SEC’s Argument for Climate-Disclosure Rules Doomed to Fail

T he SEC argues that “materiality” matters in its proposed carbon-emissions disclosures for publicly traded companies. Materiality limits disclosures “to those matters to which there is a substantial likelihood that a reasonable investor would attach importance in determining whether to purchase the security registered.” This limitation requires the disclosures of public companies to be directed at informing potential investors of the firm-specific financial risk they would be taking on when investing in them.

Such a materiality requirement is impossible to reconcile with the SEC’s proposed emissions disclosures. The emissions disclosures include Scope 1, which covers emissions that come directly from sources owned by a company, and Scope 2, which covers indirect emissions from energy purchased and consumed by a company. The SEC half-heartedly tries to rationalize Scope 1 and Scope 2 disclosures as essential in providing investors with material information regarding a public company’s transition risk. That category of risk includes the increased operating and investment costs resulting from stricter climate-related regulations, reduced demand for carbon-intensive products, and the potential for stranded assets such as oil and gas reserves that will result from the world moving rapidly to net-zero carbon emissions.

According to the SEC, this rapid move to net-zero carbon emissions will result in companies with relatively high amounts of Scope 1 and 2 emissions being hit with declining cash flows, “either from greater costs of emissions or the need to scale back on high-emitting activities,” relative to other firms with lower emissions. Hence, such disclosures will be material information for investors.

However, as discussed in my prior National Review Capital Matters article and in the comment letter that James Copland (of the Manhattan Institute) and I wrote to the SEC, the problem with this argument is that it rests on the false premise that the world is rapidly moving to net-zero carbon emissions and therefore many companies will be faced with such risk. Yes, the world is making some progress in getting to net-zero, but the progress is frustratingly slow, not rapid. This makes Scope 1 and 2 disclosures, if finalized in their current form, non-material information for the investors of most public companies for many years to come.

The argument that Scope 3 emissions (all other indirect emissions generated in the providing of a company’s inputs by suppliers and those that result from the consumption and use of the company’s products) disclosures are based on a materiality standard is no easier to defend. As explained by SEC commissioner Hester Peirce in her statement explaining why she voted against the proposed rule, Scope 3 emissions disclosures will be, in practice, essentially mandatory for all public companies.

Her conclusion is based, in part, on the expansive definition of “investor” contained in the proposed rule. This definition includes non-investor stakeholders such as investment advisers to index funds who manage huge stock portfolios but have no direct financial interest in the public companies that make up these portfolios. These advisers will eagerly use Scope 3 emissions information produced through the efforts of their portfolio companies, efforts that they did not pay for, to create Environment, Social, and Governance (ESG) index funds that produce significantly higher management fees than plain-vanilla index funds. These are the interests that the SEC wants to protect when the proposed rule “admonishes companies that materiality doubts should ‘be resolved in favor of those the statute is designed to protect, namely investors.’”

But wait, there is more. According to Peirce’s understanding of the proposed rule, Scope 3 emissions would be deemed material if they amounted to 40 percent of a company’s total carbon emissions. But even if this arbitrary 40 percent mark is not reached, Scope 3 emissions may “still be material where Scope 3 represents a significant risk [e.g., transition risk], when a significant SEC investigation indicates that additional Scope 3 emissions will ultimately be required, or ‘if there is a substantial likelihood that a reasonable [investor] would consider it important.’” The latter point goes well beyond the bounds of a definition of materiality that is focused on firm-specific financial risk.

Peirce further observes that the proposed rule guides public companies to take the following approach to Scope 3 disclosures that further upends the materiality standard: “Even if a materiality analysis requires a determination of future impacts, [e.g., a transition risk yet to be realized], then both the probability of an event occurring and its magnitude should be considered. Even 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.” Finally, if a company “determines that its Scope 3 emissions are not material, and therefore not subject to disclosure, it may be useful to investors to understand the basis for that determination.”

All of these observations led Commissioner Peirce to conclude that the SEC seems to presume materiality for all Scope 3 emissions. The ultimate result is that Scope 3 disclosures are, for all intents and purposes, close to mandatory, something that will only be reinforced by a corporate counsel preferring (as they tend to do) to take a conservative approach.

Materiality is a critical component in identifying the statutory limitations of the SEC’s regulatory authority. For the SEC to continue to pretend that its proposed emissions disclosures are material information for investors means that these disclosures are doomed to be vacated by the D.C. Circuit Court of Appeals. It makes no sense for the SEC to take this approach.