PRIMER: SEC Climate-Related Disclosures for Investors
IFLR’s latest explainer looks at the Commission’s proposal on climate disclosures for issuers, for which the comment period will end on June 17
Ever since their release in March this year, the Securities and Exchange Commission’s (SEC) proposed rules to enhance and standardise climate-related disclosures for investors have sparked much debate – sometimes, even fury – among market participants.
In this primer, IFLR considers the overarching goal of the disclosures, who they cover, what the proposal looks like, which aspects have caused the most controversy, the potential for litigation around the final rules, and what market participants should expect in the coming months.
On March 21, the SEC proposed a series of rules which, if adopted, would mandate enhanced climate-related disclosures by public companies. Companies would, for instance, need to provide detailed reporting of their climate-related risks, emissions, and net-zero transition plans.
The overarching goal of the proposal is to ensure that investors are receiving information about climate risks and greenhouse gas emissions that is consistent, comparable, and reliable.
“The SEC has a concern – and a very legitimate one – that as ESG-based investing becomes more and more of a focus, investors will make their investment decisions based on information that is inconsistent and unreliable,” said Justin Cooke, partner at A&O. “The current state of the market isn't favourable to investors, because they are being marketed products whose merits it is very difficult to analyse from an ESG perspective.”
While the SEC’s role is not to tell issuers whether a particular investment is a good one, it is, however, to ensure that investors have the information they need to make investment decisions.
"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,” said SEC chair Gary Gensler upon the proposals’ release. “Today, investors representing literally tens of trillions of dollars support climate-related disclosures because they recognise that climate risks can pose significant financial risks to companies, and investors need reliable information about climate risks to make informed investment decisions.” This proposal, Gensler added, would help issuers more efficiently and effectively disclose risks and meet investor demand, and is therefore driven by the needs of both investors and issuers.
The disclosures also come in the context of international standards for ESG and climate disclosures being developed, with the launch of the International Sustainability Standards Board (ISSB) at COP26 last year – whose mission is to develop a comprehensive global baseline of sustainability disclosures for capital markets. Shortly after the SEC released its proposal, ISSB launched a consultation on its first proposed standards through the publication of two exposure drafts – one of which set out general sustainability-related disclosures requirements, and the other climate-related ones. The exposure drafts also built upon the recommendations of the Task Force on Climate-Related Financial Disclosures (TCFD).
“The ISSB exposure drafts are out, the SEC is consulting on its proposals for corporate-level disclosures, and the EU is consulting on its own green regulations,” said Ashley Alder, board chair at the International Organisation of Securities Commissions (IOSCO), which is currently reviewing ISSB’s proposals. “What we want to avoid is having three standards that are so different and require disclosures that aren’t comparable, and that larger corporates operating cross-border have to deal and comply with three competing standards. That would be the worst outcome, which is why we need an interoperable global baseline.”
What do public companies need to disclose?
If adopted in their proposed form, the SEC rules would require public companies to include certain climate-related disclosures in their registration statements and periodic reports, including information about climate-related risks that are reasonably likely to have a material impact on their business, results of operations, and financial condition. The required information about climate-related risks would also include disclosure of a company’s greenhouse gas emissions – a now commonly used metric to assess exposure to such risks.
“One of the most noteworthy elements is the proposed change to the information required in audited financial statements, for which compliance would be a very significant undertaking for companies,” said Christina Thomas, partner at Mayer Brown. “It would be a totally new disclosure requirement and would be labour-intensive.” Another important change, Thomas continued, would be the requirement for discussion of a company's board oversight and management of climate risks, which would require a level of detail about corporate governance and day-to-day management currently not required in any other context. “This goes far beyond any other discussion that a company typically provides about interactions between its board of directors and its management,” she added.
In an explanatory note, White & Case has broken down the proposed disclosure requirements in six categories: the impact of climate risk on business and financials; the effect of climate risks on strategy, business model and outlook; governance disclosure; risk management disclosure; financial statement metrics; and scope 1, 2 and 3 greenhouse gas emissions. For context, scope 1 covers direct emissions from a company’s owned or controlled sources; scope 2 covers indirect emissions from the generation of purchased electricity, steam, heating and colling consumed by the company; and scope 3 includes all other indirect emissions occurring in the company’s value chain.
“Items one through 10 in terms of priority are – greenhouse gas emissions, greenhouse gas emissions, greenhouse gas emissions,” said Cooke. “Beyond that, there are effectively four buckets. The first one is the disclosure of climate-related risks and their impacts, where the proposal goes beyond what most issuers have been doing for the last five years. The second is corporate governance and risk management: these are new requirements that are disclosure-based. They're not prescriptive and do not mandate any changes, but they're clearly intended to provide a strong push for issuers to implement a climate-oriented corporate governance framework at the board and management levels.”
Cooke described the third bucket as climate-related impacts to financial statements. “This will require issuers to include a footnote in their financial statements that discloses, among other things, impacts that extreme weather and other natural conditions have had on specific line items, as well expenditures made to mitigate climate-related risks or as part of transition plans,” he explained. “It's a bit unusual, but conceptually, issuers should be able to wrap their head around it.”
The fourth bucket – which many agree will be the most challenging for issuers – is greenhouse gas emissions. “By far and away, this is the most onerous, costly and controversial requirement in the proposal from the perspective of issuers,” said Cooke. “For scope 2 disclosure, registrants will have to rely on third parties to tell them how much greenhouse gas emissions have resulted from the energy they purchase.” Smaller issuers will likely bear the greatest impact and will be most burdened by the costs incurred by this requirement, Cooke explained, as they are less likely than larger companies to have the systems, personnel and internal expertise needed to comply with it.
“Ultimately, legal counsel and other experts will be needed to help navigate the complexity of any final rules, and internal teams will need to be coordinated to facilitate the provision and validation of the required information,” White & Case wrote in its note. “In the interim, companies should evaluate their existing governance and risk management around climate-risk and progress, thinking about how their current climate-related disclosures may be transferrable to their SEC filings.”
Has there been market pushback?
Although market views on the proposal won’t be entirely clear until the comment period ends, the proposed rules have already sparked much debate and drawn severe criticism from some stakeholders.
“Even though the ultimate implementation date of the rules is uncertain, the amount of work needed to be ready to make these types of filings – even for large, sophisticated companies – is tremendous,” said Margaret Peloso, partner at Vinson & Elkins. “We are seeing a lot of demand from clients who are looking to understand how the proposed requirements align with existing disclosures in their practices, so that they can start to map out what it will take to be ready.”
Recent reports also show that some companies are already ramping up their ESG specialist teams and are testing new technology to prepare for compliance.
Two elements recur when it comes to pushing back against the proposed rules: the costs they incur, and their mandatory character. While making certain rules compulsory might be more commonplace in European markets, this is perceived more negatively in the US, where the preferred regulatory approach is typically market-based, as opposed to rules-based.
“These are very different than our prior disclosure rules: because they’re so prescriptive, they seem to be intended to change the way companies do things – which is troubling for a regulatory agency that’s supposed to be about disclosures,” said SEC Commissioner Hester Peirce, who has often expressed disagreement with chair Gensler’s approach. “This rulemaking tries very hard to make the case that these climate disclosures, which are very extensive, are all tied to financial returns. In reality, it falls short of doing so: it really is designed to change the function of disclosures, which is problematic.”
While climate disclosures for public companies were previously done through sustainability reports, they will now be made through SEC filings – another likely point of contention, according to Peirce. “SEC enforcement actions could result from that, but also private litigation, so the stakes are much higher: people will need to spend much more to prepare this information,” she added.
Overall, the proposal has been perceived as controversial by many, with some interested parties viewing it as costly, overly burdensome and prescriptive, and too divergent from the existing materiality-based disclosure regime. However, according to White & Case, while critics are also focused on the appropriateness of extensive SEC regulations in this area without authorising legislation, others view the proposal as a necessary next step in addressing climate change risk and impacts.
Will it lead to litigation?
Several sources pre-empt that litigation could result from the rules if they are applied in their proposed form – at company level, but also against the regulator.
“When we think about the differences between the US and other markets, there is a direct right of action in the US: we have by far the most aggressive and sophisticated securities plaintiff bar of any jurisdiction in the world,” said Cooke. “It is a foregone conclusion that whatever rule the SEC adopts, there will be court challenges to it, and that many issuers will be embroiled in litigation over the nature, extent and accuracy of these disclosures.”
These could include securities class actions against issuers and financial intermediaries, such as underwriters, for alleged misstatements or omissions from the disclosures.
“You can also imagine challenges based on whether the proposal exceeds the SEC's authority under the Securities and Exchange Act, or claims that the SEC has failed to properly consider the costs associated with the implementation of the rules for issuers, and that these costs dramatically outweigh the benefits,” Cooke added. “We've even heard rumblings about potential constitutional claims that some of the rules compel speech in a way that's unconstitutional. We can't say at this stage whether any such cases would be successful, but it’s important to understand that this could be enormously costly for the industry.” Other stakeholders also anticipated extensive exchanges following the comment period, with a wide array of opinions on perceived limits of the proposal and on whether they represent a regulatory overreach by the SEC.
Is there anything missing in the proposal?
Although on paper, the SEC’s overarching goal to better protect and inform investors is a noble one, there are some caveats to its proposal.
“It's important to keep in mind that this is not a holistic ESG framework, but it is an attempt to give investors much more uniform information to make investment decisions that relate to climate impact,” said Cooke. “More consistency is needed, but inconsistencies will remain. The SEC’s proposal is narrowly focused on climate, and specifically greenhouse gas emissions: within the ESG framework, it ultimately gets to one part. Much of the ‘E’ has been left out and so has most of the ‘S’, while the ‘G’ is only incidentally impacted by the requirements for governance-related disclosures.”
The SEC proposal should also be placed in the wider context of green finance initiatives – or lack thereof – being developed in other parts of the market.
“This proposal applies only to SEC registrants, so a huge part of the US market isn’t covered – for example, a private company that is not an SEC registrant doesn't need to produce any of this information,” said Cooke. “This could create disparities for anti-competitive dynamics between corporate issuers that are SEC registrants and those who aren’t and could give companies strong incentives not to become SEC registrants.”
In addition, there is little clarity at this stage over how consistent the final SEC rules would be with existing climate disclosures standards in other parts of the world – including the UK and the EU.
What are the next steps?
The comment period on the proposed rules was recently extended from late May to June 17, which has given the market more time to digest them and give feedback.
“Now that the SEC has extended the comment deadline, it’s time to review the list of top points for comment,” Cleary Gottlieb said in a statement. “Moderating the proposal in key respects will – far from weakening it – make it more likely to achieve the Commission’s long-term purposes of eliciting useful and consistent disclosures. Ideally, the rules would contribute to developing coherent climate disclosure practices around the world – not just for US reporting companies and not just under SEC rules.”
Given the urgency of climate action and the fast-approaching mid-term elections in the US, the SEC is expected to move fast once the comment period closes.
“I expect the SEC to adopt a final rule as soon as it can, and I do expect the rule as adopted to be highly consistent with the existing proposal,” said Cooke. “Market participants should not assume that the final rule will be significantly less onerous than the rule proposed, and accordingly, they should start thinking about planning for compliance while we await the final rule.”