The Securities and Exchange Commission (SEC), founded during the lows of the Great Depression, has traditionally aimed to protect investors. However, some SEC rules and guidance provide an incentive for good corporate citizenship—beyond shareholder returns and fraud prevention—by requiring public companies to disclose certain information that could subject them to criticism and accountability.

SEC regulation along these lines serves a demand for what is known as “publicness“. In 2012, the SEC adopted a rule requiring public companies to disclose their use of conflict minerals originating in the Democratic Republic of the Congo or adjoining countries, which could damage their reputations by associating them with human rights violations. This rule was mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act, which was passed in the aftermath of the Great Recession. However, this part of the Act was struck down in a 2015 case called National Association of Manufacturers v. SEC.

In recent years, climate change has come into focus as a topic for public disclosure by American companies. On March 21 of this year, the SEC proposed new rules requiring registered public companies to disclose climate-related risks that are “reasonably likely to have a material impact on their business, results of operations, or financial condition.” The rules also require registrants to provide climate-related financial statement metrics and to disclose their greenhouse gas emissions. While investors may find this information useful in deciding whether to invest, the proposed rules would also put a spotlight on what public companies are doing about the climate.

Why Is The SEC Regulating Climate-Related Risk Disclosures?

Some public companies already release climate-related information of their own accord, but the new rules would provide consistent and comparable information for investors about climate risks and clear reporting obligations for registrants. The rules could also help investment managers guide individual and institutional customers who care about the environment towards investments that align more with their values. For example, many universities with large endowments have agreed to divest from fossil fuel companies and invest more sustainably following protests by students.

Large asset managers and institutional investors are increasingly influential players in corporate governance because of a long-term trend towards passive investing. They have voiced increasing concerns that public companies do not provide enough disclosure about environmental, social, and governance (ESG) concerns, and have been seeking to create indexes of sustainable companies. The proposed rules respond to this demand.

SEC Chair Gary Gensler said in a recent statement:

“Our core bargain from the 1930s is that investors get to decide which risks to take, as long as public companies provide full and fair disclosure and are truthful in those disclosures. That principle applies equally to our environmental-related disclosures, which date back to the 1970s. Today, investors representing literally tens of trillions of dollars support climate-related disclosures because they recognize that climate risks can pose significant financial risks to companies, and investors need reliable information about climate risks to make informed investment decisions.”

Disclosure of Greenhouse Gas Emissions

Greenhouse gas emissions are an increasingly common metric for measuring companies’ exposure to climate-related risks, including regulatory, technological, and market risks. The scope of the proposed rules build on existing climate reporting standards and encompasses the disclosure of three categories of information on emissions:

• Scope 1 requires a registrant to disclose metrics on its direct greenhouse gas emissions.
• Scope 2 requires a registrant to disclose indirect emissions which result from purchased electricity or other forms of energy.
• Scope 3 requires registrants to disclose metrics on the greenhouse gas emissions of “upstream participants” (e.g., suppliers) and “downstream participants” (e.g., customers) in the registrants’ value chain.

Gensler noted that Scope 3 requirements in particular may be necessary “to present investors a complete picture of the climate-related risks—particularly transition risks—that a registrant faces and how [greenhouse gas] emissions from sources in its value chain…may materially impact a registrant’s business operations and associated financial performance.”

However, not all companies need to disclose Scope 3 information. Scope 3 information is only required if it is “material to investors” or if the registrant itself has set a target for emissions which includes Scope 3 emissions. Additionally, Scope 3 information is not required from smaller reporting companies. The phase-in period for Scope 3 information reporting is a year longer than that of Scope 1 and Scope 2 and would not take effect until 2024 at the earliest. Finally, companies are protected from liability for Scope 3 information through a safe harbor provision, unless the disclosure is made without a reasonable basis or not in good faith.

Scope 3 requirements are likely to attract controversy during the public comment period (the longer of 30 days after publication in the Federal Register or 60 days after the date of issuance and publication on SEC’s website) and beyond. Companies may argue that it is difficult to supervise the emissions of other participants in their value chain and that these reporting requirements are especially burdensome and ambiguous. They may further argue that their companies’ long-term financial value does not accurately depend on emissions far removed from their own operations.

What Is A “Material” Climate-Related Risk?

Investors seeking to understand the full extent of a company’s climate-related risk may still be frustrated by a broad and unclear standard for what companies should consider “material” under the proposed rules. The standard for “materiality” was laid out in the 1988 case Basic Inc. v. Levinson. SCOTUS explained that information is material if “there is a substantial likelihood that a reasonable shareholder would consider it important” or would view it as having significantly altered the “total mix” of information made available.

The proposed rules require that registrants disclose how their company determines the materiality, size, and scope of climate-related risks. In its 1976 opinion TSC Industries, Inc. v. Northway, Inc., SCOTUS established that doubts about materiality should be resolved in favor of disclosure.  This pro-disclosure standard would also apply to climate-related risk disclosure under the proposed rules.

In a statement opposing the new proposed rules, SEC Commissioner Hester M. Peirce argued that companies are already required to disclose climate-related risks to their financial performance under the existing standard of materiality and reporting requirements:

“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’ [predictions] of what should matter, companies have to think about what is financially material in their unique circumstances and disclose those matters to investors.”

However, under existing rules, companies and their officers may be wary of voluntarily providing substantive climate-related risk information. Forecasting the effect of the risk is difficult. Misleading statements in SEC reports can lead to liability. But establishing disclosure rules for all public companies could make disclosure more straightforward for those who want to make a commitment to sustainability, and could lessen greenwashing.

Will the New Rules Be Effective?

On the other hand, a one-size-fits-all approach to climate disclosure would result in measuring companies in vastly different industries using the same metrics. This may not be a realistic solution due to the fact that different industries may tend to contribute very different rates of pollution due to the unique nature of their logistics. For example, a steel company may use the most up-to-date environmental practices in its foundry but still rate as a heavy emitter compared to a tech company working out of an office.

If the concerns of investors, companies, regulators, and the public are not adequately addressed during the comment period, the proposed rules could cause companies to search for loopholes, which ultimately would undermine the effectiveness of the disclosures and hurt financial returns for retail investors. Private companies may choose not to go public due to the regulatory burdens and unwelcome attention on climate issues that these proposed rules could give them. Public companies may sell off their less environmentally-friendly assets to private companies, who could continue to operate them. This would accelerate a trend towards public markets shrinking while private markets for “unicorn” companies with their own individual reporting standards grow in prominence. But seeing as most Americans investors only have access to public companies, this trend would mean significant changes for markets.