The SEC Climate-disclosure rule — Review of Commissioner Peirce's Comments: Part 1

Nov 16, 2022

Note: This post has been divided into two parts. This is Part 1 — Part 2 is here.

In March 2022 the U.S. Securities and Exchange Commission (SEC) issued its proposed Climate-disclosure rule. Many people and organizations oppose the need for this rule. One of those people is Commissioner Peirce. On March 21, 2022 she provided the following statement to justify her decision (some detail has been removed to reduce the length of this post).

At various points I have inserted my own comments in italics.

Thank you, Chair Gensler. Many people have awaited this day with eager anticipation. I am not one of them. Contrary to the hopes of the eager anticipators, the proposal will not bring consistency, comparability, and reliability to company climate disclosures. The proposal, however, will undermine the existing regulatory framework that for many decades has undergirded consistent, comparable, and reliable company disclosures. We cannot make such fundamental changes to our disclosure regime without harming investors, the economy, and this agency. For that reason, I cannot support the proposal.

The three words consistent, comparable and reliable form the heart of the rule, so she is challenging the basic justification for the rule.

The proposal turns the disclosure regime on its head. Current SEC disclosure mandates are intended to provide investors with an accurate picture of the company’s present and prospective performance through managers’ own eyes. How are they thinking about the company? What opportunities and risks do the board and managers see? What are the material determinants of the company’s financial value? The proposal, by contrast, tells corporate managers how regulators, doing the bidding of an array of non-investor stakeholders, expect them to run their companies. It identifies a set of risks and opportunities—some perhaps real, others clearly theoretical—that managers should be considering and even suggests specific ways to mitigate those risks. It forces investors to view companies through the eyes of a vocal set of stakeholders, for whom a company’s climate reputation is of equal or greater importance than a company’s financial performance.

The rule does not create an environment where regulators tell a company’s management how it should be run. The rule merely requires that companies report on climate-related risks and opportunities. It specifically does not require that management take action to do with the information that it has reported.

As you have already heard, the proposal covers a lot of territory. It establishes a disclosure framework based, in large part, on the Task Force on Climate-Related Financial Disclosures (“TCFD”) Framework and the Greenhouse Gas Protocol. It requires disclosure of: climate-related risks; climate-related effects on strategy, business model, and outlook; board and management oversight of climate-related issues; processes for identifying, assessing, and managing climate risks; plans for transition; financial statement metrics related to climate; greenhouse gas (“GHG”) emissions; and climate targets and goals. It establishes a safe harbor for Scope 3 disclosures and an attestation requirement for large companies’ Scope 1 and 2 disclosures.

Some elements are missing, however, from this action-packed 534 pages:

A credible rationale for such a prescriptive framework when our existing disclosure requirements already capture material risks relating to climate change;
A materiality limitation;
A compelling explanation of how the proposal will generate comparable, consistent, and reliable disclosures;
An adequate statutory basis for the proposal;
A reasonable estimate of costs to companies; and
An honest reckoning with the consequences to investors, the economy, and this agency.

I will talk about each of these deficiencies in turn. My statement is rather lengthy, so I will turn my video off as I speak; by one estimate, doing so will reduce the carbon footprint of my presentation on this platform by 96 percent.

I. Existing rules already cover material climate risks.

Existing rules require companies to disclose material risks regardless of the source or cause of the risk. These existing requirements, like most of our disclosure mandates, are principles-based and thus elicit tailored information from companies. Rather than simply ticking off a preset checklist based on regulators’ prognostication of what should matter, companies have to think about what is financially material in their unique circumstances and disclose those matters to investors. Financial statements and their accompanying disclosure documents are intended to present an objective picture of a company’s financial situation.

Even under our current rules, climate-related information could be responsive to a number of existing disclosure requirements . . . Under these existing rules, companies already are disclosing matters such as the risk of wildfires to property, the risk of rising sea levels, the risk of rising temperatures, and the risk of climate-change legislation or regulation, when those risks are material the company’s financial situation. Similarly, issues like “[c]hanging demands of business partners” and “changing consumer . . . behavior” are certainly things all companies consider and disclose when they rise to the level of material risks.

Commissioner Peirce highlights an argument that is frequently made regarding this rule — if climate-related risks are a prominent concern, then they would be reported within the existing system. There is no need to create a separate climate category in the variety of reports that a company is already obliged to publish.

In 2010, the Commission issued guidance to help companies think about how to apply existing disclosure rules in the context of climate change. [10] And, last year, the Division of Corporation Finance, in a sample disclosure review comment letter, among other things, underscored the need for companies to apply existing disclosure requirements to climate risks and opportunities, as set forth in the 2010 guidance. [11] Since the 2010 guidance was issued, companies routinely disclose climate-related information in SEC filings under the current rules, and the Division of Corporation Finance has regularly evaluated such disclosures in filing reviews and issued comment letters only sparingly. [12] The Division has taken a more aggressive posture in its review of climate-related disclosures in the past year; it has issued comment letters on the subject at an increased rate; sought enhanced disclosure on a variety of issues, including a number of topics that appear in the proposal; and demanded the underlying materiality analysis. The companies’ responses are instructive: they generally have stated that the requested disclosures by SEC staff were largely immaterial and inappropriate for inclusion in SEC filings. These recent exchanges reveal that for many companies—including large manufacturers, retailers, and even insurance companies—issues like climate-related physical damage, so-called transition risks related to conjectural climate regulation and potential legislation, and expenditures related to climate change are not material. [13] Few of these exchanges resulted in agreements to provide enhanced disclosure, although one company—declaring that it “is providing this additional information not because it believes that such information is material” but out of the altruistic belief that “corporations should be good stewards of the environment”—assented to include more information in its proxy statement.

Her argument is that climate-related risks have not been shown to be material, and therefore do not need to be reported. This statement is surprising given the drastic climate changes that are already occurring, and that are bound to get worse in coming years.

Instead of being a one-size-fits-all prescriptive framework, the existing rules are rooted in the materiality principle. Depending on a company’s own facts and circumstances, existing disclosure requirements may pull in climate-related information. Over the years, however, many companies, responding to calls from various constituencies, have provided substantial amounts of information outside of their required SEC filings. For example, a lot of companies prepare sustainability reports and post them on their website. Rather than being geared toward investors, these sustainability reports have a much larger target audience of non-investor stakeholders, whose primary concern is something other than company financial performance. Because these reports are not directed toward investors, the information they contain is not limited to information that is material to the company’s financial value. The Commission proposes today to require companies to pull into Commission filings much of this non-investor-oriented information that is either immaterial or keyed to a distended notion of materiality that seems to turn on an embellished guess at how the company affects the environment.

The reference to the materiality principle builds on the earlier comments. Companies that are exposed to climate-related risks will already report on those risks if they feel that they could materially affect financial performance.

II. The proposed rule dispenses with materiality in some places and distorts it in others.

Some of the proposed disclosure requirements apply to all companies without a materiality qualifier, and others are governed by an expansive recasting of the materiality standard. Both of these approaches to determining what information should be disclosed are problematic because they depart from the generally applicable, time-tested materiality constraint on required disclosures.

Justice Thurgood Marshall described our existing materiality standard in TSC Industries v. Northway: [16] an item is material if there is a substantial likelihood that a reasonable investor would consider the information important in deciding how to vote or make an investment decision. The “reasonable investor” Justice Marshall referred to in TSC Industries is someone whose interest is in a financial return on an investment in the company making the disclosure. Thus, there is a clear link between materiality of information and its relevance to the financial return of an investment. [17]

The Commission proposes to mandate a set of climate disclosures that will be mandatory for all companies without regard for materiality. As I mentioned earlier, the comment letters that the Division of Corporation Finance issued over the past year foreshadowed this development. The staff pressed companies to include in their SEC filings disclosures that they make in their sustainability reports, but many companies responded that the information was immaterial and therefore need not be included. [18] The proposal would sweep in much of this information without any materiality nexus. For example, the proposed rules require all companies to disclose all Scope 1 and 2 greenhouse gas emissions, and the financial metrics do not have a materiality qualifier.

The Commission justifies its disclosure mandates in part as a response to the needs of investors with diversified portfolios, who “do not necessarily consider risk and return of a particular security in isolation but also in terms of the security’s effect on the portfolio as a whole, which requires comparable data across registrants.” [19] Not only does this justification depart from the Commission’s traditional company-specific approach to disclosure, but it suggests that it is appropriate for shareholders of the disclosing company to subsidize other investors’ portfolio analysis. How could a company’s management possibly be expected to prepare disclosure to satisfy the informational demands of all the company’s investors, each with her own idiosyncratic portfolio? The limiting principle of such an approach is unclear.

Even where materiality thresholds exist, the proposal tweaks materiality. The Commission obliquely admits that it is playing a little fast and loose with materiality, but assures us that the “materiality determination that a registrant would be required to make regarding climate-related risks under the proposed rules is similar to what is required when preparing the MD&A section in a registration statement or annual report.” [20] Similarity is in the eye of the beholder, and so is materiality if it is decoupled from its financial context, as the proposal seeks to do—just try asking an investor in the company and a climate activist what each finds material about a company’s business. You might not get the same answer. The proposal, unlike a standard MD&A materiality determination, requires short-, medium-, and long-term assessments of materiality to account for “the dynamic nature of climate-related risks.” [21] Moreover, the proposal would seek to get behind these materiality determinations by requiring disclosure of how the company “determines the materiality of climate-related risks, including how it assesses the potential size and scope of any identified climate-related risk.” [22] As the proposal acknowledges, assessing the present materiality of potential consequences of ongoing and future climate change will be difficult, but have no fear, “climate consulting firms are available to assist registrants in making this determination.” [23] Score one for the climate industrial complex!

With respect to Scope 3 greenhouse gas emission [24] disclosures, the Commission also maintains the fiction that it is not departing from the materiality standard. Under the proposal, a company, unless it is a smaller reporting company, would have to disclose Scope 3 emissions, but only if the company has set an emissions reduction target that includes Scope 3 emissions or if those emissions are material. The materiality limitation is not especially helpful because the Commission suggests that such emissions generally are material [25] and admonishes companies that materiality doubts should “‘be resolved in favor of those the statute is designed to protect,’ namely investors.” [26] That admonition does not work as the Supreme Court intended it when “investors” are redefined to mean “stakeholders,” for whom the cost of collecting and disclosing information is irrelevant. The release offers without explicitly endorsing a possible quantitative metric (40% of a company’s total GHG emissions) at which Scope 3 emissions might well be material, [27] but then layers on a hazy qualitative test: “where Scope 3 represents a significant risk, is subject to significant regulatory focus, or ‘if there is a substantial likelihood that a reasonable [investor] would consider it important.’” [28] The Commission also reminds companies that “[e]ven if the probability of an adverse consequence is relatively low, if the magnitude of loss or liability is high, then the information in question may still be material.” [29] Further deterring omission of Scope 3 data, the release says, “it may be useful [for investors of companies that do omit Scope 3 emissions for lack of materiality] to understand the basis for that determination.” [30] Likewise, if a company “determines that certain categories of Scope 3 emissions are material, [it] should consider disclosing why other categories are not material.” [31] In sum, the Commission seems to presume materiality for Scope 3 emissions.

The Scope 3 materiality confusion stems in part from the fact that Scope 3 emissions reflect not the direct activities of the company making the disclosure, but the actions of the company’s suppliers and consumers. As the proposal recognizes, “a registrant’s material Scope 3 emissions is a relatively new type of metric, based largely on third-party data, that we have not previously required.” [32] A company’s Scope 3 emissions are based on what third parties do either in contributing to the company’s creation, processing, or transport of its products or when using and disposing of the company’s products. [33] Admittedly, a company’s choices about things like what products to produce and which suppliers and distributors to use affect its Scope 3 numbers, but Scope 3 data is really about what other people do. The reporting company’s long-term financial value is only tenuously at best connected to such third party emissions. Hence, the Commission’s distorted materiality analysis for Scope 3 disclosures departs significantly from the “reasonable investor” contemplated by Justice Marshall.

III. The proposal will not lead to comparable, consistent, and reliable disclosures.

The proposal optimistically posits that mandatory disclosure of reams of climate information will ensure that all companies disclose comparable, consistent, and reliable climate information in their SEC filings. The proposal does not just demand information about the company making the disclosures; it also directs companies to speculate about the habits of their suppliers, customers, and employees; changing climate policies, regulations, and legislation; technological innovations and adaptations; and changing weather patterns. Wanting to bring clarity in an area where there has been a lot of confusion and greenwashing is understandable, but the release mistakenly assumes that quantification can generate clarity even when the required data are, in large part, highly unreliable. Requiring companies to put these faulty quantitative analyses in an official filing will further enhance their apparent reliability, while in fact leaving investors worse off, as Commission-mandated disclosures will lull them into thinking that they understand companies’ emissions better than they actually do.

Another area where the proposal will mandate disclosure of information that appears useful but that likely will be entirely unreliable involves physical risks tied to climate change. Establishing a causal link between physical phenomena occurring at a particular time and place and climate change is, at best, an exceedingly difficult task. Disclosures on the physical risk side will require companies to select a climate model and adapt it to assess the effects of climate change on the specific physical locations of their operations, as well as on the locations of their suppliers and customers. This undertaking is enormous. [34] It will entail stacking speculation on assumptions. It will require reliance on third-parties and an array of experts who will employ their own assumptions, speculations, and models. How could the results of such an exercise be reliable, let alone comparable across companies or even consistent over time within the same company? Nevertheless they will appear so to investors and stakeholders.

Required disclosures of so-called transition risks also present these challenges. The proposal defines “transition risks” broadly as:

the actual or potential negative impacts on a registrant’s consolidated financial statements, business operations, or value chains attributable to regulatory, technological, and market changes to address the mitigation of, or adaptation to, climate-related risks, such as increased costs attributable to changes in law or policy, reduced market demand for carbon-intensive products leading to decreased prices or profits for such products, the devaluation or abandonment of assets, risk of legal liability and litigation defense costs, competitive pressures associated with the adoption of new technologies, reputational impacts (including those stemming from a registrant’s customers or business counterparties) that might trigger changes to market behavior, consumer preferences or behavior, and registrant behavior. [35]

Transition risk can derive from potential changes in markets, technology, law, or the more nebulous “policy,” which companies will have to analyze across multiple jurisdictions and all across their “value chains.” These transition assessments are rooted in prophecies of coming governmental and market action, but experience teaches us that such prophecies often do not come to fruition. Markets and technology are inherently unpredictable. Domestic legislative efforts in this context have failed for decades, [36] and international agreements, like the Paris Accords, have seen the United States in and out and back in again. [37] How could this proposal thus elicit comparable, consistent, and reliable disclosure on these topics?

IV. The Commission lacks authority to propose this rule.

This proposal exceeds the Commission’s statutory limits. Congress gave us an important mission—protecting investors, facilitating capital formation, and fostering fair, orderly, and efficient markets—and granted us sufficient regulatory authority to achieve that mission. Effective execution of that mission forms the basis for healthy capital markets and, in turn, a healthy economy. Congress, however, did not give us plenary authority over the economy and did not authorize us to adopt rules that are not consistent with applicable constitutional limitations. This proposal steps outside our statutory limits by using the disclosure framework to achieve objectives that are not ours to pursue and by pursuing those objectives by means of disclosure mandates that may not comport with First Amendment limitations on compelled speech.

All the disclosure mandates we adopt under authority granted to us by Congress are at bottom compelled speech, and this one in particular prescribes specific content for the speech that it mandates. The Supreme Court has made clear that corporations do enjoy protections under the First Amendment’s freedom of speech clause, but also has concluded that the government is subject to lesser scrutiny—and therefore has greater leeway—when requiring companies to disclose “purely factual and uncontroversial information.” [38] For this reason, our disclosure mandates are at their strongest when there is a clear and indisputable connection between the factual information to be disclosed and our three-part mission.

Attempting to establish that essential connection, the Commission points to “significant investor demand for information about how climate conditions may impact their investments.” [39] Large asset managers—who are paid to invest other people’s money [40]—some institutional investors, and some retail investors have been vocal proponents of climate change disclosures. But why are they asking? If they are asking for information to help them assess the financial value of companies in which they are considering investing, this information may be material and is likely covered by existing disclosure rules. But many calls for enhanced climate disclosure are motivated not by an interest in financial returns from an investment in a particular company, but by deep concerns about the climate or, sometimes, superficial concerns expressed to garner goodwill. [41]

The fact that retail and institutional investors and asset managers have myriad motivations when making investing decisions and by extension therefore might want different categories of information necessarily means that we cannot adopt a disclosure regime that provides all information desired by all investors and asset managers. Indeed, we have been cautioned against disclosure requirements so sweeping that they “simply . . . bury the shareholders in an avalanche of trivial information.” [42] We have in the past achieved the necessary balance between mandating enough but not too much information by focusing on what information is material to an objectively reasonable investor in her capacity as an investor in the company supplying the information seeking a financial return on her investment in the company.

Focusing on information that is material to a company’s value proposition not only serves as a key mechanism to winnow out needless volumes of information, but also keeps us from exceeding the bounds of our statutory authorization. The further afield we are from financial materiality, the more probable it is that we have exceeded our statutory authority. One commentator argues that the rationales relied on by the Commission here—that the “Commission has broad authority to promulgate disclosure requirements that are ‘necessary or appropriate in the public interest or for the protection of investors’” [43] or that “promote efficiency, competition, and capital formation” [44]—cannot justify disclosure mandates that lie outside the “subject-matter boundaries” Congress imposed on it. [45] Indeed, in the rare instances when Congress has wanted us to go beyond those subject-matter boundaries, it has told us to do so. [46] We do not have a clear directive from Congress, and we ought not wade blithely into decisions of such vast economic and political significance as those touched on by today’s proposal.

Other scholars similarly have raised serious and fundamental questions regarding our authority to mandate climate-related disclosures in the manner proposed here. A proper understanding and application of our materiality standard is essential. Professor Sean Griffith contends that First Amendment jurisprudence suggests that the SEC cannot compel disclosures of the type proposed today. He proposes that to determine whether a particular mandated disclosure is uncontroversial, one should look to the degree that it is consistent with the language and objectives of the statute authorizing the mandate. If there is a clear and logical connection between disclosing the information and achieving the objectives of the statute, then it likely is uncontroversial; however, if disclosing the information is unrelated, or only tangentially related, to the statutory objectives, then it likely is controversial. [47] The objective of Congress’s instruction for us to regulate in the public interest and for the protection of investors is to protect investors in their pursuit of returns on their investments, not in other capacities. For this reason, to qualify as uncontroversial and thereby stay within First Amendment bounds, our disclosure mandates must be limited to information that is material to the prospect of financial returns. In Professor Griffith’s view, disclosures of information material to financial returns are uncontroversial because the quest for financial returns is the common goal that unites all investors. Their other individualized goals—whether ameliorating climate change, encouraging better labor relations, pursuing better treatment of animals, protecting abortion rights, or any other number of issues—are material for purposes of our disclosure regime only to the extent they relate to the financial value of the company.

The Commission today proposes to require companies to disclose information that may not be material to them and recasts materiality to encompass information that investors want based on interests other than their financial interest in the company doing the disclosing. We would do well to heed the admonition of the Supreme Court in a case involving the agency Congress charged with regulating the environment:

When an agency claims to discover in a long-extant statute an unheralded power to regulate “a significant portion of the American economy,” we typically greet its announcement with a measure of skepticism. We expect Congress to speak clearly if it wishes to assign to an agency decisions of vast “economic and political significance.” [48]