can imagine that devious firms would still find ways to not estimate their scope 3 emissions honestly. Scope 3 emissions include the transportation of goods, warehousing of goods, use of sold and leased products, and the end of life treatment of sold products and assets (US EPA 2016). Firms are concerned that it will be costly to report Scope 3 emissions, and that they are at risk of providing inaccurate numbers. Firms can combat the possibility of misleading metrics by selecting vendors with a focus on emissions reduction, and detailed emissions data collection practices. Additionally, firms must provide metrics for the negative impacts of severe weather events, environmental transition activities, and climate-related risks (Gez et al. 2022).
Disclosures are also required for 10-K and 20-F filers (Corb et al. 2022). 10-K reports are required for filers with $10 million or more in assets and a class of securities held by more than 2000 holders. 20-F filers are often used by foreign companies who trade securities in the US, and use the filing to standardize reporting requirements across all publicly traded companies. The current proposal requires firms to begin including emissions in annual reports starting in the filing year 2024, and smaller companies are required to report information in the fiscal year 2024, meaning they have a yearlong grace period. Interestingly, however, smaller companies are excluded from Scope 3 reporting requirements (Corb et al. 2022). Though there are differing requirements for small firms, the proposal will still influence small firms to change their behavior towards a focus on sustainability without unreasonably burdening them by requiring Scope 3 emissions disclosures.
After the SEC received thousands of comments on the proposal, major accounting firms, law firms, and academic journals identified the major issues and published detailed explanations behind them. White and Case, a global law firm based in New York, believe that the proposal’s overly broad disclosures may force public companies to make imprecise assumptions. The other issue White and Case found is that the SEC may be overstepping its authority, causing people to question its role in climate change disclosure (Gez et al. 2022). The prior administration utilized more “principles-based” regulations, while this proposal is “prescription-based,” and calls for firms to integrate the policy with oversight functions and internal controls (Gez et al. 2022). Principles-based rules give firms the flexibility to determine how to disclose information, and to decide if it is material to an investment decision. Prescription-based rules are more quantitatively detailed, and require each firm to disclose the same sets of information.
The Harvard Law School Forum of Corporate Governance highlighted four major publicly expressed concerns with the proposal. First, the SEC lacks the authority to promote rules that require climate-related disclosures. Several state attorneys mentioned that the SEC’s enabling statutes claim that the purpose of the SEC is to require disclosures that “protect investors from inflated prices and fraud, not merely helpful for investors interested in companies with corporate practices consistent with federally encouraged social views”(Vallette and Gray 2022). It is not clear if environmental disclosures fall under the SEC’s enabling statutes . Additionally, the proposal may exceed the limit of major policy questions. The “major policy questions” doctrine derives from the principle that important questions regarding social policy should be made by Congress (Vallette and Gray 2022). The challengers to the proposal argue that the SEC should not be able to rule on a question of such economic and political importance without congressional authority. Furthermore, the proposal may unconstitutionally compel free speech. Mandatory environmental disclosures might force firms to make denigrating remarks about their operations, which the first amendment protects against. The final challenge of the proposal is that the final ruling could be “arbitrary and capricious” under the Administrative Procedure Act (Vallette and Gray 2022). To change an SEC policy, the new rule must provide definitive reasoning to depart from the previous policy. Depending on the language of the final policy, challengers can argue that it lacks appropriate reasoning over alternatives, and that it will not generate comparable, consistent, and reliable disclosures (Vallette and Gray 2022).
As members of the SEC read through the public comments responding to the proposal, they must adjust the proposal and change some of the terms. If the SEC enacts the proposed rules without adequately addressing the critiques, it may lead to future legal challenges and possibly a Supreme Court decision on the extent of agency rule-making power (Uslaner and Horowitz 2022). Although there are challenges that lie ahead for the Enhancement and Standardization of Climate Related Disclosures proposal, if it is passed it will likely become the new standard by which all companies are evaluated. Environmental disclosures requirements have the potential to make companies more attractive to customers and investors and put private companies without environmental disclosures at a competitive disadvantage. The proposal will hold public corporations accountable, and firms will need to actualize their publicized net-zero commitments. Some firms may lose revenue or market share if their business produces more emissions than competitors. The proposal is a critical piece of legislation, as companies will no longer be able to fully prioritize growth and revenue over their GHG emissions and impact on the climate.
References
Corb, Laura, Kimberly Henderson, Tim Koller, and Shally Venugopal. 2022. “Understanding the SEC’s Proposed Climate Risk Disclosure Rule.” Www.mckinsey.com. June 3, 2022. https://www.mckinsey.com/capabilities/strategy-and-corporate-finance/our-insights/understanding-the-secs-proposed-climate-risk-disclosure-rule
Gez, Maia, Taylor Pullins, Claudette Druehl, and Fatima Hassan Ali. 2022. “SEC Proposes Long-Awaited Climate Change Disclosure Rules | White & Case LLP.” Www.whitecase.com. June 13, 2022. https://www.whitecase.com/insight-alert/sec-proposes-long-awaited-climate-change-disclosure-rules.
SEC. 2022. “SEC.gov | SEC Proposes Rules to Enhance and Standardize Climate-Related Disclosures for Investors.” Sec.gov. March 21, 2022. https://www.sec.gov/news/press-release/2022-46.
Soroosh, Jalal. 2022. “An Overview of the SEC’s Proposed Climate-Related Disclosures.” The CPA Journal. October 24, 2022. https://www.cpajournal.com/2022/10/24/an-overview-of-the-secs-proposed-climate-related-disclosures/.
Soyoung Ho. 2022. “Commissioner Crenshaw Says SEC Is Not a Merit-Based Regulator in Response to Climate Rulemaking Criticism.” Thomson Reuters Tax & Accounting News. November 4, 2022. https://tax.thomsonreuters.com/news/commissioner-crenshaw-says-sec-is-not-a-merit-based-regulator-in-response-to-climate-rulemaking-criticism/.
US EPA. 2016. “Scope 3 Inventory Guidance.” Www.epa.gov. November 8, 2016. https://www.epa.gov/climateleadership/scope-3-inventory-guidance.
Uslaner, Jonathan D., and Will Horowitz. 2022. “Will the SEC’s Proposed Climate Risk Disclosure Rules Survive Supreme Court Scrutiny?” Reuters, August 5, 2022, sec. Legal Industry. https://www.reuters.com/legal/legalindustry/will-secs-proposed-climate-risk-disclosure-rules-survive-supreme-court-scrutiny-2022-08-05/.
Vallette, Jacqueline, and Kathryne Gray. 2022. “SEC’s Climate Risk Disclosure Proposal Likely to Face Legal Challenges.” The Harvard Law School Forum on Corporate Governance. May 10, 2022. https://corpgov.law.harvard.edu/2022/05/10/secs-climate-risk-disclosure-proposal-likely-to-face-legal-challenges/.