Securities and Exchange Commission Chair Gary Gensler on Wednesday will hold a vote on one of his most controversial proposals: a rule that would require corporate America to disclose material risks posed by climate change.
President Joe Biden said climate risk is an “existential threat” and that it posed a greater risk than nuclear war.
The climate disclosure rule was first proposed in March 2022. When it was proposed, Gensler said, “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.”
“Today’s proposal would help issuers more efficiently and effectively disclose these risks and meet investor demand, as many issuers already seek to do,” he added.
The final proposal has not yet been released.
When the initial proposal was made in 2022, it would have required disclosure in three categories: Scope 1, which is direct emissions the company produces through its sources; Scope 2, which is indirect emissions, such as from generation of energy; and Scope 3, which is emissions from their supply chains and users of their products.
The Scope 3 disclosure requirements have drawn strong criticism from many corporations, who claim the regulations are too burdensome. Reuters has reported that the Scope 3 disclosure requirements will be dropped in the final proposal, and that parts of the Scope 1 and 2 disclosure requirements have been softened.
Proposal generates record number of comments
Gensler said the SEC has received over 15,000 comment letters on its proposal, the most ever received for a single proposal. While many argue that the proposal is another example of government overreach, others insist that the SEC has long required publicly traded companies to disclose information that indicates risks they may face.
“Throughout its history, the SEC has repeatedly required disclosure of information that, while not financial on its face, is nevertheless relevant to investors’ assessment of a registrant’s future financial prospects,” a letter jointly submitted to the SEC from The Institute for Policy Integrity at New York University School of Law and the Environmental Defense Fund stated.
Several companies submitted letters that were generally supportive of the SEC’s efforts.
Supporters say corporate America already reports much of this data and this would systemize the reporting.
Walmart, for example, said, “We wholeheartedly support the Commission’s objective of facilitating the disclosure of consistent, comparable, and reliable information on climate change and other environmental, social, and governance (ESG) topics,” Kathleen McLaughlin, executive vice president and chief sustainability officer of Walmart, wrote.
She noted that “Walmart has been reporting climate-related information for 15 years and on certain other ESG issues for longer.”
Get ready for lawsuits
Still, parts of the proposed rule, particularly Scope 3, is facing considerable opposition from the business community, which argues that there is too much disclosure required, and from Republicans who claim that it is another example of government overreach and a backdoor means to push a climate change agenda.
Depending on the scope of the final disclosure requirements, the SEC may face an avalanche of litigation from corporate America.
One likely path for litigation is to sue under the Administrative Procedure Act, which outlines the rulemaking procedures federal agencies need to follow.
A critical standard outlined in the APA is the “arbitrary and capricious” standard, which requires that the actions of any federal agency should be based on some connections between the facts found and the regulation that is created.
It requires the agency to consider all relevant factors, such as costs, and to consider input from those who would be affected by the actions.
In this case, corporations will likely argue that the SEC failed to establish there was a problem that needed regulatory action, or didn’t properly do a cost/benefit analysis to assess the impact on corporations, or didn’t properly account for public views.
A Supreme Court case opens another litigation avenue
In 2022, in West Virginia v. EPA, the Supreme Court ruled that there are limits on a regulator’s powers. In that case, the Court relied on the “major questions doctrine,” which holds that Congress has not delegated issues of major significance to regulatory agencies.
Any agency must be able to point to a clear statement from Congress authorizing its action.
That case related to the Clean Air Act and the ability of the EPA to regulate carbon dioxide emissions. Since Congress has not passed major climate legislation for years, opponents of the SEC’s climate rule will likely sue the SEC and cite West Virginia v. EPA, again arguing that Congress has not granted specific authority for the SEC to act on climate change.
What’s it mean for corporate America?
Even if a scaled-back proposal is approved, it will mean more regulation, and a lot more paperwork, for publicly traded companies.
Corporate America will face: 1) increased costs, 2) increased activism and 3) increased litigation risk. There will be a new cottage industry around advising and consulting on climate change, just like there is now for cybersecurity.
Why increased litigation risk? “If the disclosure is wrong, they can get sued by the SEC,” one industry observer, who asked to remain anonymous in order to speak candidly, told me. “Even if it is right, the disclosures will be used by activists complaining corporate America is not doing enough on climate change.”
The ETF community is watching carefully
The Exchange Traded Funds community is watching the vote closely, because the proposal will provide much more data on climate issues that can be incorporated into environmental, social and governance ETFs.
Arne Noack, DWS head of systemic investment solutions for the Americas, which runs the Xtrackers S&P 500 ESG ETF (SNPE) and the Xtrackers MSCI USA Climate Action Equity ETF (USCA), noted that much of corporate America already reports data emissions.
“The emissions data we have on S&P 500 companies is already pretty good,” Noack told me. “It’s either self-reported or we have external data.”
Still, Noack is supportive of the new rule.
“The better the data quality, the better the data we have for ESG strategies, and the better we can make the portfolios,” he said. “We live in a world where emissions are high, and the ambition is they get lower. To get there, certain things need to happen, but the key is data. If we don’t know what the data is, we have to estimate.”
A few years ago, ESG ETFs were all the rage. But that early enthusiasm has cooled dramatically.
There have been outflows from most ESG funds, and several have shuttered, victims of: 1) investor uncertainty over how to define and measure ESG, 2) high fees and 3) political controversy.
The fuzziness of ESG has attracted the interest of the SEC.
Last year, the SEC amended its “Name Rule” to require that 80% of a fund’s portfolio be held in assets that reflect the fund’s name. The proposal came about because of concern that ESG funds were charging higher fees for what appeared to be specialized stock picking but in reality just mimicked index funds.
The disclosures required from the proposed SEC rule may shuffle the deck on companies that are considered “green” or “not so green.”
If there are funds that contain companies that activists say are not so green based on their disclosures, those funds will surely get criticism for why they are charging so much money for these funds that don’t reflect ESG principles.
“This will further politicize ESG investing,” Todd Sohn, ETF and technical strategist at Strategas, who follows the ETF business, told me. “A lot of ESG products will get hung out to dry if many of their holdings are revealed to actual be unfit for the portfolio – based on whatever they disclose.”
Arne Noack, manager of the Xtrackers S&P 500 ESG ETF and DWS Head of Systemic Investment Solutions for the Americas, will be the guest on ETF Edge at 1:10 p.m. ET Monday. He’ll be joined by Dave Nadig, formerly financial futurist at Vettafi. ETFedge.cnbc.com.
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