May 20th, 2022
Sharon Lee
Sharon Lee is a senior in the College of Arts and Sciences studying Political Science with a minor in Environmental Studies. In addition to studying political and environmental risk management, she participated in the Risk Center’s Undergraduate Fellowship this year and gained exposure to important risk management, climate mitigation, and adaptation concepts and leaders.
This article provides updates to an earlier blog post, Status Update: Climate Action & the SEC (2021) on the Securities and Exchange Commission’s Chairman Gary Gensler commitment to focus on climate-related disclosures. We revise that analysis based on a newly proposed rule change in March 2022.
For background on mandatory and voluntary climate disclosures, read the Wharton Risk Center’s April 2021 primer, Understanding U.S. Climate Risk Disclosures.
On March 21, 2022, almost exactly a year after SEC Chairman Gary Gensler was confirmed on his commitment to focus on climate-related disclosure, the SEC proposed a rule to enhance and standardize climate-related disclosures for investors. This article explores the background of climate-related disclosures, the implications of the proposed rule change, and perspectives on its efficacy.
Current Lack of Standardization in Firm’s Disclosures
Although many companies voluntarily report ESG (Environment, Social and Governance) disclosures, there is a lack of standardization and therefore discrepancy. For example, Ford Motor currently reports the total emissions of all its vehicles, including the emissions from its production factories and the fuel used by its vehicles. However, its competitor, Tesla, reports only the emissions generated in creating a single model of Tesla vehicles: the Model 3. Such discrepancies and the resulting lack of data transparency make it difficult for investors to effectively utilize climate-risk data to make investment decisions. As a result of such shortcomings, ESG data providers – such as MSCI – publish research based on a variety of sources (e.g. press releases, political contributions, etc.) to provide some transparency of firms’ ESG risks and opportunities to investors. Despite the progress achieved by such ESG data providers, Professor of Management Witold Henisz points to a deep-rooted issue in which voluntary compliance leads to partial and selective reporting, which in turn results in the data limitations that currently pose as great impediment to investors.
“Were the U.S. and EU to mandate disclosure [of material climate risks and mitigation strategies], investors and creditors would have comparable information on firms’ exposure and mitigation strategies to the material risks of climate change. Greater transparency in the magnitude of risks and opportunities would lead to improved allocation of financial and human capital seeking only financial returns as well as the growing pools of such capital seeking to contribute to climate risk mitigation and adaptation.” – Deloitte & Touche Professor of Management, Director of Wharton Political Risk Lab, Founder of ESG Analytics Lab, Prof. Witold Henisz.
SEC rules under the Securities Act of 1933 and the Securities Exchange Act of 1934 currently require that public companies in the U.S. publish disclosures about their financial performance and risk management. The rule change proposed in March of 2022 would add the requirement for all public companies to provide climate-related disclosures, making a currently voluntary disclosure into a required one.
“I am pleased to support today’s proposal because, if adopted, it would provide investors with consistent, comparable, and decision-useful information for making their investment decisions, and it would provide consistent and clear reporting obligations for issuers.” – SEC Chair Gary Gensler.
This proposed rule change would require the disclosure of the following:
(1) The registrant’s governance of climate-related risks and risk management processes
(2) How climate-related risks identified by the registrant have had or are likely to have a material impact on its businesses and financial statements, short- or long-term
(3) How identified climate-related risks have affected or are likely to affect the registrant’s strategy, business model, and outlook
(4) The impact of climate-related events and transition activities on the registrant’s financial statements, including on the estimates and assumptions used in said financial statements.
(5) Information about its direct and indirect greenhouse gas emissions
Perspectives on the Rule Change
To some experts, this rule change represents an ineffective regulatory burden on public firms that is outside of the SEC’s domain. In October of 2021, the Financial Economists Roundtable (FER) released a statement arguing that mandating the disclosure of a firm’s impacts on environmental outcomes is outside the SEC’s statutory mandate and expertise of financial disclosures. The FER argued that the SEC should limit its disclosure requirement to matters that directly affect a firm’s cash flows on its 10-K (the comprehensive financial report required annually from publicly-traded firms by the SEC), and the inclusion of information about raters, the factors used, and weights on factors in issuer filings of ESG ratings.
The FER further recommends that the SEC oversee the development of a glossary of terms related to ESG, following the example set by other agencies, such as the Environmental Protection Agency’s (EPA) “vocabulary catalog.” The clarification of terms, the FER argues, leaves less room for managerial discretion in disclosure and thereby decreases the ability of companies to leverage unclear terms to their advantage.
In an interview, Dr. Catherine Schrand, a signatory of the FER statement and the Celia Z. Moh Professor of Accounting at Wharton, further described that the 5th requirement of the proposed rule – the requirement of greenhouse gas emissions disclosures – would place a disproportionate burden on firms. She described that if such disclosures – beyond those that impact cash flow – become a part of the 10-K, investors would benefit at the cost of the firms. If this data is included on the 10-K, the data is very easy to aggregate, whereas the current system of various third party ratings make it more challenging to aggregate the data; thus, the 5th requirement of the proposed rule would move the burden from the investors to the firms. However, given the impacts of placing the burden on firms as described in the FER statement – for example, firms being disincentivized from going public because of increased costs – Dr. Schrand expressed her belief that firms should not have to take on such substantial costs to make investors’ analysis easier; in the long run, the costs may outweigh the benefits.
Concerns about disincentivizing firms from being publicly-listed is notable with respect to the declining trend of publicly-listed companies throughout the past two decades. Some pundits worry that burdensome and costly regulations have hindered companies from going public, and have thereby limited average (that is, non-institutional) investors’ access to lucrative investment opportunities. However, it is also worth noting that experts disagree as to whether the decline is indicative of a deep-rooted issue plaguing the markets, or if it is a normal part of the markets’ ebb and flow. Moreover, despite significant decreases from the public-listing peak of the mid-1990s, trends have stayed relatively stable since 2010.
Other entities view the SEC rulemaking as a positive step. The Center for American Progress (CAP) has consistently published reports about the need for the SEC to take action, and argues that the SEC has the authority to require ESG disclosures. Under the Securities Act of 1933 and the Securities Exchange Act of 1934, the SEC has regulatory authority to require disclosures that are appropriate for the public interest or for the protection of investors. CAP, in advocating for the SEC’s authority to require ESG disclosures, emphasizes that the existing legislation does not limit the SEC’s authority to requiring only disclosures of materiality. Thus, CAP argues that in order to fulfill its responsibility to adequately protect investors, the SEC should require ESG disclosures in order to equip investors with access to relevant information that is imperative to their investment decision-making processes. Additionally, CAP argues that the SEC can further pursue its duty to ensure “fair, orderly, and efficient capital markets” and facilitate capital formation by requiring disclosures, because such disclosures are used not only by investors but also by financial regulators that work to fight systemic risk.
Moreover, CAP argues that the SEC could go further, by requiring companies to disclose their Scope 3 Emissions, which the current rule change leaves to the discretion of the firm. Scope 3 Emissions are a broad category that include emissions that occur upstream and downstream from the value chain, including employees, supplies, and consumers. CAP argues that without disclosure of Scope 3 Emissions –often the largest category of emissions associated with a firm – the holistic risk is hidden from investors and essentially makes many firm’s net-zero goals unobtainable. CAP refers to the United Kingdom’s requirement for certain companies to disclose information about Scope 3 Emissions and their commitment to expand upon such requirements in the future. Moreover, they argue that if the U.S. fails to follow the UK’s example, those who invest in U.S. companies will be disadvantaged in the competitive marketplace.
Focus on the inclusion of Scope 3 Emissions is shared by Ceres, an investment advocacy non-profit corporation. In a June 2021 letter to the SEC, Ceres argued that in order to comprehensively capture risks posed by greenhouse gas emissions, mandatory disclosures must include Scope 3 Emissions. Ceres also advocated for industry-specific disclosure requirements that effectively capture important climate risks specific to certain industries (for example, industries that directly contribute to deforestation). In support of the recently proposed rule, president of Ceres and former regional administrator for the EPA, Mindy S. Lubber stated that the proposed rule would enable investors and firms to better address “climate-related financial risks across investment portfolios and global supply chains.”
Conclusion
Questions about the SEC’s jurisdiction and the role it should – or should not – play in the realm of climate change have become more relevant than ever before. The arguments outlined above are not centered around anti- and pro-climate disclosure perspectives, but rather the question of whether the SEC has the authority to require such disclosures. The 60-day public comment period ends on May 20, 2022, through which Chairman Gensler promised that the SEC would earnestly consider public comments before enacting a rule. If the proposal is codified into law, the rule would be enacted in the 2023 fiscal year and firms will have to get to work.