Published: June 27, 2024
By: Concentric Staff Writer
There is a legal tumult swirling around the U.S. Securities and Exchange Commission (SEC) and its recent issuance of a suite of new climate disclosure rules for publicly traded companies, with states, energy interests, and environmental groups immediately launching a flurry of court challenges.
The agency says the importance of the climate risk disclosures required in the Enhancement and Standardization of Climate-Related Disclosures: Final Rules, approved March 28 in a 3-2 vote, has grown due to increasing risks and possible impacts on financial performance and position due to extreme weather- and climate-related challenges. Various types of environmental impact reporting have been required for more than 50 years, according to the SEC.
After multiple lawsuits were immediately filed, the SEC in April voluntarily stayed the rules, but said in a news release that does not mean the Commission is in doubt about the rules’ legality.
“In issuing a stay, the Commission is not departing from its view that the Final Rules are consistent with applicable law and within the Commission’s long-standing authority to require the disclosure of information important to investors in making investment and voting decisions,” the SEC said when announcing the stay.
The SEC said it recognized that many commenters had expressed concern over the scope of the proposed rules, saying they require too much detail, could be overly costly or burdensome, could harm companies’ competitiveness, or obscure other relevant information. The Commission said that it tried to address these concerns by modifying the definition of climate-related risk, making the rules less prescriptive and adjusting reporting time frames.
The SEC’s final rules were “watered down” from a proposed rule issued more than two years ago, according to Concentric Energy Advisors Project Manager Michael Buckley, an expert in Environmental Social and Governance (ESG) investing principles and sustainability data and information. After the more stringent proposed rule was issued, publicly traded companies pushed back, saying the disclosures would be overly burdensome and compliance would be too costly, according to Buckley.
Parties filing suit against the SEC over the final rules range from the Natural Resources Defense Council, Sierra Club, Texas Alliance of Energy Producers, The U.S. Chamber of Commerce, and states such as Louisiana, Iowa, and West Virginia.
The SEC tried to strike a middle ground by making the new requirements less intensive than the proposed rule, according to Buckley. Lawsuits from states and companies were filed on the basis that the SEC overstepped its authority, while other lawsuits were filed by parties that said the agency didn’t go far enough.
“They’re stuck in the middle, trying to balance both viewpoints,” Buckley said. He expects the fallout from the final rules and the legal challenges to swirl.
In describing the need for the disclosures, the SEC said that an increasing number of retail and institutional investors have expressed a need for more detailed information on the effects of climate-related risks. Also, investors need more information regarding how companies will meet their publicly stated climate and net-zero goals.
“The final rules are a continuation of the Commission’s efforts to respond to investor need for more consistent, comparable, and reliable information about the financial effects of climate-related risks on a registrant’s business, as well as information about how the registrant manages those risks,” the SEC said.
The new SEC rules require registered companies to disclose climate-related risks that could impact business strategy, financial condition, or the results of their operations, as well as actual and potential impacts of climate-related risks on strategy, business model, and outlook. Companies must also describe material expenditures they have incurred as part of a strategy to mitigate or adapt to a material climate-related risk, including transition plans, scenario analyses, or internal carbon prices. Also required to be disclosed is any board of directors- or management-level oversight of climate-related risks, as well as any processes for identifying, assessing, and managing climate risks.
Other requirements of the rules are reporting of expenditures, charges, and costs from severe weather events such as hurricanes, tornadoes, flooding, drought, wildfire, extreme temperatures, and sea level rise. Costs related to carbon offsets and renewable energy credits must also be disclosed if they are used by companies to achieve climate-related goals.
Central to the case is the greenhouse gas (GHG) emissions reporting requirement, a protocol that is divided into Scope 1, Scope 2, and Scope 3 emissions. In the final rules, emissions reporting is required for Scope 1 (direct emissions from sources that are owned or controlled by the company) and Scope 2 (indirect emissions from the generation of purchased energy, including electricity, heat, or steam from a utility company or other supplier). But a proposed Scope 3 reporting requirement that was included in the proposed rule was dropped from the final rules. Scope 3 emissions include indirect emissions that occur in the value chain, including both upstream and downstream such as purchased goods and services, employee commuting, business travel, transportation and distribution, and waste generated in operations.
Organizations that opposed the Scope 3 reporting requirement in the proposed rule included the Edison Electric Institute (EEI) and the American Gas Association (AGA). In joint comments, they said that Scope 3 disclosures should only be required if a company has a Scope 3 emissions goal or target, and there should be very clear boundaries on the information that needs to be included. They also argued that the SEC should exempt from the final rules any companies that are consolidated subsidiaries of a parent company when the parent company’s climate-related disclosures encompass the subsidiaries.
“The Commission is asking for an unprecedented level of disclosure; the liability exposure needs to be adjusted to encourage good-faith disclosures of the unique information it would require. In order to further the Commission’s intent to increase the amount of climate-related information that is disclosed, there should be no increased risk exposure for disclosure made in good faith,” EEI and AGA said in their joint comments.
However, the two groups said they do not oppose the climate reporting requirements, calling them “an important step forward on GHG disclosure.”
Meanwhile, various courts are hearing challenges to the rule.
19 Democratic Attorneys General—including Massachusetts and the District of Columbia—worked in partnership to defend the climate rule in the 8th Circuit Court of Appeals in St. Louis, allowing them to intervene in the case, which consolidated more than nine lawsuits. Attorneys General Offices opposing the rule include Alabama, Alaska, Arkansas, Georgia, Idaho, Indiana, Iowa, Kentucky, Missouri, Montana, New Hampshire, Oklahoma, Nebraska, North Dakota, South Carolina, South Dakota, Tennessee, Utah, Virginia, West Virginia, and Wyoming. The 8th Circuit proceeding also consolidated petitions for review filed by the U.S. Chamber of Commerce and the Ohio Bureau of Workers’ Compensation.
In a separate legal tendril, at an April 30 hearing in the 5th Circuit Court of Appeals, where Texas, Louisiana, Utah, and West Virginia filed a petition for review of the SEC rules in February 2023, judges questioned appellant’s attorneys as to whether the rules would increase costs for states as they allege. Attorneys for the SEC argued that the parties lack standing in the 5th Circuit case because they do not have sovereignty on the issue. The judges at times seemed skeptical that reporting requirements would be overly onerous for companies, with a judge describing them as “cut and paste.”
Legal challenges to the rules rely on several legal precedents and laws, according to a blog post from the Harvard Law School Forum on Corporate Governance. These include a requirement under the Administrative Procedure Act that courts must generally set aside agency action that is an abuse of discretion, contrary to constitutional right, out of the agency’s jurisdiction, or issued without observance of procedure required by law. There is also the major questions doctrine, which holds that courts will presume that Congress does not delegate to executive agencies any questions of major political or economic significance, as well as the Chevron doctrine, which says courts should defer to an agency’s interpretation of an ambiguous statute. However, the Chevron doctrine is under review by the U.S. Supreme Court.
There has also been political pushback on the climate disclosure issues, as Sen. Tim Scott (R-S.C.) on April 17 introduced a Congressional Review Act resolution to overturn what he called the “radical” SEC rule, that he added “would bury public companies in paperwork, raise costs for consumers, and stifle economic opportunity.” Every Republican on the Senate Committee on Banking, Housing and Urban Affairs signed on to the resolution.
An important aspect of the rules, according to Buckley, is that the SEC still provides companies leeway in their disclosures to determine their own “materiality” thresholds. The U.S. Chamber of Commerce commented, however, that the new rules erode the reasonable investor standard of materiality and micromanage how companies make key determinations about materiality.
The traditional concept of materiality covers financial risks that could arise over the next quarter or the next year, but long-term impacts, including those that could come from climate change, are on much longer timelines. Investors also have different timelines, as some investors are also looking more for long-term value, Buckley said.
One issue with the rules is that there is a lot of estimation required in compliance and currently a lack of good data, which could lead to some inconsistency, Buckley said. But the rules will give investors an idea of what kind of carbon footprint a certain company has, even if the accuracy of the data is not perfect. The disclosures will lead to more qualitative information regarding companies’ efforts to reduce emissions than has been present before, he said.
There is also more data coming in on companies’ sustainability efforts every year, with utilities leading the way. In the order, the SEC discussed the historic filing of sustainability reports by companies belonging to the Russell 1000 Index, a stock market benchmark for large-capital investing in the U.S. equity market. In calendar year 2022, a record 90 percent of companies published sustainability reports, including climate-related information, up from 60 percent that made such disclosures in 2018. The number of companies in the bottom half of the Russell 1000 Index increased their sustainability reporting percentage from 34 percent in 2018 to 82 percent in 2022. The utility sector had the highest percentage of companies that published a sustainability report in 2021, at 100 percent. They were followed by materials (95 percent); energy (94 percent); consumer staples (91 percent); real estate (90 percent); industrials (89 percent); financials (85 percent); consumer discretionary (81 percent); information technology (71 percent); and health care (69 percent).
The SEC acknowledged in the rules that Scope 1 and Scope 2 emissions might not fully reflect a company’s exposure to transition risks because some of those risks could only be captured through other metrics, such as Scope 3 emissions. Companies that face similar exposure to emissions-related climate risks could report different Scope 2 emissions depending on whether they pay directly for their utilities (Scope 2), or utilities are included in leases (Scope 3), or whether they have employees that work from home and do not directly contribute to utility expenses. To account for these differences, the rules require disclosures on methodology, significant inputs, significant assumptions, organizational and operational boundaries, and reporting standards with respect to Scope 1 and 2 emissions.
“These disclosures will provide additional context to help investors understand the disclosures and will enable investors to draw more reliable comparisons across registrants,” the SEC said in the rules. The Commission ended up exempting Smaller Reporting Companies (SRCs) and Emerging Growth Companies (EGCs) from the GHG disclosure requirements to limit costs imposed on them and to avoid deterring these companies from conducting initial public offerings.
The SEC received more than 4,500 individual comments and 18,000 form letters on its proposed rules, from entities including academics, accounting and audit firms, individuals, industry groups, investment firms, non-governmental organizations, pension funds, climate advisors, state government officials and members of the U.S. Congress. Many commenters generally support the required disclosures, while others opposed them whole or in part. The SEC’s Investor Advisory Committee offered broad support and recommended certain modifications.
The Commission said that while climate-related issues are subject to other regulatory schemes, its objective was limited to advancing its mission to protect investors, maintain fair and efficient markets, “and not to address climate-related issues more generally.”
The SEC said it is agnostic about whether and how companies consider or manage climate-related risks, but investors have expressed a need for information regarding risks in valuing securities they hold or are considering purchasing.
Many commenters on the rules said the current, largely voluntary reporting of climate-related information under differing third-party frameworks is inadequate. The current, largely voluntary regime has led to selective choosing by companies of which climate-related risks to disclose and has not provided reliable and complete information to make good investment decisions. Adoption of mandatory climate-related disclosures would improve the timeliness, quality and reliability of climate-related information and lead to more accurate valuation of securities, the SEC said.
The SEC based the rules on the Task Force on Climate-Related Disclosures (TCFD) disclosure framework created by the Financial Stability Board, an international organization that monitors and makes recommendations on the global financial system. The TCFD consists of four key themes, including governance, strategy, risk management, and metrics and targets. Many investors are already familiar with the TCFD framework and are already making disclosures that are consistent with it, and using the framework should help mitigate the compliance burden.
Whatever happens with the legal challenges to the SEC rules, it is clear that the reporting of GHG emissions by companies is on the rise. This issue will likely increase in prominence in coming years as investors decide where to put their capital and see more information on assessing the risks of doing so.
—
All views expressed by the contributors are solely the contributors’ current views and do not reflect the views of Concentric Energy Advisors, Inc., its affiliates, subsidiaries, related companies, or clients. The contributors’ views are based upon information the contributors consider reliable at the time of publication. However, neither Concentric Energy Advisors, Inc., nor its affiliates, subsidiaries, and related companies warrant the information’s completeness or accuracy, and it should not be relied upon as such.