To Survive Legal Challenges, SEC Must Remove Scope 3 From Sustainability Reporting Rule

Gary Gensler, chairman of the US Securities and Exchange Commission (SEC), center, during a meeting … [+] at the SEC headquarters in Washington, DC, US, on Wednesday, Dec, 13, 2023. Photographer: Samuel Corum/Bloomberg

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The U.S. Securities and Exchange Commission is poised to adopt the much-anticipated Climate Related Disclosure Standards, most likely in March. According to reports, the SEC has chosen to drop the mandatory Scope 3 reporting requirement relating to greenhouse gas emissions within a business’ supply chain. Doing so drastically increases the likelihood that the new rule will withstand the inevitable legal challenges, although success is not certain.

Initially proposed in March 2022, the CRDS is part of a global framework of sustainability reporting standards. While the final rule is not yet public, the draft rule adopts three levels of reporting of GHG. Generally, Scope 1 focuses on the direct GHG emissions of the company and Scope 2 reports GHG emissions of the energy providers used by the company. Scope 3 focuses on GHG emissions along the supply chain, including those of private companies who sell to publicly traded companies, and of the end consumer.

The most controversial points are Scope 3 and Regulation S-X. Regulation S-X, also referred to as the footnote requirement, will require companies to amend their previous years disclosures via a footnote, to take into consideration severe weather events and the costs of transition to sustainability.

The development of the CRDS closely parallels the development of the European Union’s Corporate Sustainability Reporting Directive. Proposed in April 2021, the CSRD increases existing reporting requirements for businesses operating in the EU. The proposed directive replaced the existing Non-Financial Reporting Directive, greatly expanding the scope of the reporting and the number of impacted businesses. The new reporting requirements go beyond traditional financial reporting to include environmental, social, and governance actions of businesses.

Simultaneously, the International Sustainability Standards Board drafted the International Financial Reporting Standards Foundation Sustainability Disclosure Standards. IFRS is an independent, nonprofit organization that develops financial reporting standards, including international accounting standards.

Released in June 2023, the IFRS Standards were adopted by the ISSB as the global standard for sustainability and climate change reporting, including greenhouse gas emissions. IFRS is not used in the U.S., who uses generally accepted accounting principles, also known as GAAP, but is used in 132 jurisdictions including EU member states. The environmental ESRS are designed to work alongside and incorporate the IFRS Standards.

Unlike the EU, which has the authority to regulate publicly and privately held businesses of all sizes, the SEC only has the authority to regulate publicly traded companies. In the U.S.,the regulation of privately held companies is generally managed by the states. This creates a legal problem when it comes to Scope 3 reporting, as it requires publicly traded companies to seek out information from privately held companies. This creates an indirect regulation of privately held companies, who are clearly outside the SEC’s regulatory authority.

According to Reuters, the final draft of the CRDS being circulated among SEC commissioners removes the mandatory Scope 3 requirements. The official text of the final rule has not been made public, so the details are unclear. However, I continue to suspect that the SEC workaround will be to make Scope 3 optional, with each company making their own decision if the disclosure is material. Materiality is based on the company’s decision as to whether something is relevant to the investors. This leaves the company with wide discretion. However, it will become required if the company makes a public commitment relating to Scope 3 emissions.

The SEC is aware that any CRDS rule will face both legal and political challenges. At a presentation to the U.S. Chamber of Commerce in October 2023, SEC Chair Gary Gensler joking asked if they were going to serve him with litigation papers during the meeting. This consideration is clearly a factor in the decision making process, especially as it relates to Scope 3.

Any reduction in the Scope 3 reporting requirement will inevitably upset sustainability reporting advocates who view the EU standard as what the SEC should adopt. However, it is my personal legal opinion that the SEC has no alternative. Including mandatory Scope 3 is a legal Achilles heel.

Additionally, the legal challenges Gensler alluded to will be more than just Scope 3. There are valid legal questions as to whether the SEC even has the delegated authority to draft the regulation, or if it requires an act of Congress. While Gensler asserts the SEC has the authority, it will inevitably be decided by the Court. Given that the current Supreme Court of the United States has adopted a very textualist approach as it relates to the delegated authority of administrative agencies, pressure is high on the SEC to get it right.

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