Better information leads to better decisions – this is the idea behind the regulatory device known as “mandated disclosure.” Mandated disclosures are all around you – from calorie counts on fast food restaurant menus to conversations with doctors around informed consent. But the biggest experiment yet in mandated disclosure is the U.S. Securities and Exchange Commission (“SEC”)’s proposal to extend these ideas to climate impacts facing U.S.-listed companies and require uniform climate disclosures.
The SEC’s proposed disclosure rules, which the regulator released in late March, would require publicly traded companies to release information to investors about their emissions and how they are managing risks related to climate change and future climate regulations. Largely in response to investors clamoring for more information about climate risks, as well as pressure from green groups that believe disclosure will drive climate-conscious investing, SEC Chair Gary Gensler announced in 2021 that the commission would use its statutory authority to require climate-related disclosures.
While it is easy to spot risks facing companies like ExxonMobil, which produces and sells fossil fuels that contribute to global warming, more hidden vulnerabilities exist for businesses across the U.S. economy. Here is what you need to know about climate disclosures and some of the challenges the SEC faces in adopting them.
What investors want to know
Investor pressure for better information about climate impacts comes from two directions. First, some investors want to avoid companies that will be most affected by climate change. A company’s products may be regulated in the future because of their impact on the climate, for instance, or its supply chains may get more expensive over time. Investors want to know which businesses will be able to adapt and preserve profitability.
Second, many investors are interested in ESG investing, which involves assessing companies’ commitments to environmental, social and governance factors. Today, ESG investing accounts for $17.1 trillion – or 1 in 3 dollars – of the total U.S. assets under professional management. The challenge for the SEC is to ensure that claims being made about the sustainability of a company are based on reality.
The trend toward ESG investment has led to an outpouring of voluntary disclosure: About 90 percent of companies in the S&P 500 voluntarily publish reports disclosing statistics on things like carbon emissions and how much renewable energy they use. Meanwhile, some large investors – and certain governments – require disclosure. For example, BlackRock, a multinational asset manager with around $10 trillion under its control, requires companies it invests in to disclose certain climate information. The United Kingdom plans to implement rules requiring climate disclosures starting in April 2022, and the European Union has reporting rules in place.
But the U.S. has been slow to impose mandatory climate disclosure requirements. Public companies have only been subject to a more general legal standard that they not materially mislead investors. The SEC released guidance in 2010 to encourage climate disclosures, but it has not been enforced and has failed to prompt standardized disclosures.
Rule benders & the effectiveness of climate disclosure
Research on the broader use of mandated disclosure, such as for home mortgage lending and consumer product labeling, shows that crafting effective disclosure regulations is difficult. One reason is that the companies can easily evade disclosing useful information while still complying with the letter of the law, and these “rule benders” can be very creative. Consider the restaurant in New York City that was subject to a health inspection grading regulation and managed to disguise its “B” rating by simply adding “EST” to its display of its grade. Disclosure regulations can also fail when they don’t effectively communicate valuable information.
A study of one type of climate disclosure – emissions labels on consumer products – found mixed evidence as to whether consumers altered their behavior in response. Rule benders can exploit human tendencies to discount or filter out warnings by providing an avalanche of unnecessary information that confuses and overwhelms the intended recipient.
Expect court challenges
One challenge the SEC has grappled with is whether it has statutory authority to require companies to disclose their “Scope 3” emissions – or emissions that a company does not directly control, such as emissions from the use of its products or emissions that come by way of its supply chain. A company like Amazon, for example, may have extensive upstream Scope 3 emissions in its suppliers’ transportation networks. General Motors would have extensive downstream emissions when people drive its gas-powered vehicles.
The SEC’s three Democratic commissioners, who make up a majority of the commission, have reportedly split on whether certain Scope 3 emissions can be viewed as “material” to investors and therefore subject to disclosure. “Material” is defined as information that a reasonable person would consider important in making an investment decision.
Some critics of climate disclosures, including several Republican state attorneys general, suggest that the SEC has no authority to require disclosures that are not financially material. Missouri’s attorney general wrote that requiring climate reporting would impose “large costs and administrative burdens” on publicly traded companies. A group of senators suggested greenhouse gas-related assets would shift to private companies. West Virginia’s attorney general threatened to sue the SEC. At the same time, critics note that the costs of disclosure would vary. Some companies already intensely monitor emissions. Others would likely face high costs if Scope 3 emissions were included. An oil company, for one, might have to measure emissions from all the vehicles using its fuel.
The Administrative Procedure Act allows courts to vacate SEC rules that are deemed arbitrary or capricious because the agency failed to offer sufficient justification for choosing the proposal over alternatives. The SEC is acutely aware of this risk. A prior oil and gas extraction disclosure rule was invalidated by a court in 2013 as arbitrary and capricious.
The SEC’s proposed climate risk disclosure rules, the public comment period for which the regulator recently extended by almost a month, will not be the final effort to use information to shape the private sector’s response to climate change. What the SEC does will affect those future moves, which is likely why it took its time and is proceeding cautiously.
Daniel E. Walters is an Assistant Professor of Law at Penn State. William M. Manson is a Law Student at Penn State. (This article was initially published by The Conversation.)
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