Why did the SEC issue a climate risk disclosure rule?
Climate change creates financial risk for companies
As the impacts of climate change accelerate, companies face new and growing risks. Companies must confront the physical impacts of climate change such as worsening natural disasters from hazardous flooding and dangerous heatwaves. They must also adapt to changing consumer preferences and a shifting regulatory landscape as states and countries take steps to reduce greenhouse gas emissions. These climate-related risks create financial risks for companies and for their investors. In a 2019 survey, CDP, an international nonprofit focused on environmental disclosure, found that 215 of the largest global companies faced nearly $1 trillion in risk from climate impacts.
Investors are demanding more reliable climate risk information
How a company plans for and responds to climate risks affects financial performance[1] and investors are demanding clearer and more comprehensive information to make informed decisions. For example, over 4,000 investment firms managing over $120 trillion in assets support the United Nations-sponsored Principles for Responsible Investment. These signatories, including BlackRock, Vanguard, State Street, and other major US asset managers, commit to incorporating environmental, social, and governance (ESG) issues, including climate risk, into investment analysis and seeking disclosure from the companies in which they invest.
Current reporting on climate risk is inadequate
While a growing number of companies seek to address climate change risk through voluntary reporting, this information is often inconsistent and fragmented.[2] The Governance and Accountability Institute reported that 70 percent of companies in the Russell 1000 published sustainability reports in 2020, yet 86 percent of institutional investors surveyed in 2021 were skeptical about companies’ ability to deliver on their sustainability goals. Investors are calling for standardized reporting requirements to enhance the comparability, reliability, and transparency of this information.[3]
SEC is responding to investor demand for decision-useful risk information
The Securities and Exchange Commission (SEC) recently proposed requirements for companies to disclose information about climate-related risks – such as drought, wildfires, or market shifts – that are likely to have an impact on their business, as well as climate goals or planning processes that the company has developed in response to climate risks. Companies would also report their greenhouse gas emissions. The SEC’s goal for this rule is to provide “consistent, comparable, and reliable – and therefore decision-useful – information to investors.”[4] The proposed rule is open for comment until June 17.
What’s in the proposed rule?
The SEC’s proposed rule would require standardized climate-related information in statements and reports to the commission. The commission designed the disclosure requirements to help investors assess risk. The content of the disclosures, which draw from the Task Force on Climate-Related Financial Disclosure,[5] include:
- The oversight and governance of climate-related risks by the company’s board and management;
- How climate-related risks, including known risks and risks that are reasonably likely to have a material impact on the business or consolidated financial statements, may affect the business in the short, medium or long term;
- How climate-related risks have shaped or are likely to affect the company’s strategy, business model, and outlook;
- The company’s processes for identifying, assessing, and managing climate risks and how those processes fit into overall risk management; and
- The impact of climate-related events (g., severe weather) and transition activities (e.g., policy changes) on the line items of the company’s consolidated financial statements and on its financial estimates and assumptions used in the financial statements.
The rule would also allow, but not require, companies to disclose information about climate-related opportunities. Additionally, companies that have set climate-related targets or undertaken climate planning, including a transition plan or scenario analysis, would need to provide information about those planning processes.
The proposed rule would also require companies to disclose greenhouse gas emissions metrics, informed by the widely used Greenhouse Gas Protocol, including:
- Scope 1 and 2 emissions metrics both by disaggregated constituent greenhouse gases and in the aggregate, reported in absolute and intensity terms; and
- Scope 3 emissions and intensity if material, or if the company has set an emissions target that includes Scope 3 emissions, with some exceptions.
The SEC’s fact sheet about the rule is available here.
The proposed rule is consistent with SEC’s legal authority
It is consistent with the SEC’s authority to require companies to disclose information that is necessary for protecting investors, including information about a company’s climate risks and related planning. The Securities Act and the Securities and Exchange Act authorize the SEC to require disclosures that are “necessary or appropriate in the public interest or for the protection of investors.”[6] Along with investor protection, the SEC is tasked with “promot[ing] efficiency, competition, and capital formation.”[7]
In proposing this rule, the SEC explains that it is responding to “investor need [for] information about climate-related risks” that “have present financial consequences.”[8] This proposed rule relies on the SEC’s well-established authority to require disclosures to ensure that investors have the information they need to make sound decisions.
The SEC’s proposal builds on past disclosure requirements to meet the growing financial risks posed by climate change now and in years to come. This rule is grounded in the SEC’s past work on risk disclosure in the environmental realm, starting with the disclosure of risk factors related to environmental law compliance in 1971[9] and including its 2010 interpretive guidance on climate-related risk disclosure.[10] The proposal incorporates extensive public comments on climate disclosure that the commission received in response to its 2021 Request for Input on climate risk disclosure, in which 70 percent of investor commenters called for disclosure in alignment with the TCFD and 65 percent of investor commenters called for reporting on Scope 1, 2, and 3 emissions.[11]
The proposed rule also reflects how the state of the law has changed as investors demand more detailed disclosure on climate risks and opportunities, a trend that EELP analysis has examined.[12] Since the formation of the TCFD in 2015, we have seen an increasing focus on climate change. A growing number of companies disclose at least some material climate risk information in their SEC filings since information not specifically requested by the SEC may nonetheless be material if “necessary to make the required statement, in the light of the circumstances . . . not misleading.”[13] The rule is grounded in the traditional definition of materiality and Supreme Court case law, and it is also bolstered by the ongoing evolution of the information investors demand.
What’s ahead for the proposed rule?
The SEC has crafted this proposed rule to respond to investor demand while creating flexibility for companies. Companies must report the climate risks they are tracking in a more standardized, comparable way. If companies use a tool for climate risk management, they will need to show their work, but the proposed rule would not require a company to undertake any specific climate-risk planning or use a specific methodology.
Many investors and companies have voiced support for the proposed rule, which incorporates extensive input from a range of stakeholders in response to the 2021 Request for Input to guide rulemaking. The ever-evolving SEC disclosure regime is responsive to investor concerns and supporters point to the rule as an appropriate next step that is well within the bounds of the SEC’s statutory mandate.[14]
At the same time, opponents of the proposed rule are lining up to challenge it. They raise many concerns, including questioning the scope of the SEC’s statutory authority, contending that the disclosures run afoul of the First Amendment, and pointing to the major questions doctrine, which the Supreme Court has increasingly relied on to strike down agency rules.[15]
There are practical considerations to the proposed rule as well. Increased climate reporting may have the effect of integrating climate risk into companies’ planning and operations to make companies more resilient in the long term. At the same time, the proposed rule raises questions about the possible chilling effect of increased company disclosure on ambitious net zero plans and the new expertise required within companies and at consulting and accounting firms to complete these filings.
Despite these criticisms, the proposed rule is designed to be consistent with the SEC’s statutory authority and is necessary to protect investors. It follows the SEC’s traditional disclosure framework by requiring information from companies about how they respond to and plan for climate impacts but does not require companies to take any actions to address identified climate risk. The greenhouse gas disclosures in the rule provide investors with data to support their analysis of financial risk related to climate change. Scope 3 emissions, in particular, would provide information about the risks embedded in a company’s value chain that investors have demanded to know.
While some have urged the SEC to require Scope 3 emissions disclosure for all companies, the SEC’s proposed approach would require Scope 3 emissions disclosure only if a company’s Scope 3 emissions are material or if a company’s climate targets include Scope 3. In determining materiality, the SEC explains that companies should consider whether Scope 3 emissions are a “relatively significant portion” of their GHG emissions or pose a “significant risk,” either of which would make them important for investment decisions.[16] The SEC further explains that industries are facing transition risk from changing laws, new financial institution requirements, or a shift to low-emission technologies and that investors want to know about a company’s exposure to this risk. The commission notes that Scope 3 emissions are likely to be material for the auto industry and oil and gas sector, for example.[17] Critics have argued that the complexity of Scope 3 accounting creates a burden for reporting companies, but the SEC has built in accommodations including a safe harbor provision, an exemption for smaller reporting companies and GHG methodology flexibility.
To support the SEC’s finalization of the rule, the commission has asked investors to comment on what climate risk information they need to make investment and voting decisions, how they will use the proposed disclosures in decision-making, and whether the proposed disclosures hit the mark. The commission has asked public companies to share information about how they make disclosure decisions, what investors are already asking for on climate risk, and what the economic impact of this additional disclosure might be. Along with these key areas, the SEC posed 201 specific questions on which it is seeking input. This input from commenters can help further bolster the rule’s effectiveness and legal durability.
The commission will continue to refine the rule based on comments from public companies, investors, and others and anticipates finalizing the rule as early as the end of 2022 with disclosures starting in 2024.
[1] See Financial Stability Oversight Council, Report on Climate-Related Financial Risk (2021), https://home.treasury.gov/system/files/261/FSOC-Climate-Report.pdf.
[2] See, for example, Parker Bolstad, Sadie Frank, Eric Gesick, and David Victor, Flying Blind: What do investors really know about climate change risks in the U.S. equity and municipal debt markets?, Hutchins Center at Brookings Working Paper 67 (2020), https://www.brookings.edu/wp-content/uploads/2020/09/WP67_Victor-et-al.pdf.
[3] See, for example, BlackRock Letter to SEC re: Request for Input on Climate Change Disclosure (2021), https://www.sec.gov/comments/climate-disclosure/cll12-8906794-244146.pdf; State Street Letter to SEC re: Request for Input on Climate Change Disclosures (2021), https://www.sec.gov/comments/climate-disclosure/cll12-8914407-244702.pdf.
[4] Securities and Exchange Commission, The Enhancement and Standardization of Climate-Related Disclosures for Investors (2022) (“SEC Proposed Rule”), https://www.sec.gov/rules/proposed/2022/33-11042.pdf.
[5] Many companies recommended adopting the framework established by the Task Force on Climate-related Financial Disclosure, including Adobe; Alphabet Inc., bp, Chevron, ConocoPhilips, and Walmart.
[6] 15 U.S.C. 77g; 15 U.S.C. 78l, 78m, 78o.
[7] 15 U.S.C. 77b(b); 15 U.S.C. 78c(f).
[8] See SEC Proposed Rule at 9.
[9] See SEC Release No. 33-5170 (1971).
[10] Securities and Exchange Commission, Commission Guidance Regarding Disclosure Related to Climate Change (2010), https://www.sec.gov/rules/interp/2010/33-9106.pdf.
[11] See Ceres, Briefing on Climate Risk Disclosure Rule (2022), https://www.youtube.com/watch?v=Zq9G_Nhvi5M.
[12] EELP analysis has shown that we are entering a new era in climate-related disclosure in which the expectations of a reasonable investor that underpin the materiality standard have evolved. See Hana Vizcarra, Entering a New Era in Climate-Related Disclosure and Financial Risk Management in the U.S (2021), http://eelp.law.harvard.edu/wp-content/uploads/Vizcarra-ALI2021-ClimateFinanceRiskOutlook.pdf.
[13] 17 C.F.R. §230.408(a) (2019). According to Bloomberg Law analysis, the number of S&P 500 companies referencing climate change or GHG as risk factors in their 10-K filing with the SEC increased from roughly 60 companies in 2019 to 220 companies in 2020. See Andrew Romanas and Jacob Rund, Climate Change Risks Surge in Companies’ Annual Reports to SEC (2021), https://news.bloomberglaw.com/securities-law/climate-change-risks-surge-in-companies-annual-reports-to-sec.
[14] See, for example, Ceres, Get Ready for Mandatory Climate Disclosures (2022), https://ceres.org/sec.
[15] Dissenting SEC Commissioner Hester Peirce’s comments on the proposed rule captures many of the common critiques. See SEC Commissioner Hester Peirce, We are Not the Securities and Environment Commission – At Least Not Yet (2022), https://www.sec.gov/news/statement/peirce-climate-disclosure-20220321.
[16] SEC Proposed Rule at 165-166. Note that for some sectors, Scope 3 emissions represent the majority of GHG emissions. For example, S&P Global data found that Scope 3 emissions made up 75% of the power sector’s total emissions in 2019. See Brandon Mulder and Kate Winston, US power utilities begin adding Scope 3 emissions to climate goals, S&P Global Commodity Insights (2022), https://www.spglobal.com/commodityinsights/en/market-insights/latest-news/natural-gas/032922-feature-us-power-utilities-begin-adding-scope-3-emissions-to-climate-goals.
[17] SEC Proposed Rule at 165.