George a. Mocsary & John p. Anderson
In May 2021, President Joseph Biden issued his “Executive Order on Climate-Related Financial Risk.” According to the order, the “intensifying impacts of climate change present physical risk to . . . publicly traded securities” due to “extreme weather.” In addition, the order explains that the “global shift away from carbon-intensive energy sources [through increased regulation also] presents transition risk to many companies.” To address these risks, Biden directed Secretary of the Treasury, Janet Yellen, to issue a report discussing, among other things, “the necessity of any actions to enhance climate-related disclosures by regulated entities.”
Even before Biden’s order was issued, in March 2021, then Acting Securities and Exchange Commission (SEC) Chair, Allison Herren Lee signaled that the SEC was poised to move forward with increased climate change disclosure mandates by announcing the formation of an “Enforcement Task Force Focused on Climate and ESG Issues” and by issuing a call for public comments on Climate Change Disclosures.
The SEC’s new Chair, Gary Gensler, has continued to prioritize climate change disclosures. Gensler recently stated that “[w]hen it comes to climate risk disclosures, investors are raising their hands and asking for more.” Accordingly, Gensler asked his staff to prepare recommendations on a comprehensive new mandatory climate-change disclosure rule. There appear to be two overarching goals driving enhanced climate disclosure proposals. First, to advise current and prospective investors of previously undisclosed physical and transitional climate-related risks through a reliable, consistent, and comparable mandatory disclosure regime. Second, to structure the disclosure requirements to highlight “bad actors” and incentivize changes in the climate-related behavior of publicly traded companies.
But regulators and the investing public are not uniform in their support of increased climate change disclosure. Two of the five SEC Commissioners have suggested that increased mandatory disclosure in this area may be unnecessary. In addition, securities-law scholars like Stephen Bainbridge and Paul and Julia Mahoney have expressed concern over the costs of a new climate-disclosure regime, and skepticism over the claim that climate disclosures are important to Main Street investors. So, despite the Biden administration’s making new climate change disclosure rules a priority, it is far from certain that this push will (or should) result in actual changes to the law.
In the midst of such uncertainty, and with so much at stake, it seems wise to engage in honest discourse about the wisdom of mandatory climate-related disclosures for publicly traded companies. The following questions thus present themselves: (1) Are the goals behind the proposed reforms worthy and appropriate for an SEC disclosure regime (the mission of which is to maintain efficient markets and facilitate capital formation)? (2) Can these goals be accomplished under the existing regime? (3) What would a new disclosure requirement cost, both directly and indirectly? (4) Would any benefits from increased disclosure outweigh those costs? In what follows, we look to advance this discussion by offering some thoughts concerning each of these questions.
Existing Disclosure Requirements
In a 2010 interpretation of Regulation S-K, a set of disclosure rules applying broadly across the securities laws, the SEC discussed several provisions under which climate change issues would have to be disclosed if they became serious enough. Three of these provisions are especially salient. Most importantly, Item 105 (formerly Item 503(c)) requires the disclosure of risks that significantly impact investors’ valuation of the company. These disclosures are issuer-specific. Risks attendant on the market as a whole need not be disclosed; investors are presumably already aware of such broad market risk.
Item 101 of Reg. S-K requires that issuers disclose the material effects on their business of complying with federal, state, and local laws relating to environmental discharge. The disclosures must include effects on capital expenditures, earnings, and competitive position for the current and all future periods in which the effect is expected to be felt.
Similarly, Item 103 of the regulation ensures that legal proceedings, perhaps resulting from poor compliance in the first instance, must likewise be disclosed. This litigation requirement is broad, explicitly covering more than merely those proceedings with a material impact on the issuer’s business or financial condition. It extends, for example, to otherwise immaterial proceedings to which a governmental entity is a party.
In other words, material risks—those which are relevant to investors, and thus markets—must already be disclosed. But the SEC is not limited to mandating the disclosure of only material items. Its ability to require disclosures is, however, bound by statute.
The SEC’s Authority
“The mission of the SEC is to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation. The SEC strives to promote a market environment that is worthy of the public’s trust.” The Securities Act of 1933 (‘33 Act) and Securities Exchange Act of 1934 (‘34 Act), which created the SEC and are the foundational sources of its authority provide as much. If the SEC is to mandate eco-disclosures, it must be statutorily authorized to do so.
As Andrew N. Vollmer observes, calls for the SEC to mandate eco-disclosures are typically grounded in language of the ‘33 Act and ‘34 Act stating that
Whenever pursuant to this title the Commission is engaged in rulemaking, [or in the review of a rule of a self-regulatory organization,] and is required to consider or determine whether an action is necessary or appropriate in the public interest, the Commission shall also consider, in addition to the protection of investors, whether the action will promote efficiency, competition, and capital formation.
But as a threshold matter, this language, on its own terms, does not give the SEC stand-alone authority to enact any disclosure (or other) rule if that rule merely advances the public interest, investor protection, efficiency, competition, or capital formation. Rather, it sets forth overarching requirements that must be adhered to whenever the SEC acts pursuant to authority granted to it by any other provision in the Acts. Otherwise, Vollmer points out, such a reading would allow the SEC to regulate on any topic with a conceivable nexus to the public interest.
He notes, moreover, that both the above and more specific arguments in favor of eco-disclosures neglect to read ostensibly enabling statutory language “in their context and with a view to their place in the overall statutory scheme.” Instead, these claims of authority read the language in isolation, contrary to U.S. Supreme Court precedent. Broadly speaking, the SEC may require disclosures related to a company’s business, financial prospects, management, and the features of its securities. The SEC acknowledged in 2016 that “disclosure relating to environmental and other matters of social concern should not be required of all registrants unless appropriate to further a specific congressional mandate or unless, under the particular facts and circumstances, such matters are material” to reasonable investors.
Exceptions must be Congressionally mandated. And when Congress wanted disclosures that are afield from the SEC’s core mission, it has affirmatively prescribed them. At the same time, Congress has required and encouraged the SEC to reduce Regulation S-K’s disclosure burden. In this setting, it is difficult to imagine that the national legislature would want the SEC to coerce eco-disclosures by regulatory fiat. Influencing issuers’ substantive conduct—their business policy decisions—is not within the SEC’s authority.
New Disclosure Rules May Be Unnecessary and Undesirable
It is expected that the mandatory climate-change disclosures under consideration will fall into two broad categories based on the nature of the risk: “transitional” or “physical.” A recent focus piece published by the Congressional Research Service defines these risks:
Physical risks: These risks include direct and indirect risks arising from extreme weather events and from longer-term shifts in climate patterns, including, for example, changes in water availability and food security. Physical risks have important implications for many companies’ physical facilities, operations, transportation costs, supply chains, and employees.
Transition risks: These risks arise from policy, legal, technology, and market changes as the world transitions to a lower-carbon economy, with potential financial or reputational effects on businesses. For example, a company may engage in efforts to reduce greenhouse gas emissions or otherwise respond to changing consumer behavior.
As noted above, the SEC has acknowledged that disclosures relating to “environmental and other matters of social concern” should not be mandated unless they are material or expressly authorized by Congress. Requiring disclosure of investor-relevant information, to the exclusion of that which is irrelevant (and potentially distracting to investors), is sensible and coheres with the SEC’s mission. The following analysis thus assumes that any new eco-disclosure rules would focus primarily on material transitional and physical risks to firms.
In the context of transitional risks, existing or imminent state or federal regulations (e.g., those imposing emission restrictions, limiting the use of specific resources and practices, and associated penalties or incentives) can be expected to have a material impact on some firms—particularly in the energy and manufacturing sectors. Moreover, firms should be able to determine this impact objectively and with precision. It is therefore appropriate and useful to investors for the SEC to demand such disclosures. But, as noted above, the current regime already requires disclosure of material information pertaining to such risks under Regulation S-K. Mandating a separate, universal disclosure of such risks would be redundant.
Perhaps the SEC is contemplating new disclosure requirements that will be less specific in scope, focusing on the impact of broader market trends. For example, the SEC could mandate that a firm disclose potential risks to its business (financial or reputational) in light of the global trend toward a “lower-carbon economy.” But such risks would be an odd fit for an SEC disclosure regime.
Perhaps the push for mandatory disclosure of climate-change-related physical risk is less about providing useful information to Main Street investors, and more about forcing every issuer to publicly avow the link between human-influenced climate change and extreme weather events.
There is little that is certain regarding global (or even local) trends pertaining to carbon emissions and the broader economy. Even in the United States, the dramatic reversals in policy from one administration to the next demonstrate how unpredictable policy-driven trends can be in this area. Mandating disclosure of the impacts of geopolitical climate-related trends in the midst of such uncertainty would force firms to speculate. Such speculation would be unlikely to reveal material (or even marginally useful) information to the average investor.
Even if one were confident that there is a clear and predictable global trend toward a lower-carbon (or even carbon-neutral) economy in the near future, this confidence would itself undermine the need for individual issuer disclosures. If the trend toward a lower-carbon economy is obvious and certain, then the investing public is well aware of it. In that case, issuer-specific disclosures pertaining to the impacts of global trends would not be material because they would not add to the total mix of information available to the investing public. This is why the SEC has not historically required that firms disclose market-level risks.
It thus begins to feel as if the contemplated mandatory transitional risk disclosures are not really intended to inform the general public about issuer-specific material financial risk at all. Perhaps the goal is to force the boards of every publicly traded company to take a stand on the reality of climate change, its human influences, and the existential threat it poses to the Earth. In other words, maybe the goal is to force all issuers to embrace (and continually reaffirm) the current administration’s climate agenda in their quarterly filings on pain of being “outed” as targets for activists. If this is the goal, then it is hard to see how it can fit within the SEC’s statutory mission.
What about mandatory disclosures pertaining to physical risks? Such disclosures would focus on risk to firms’ physical assets, business, and supply chain from extreme weather events caused by climate change (e.g., drought, flooding, fires, hurricanes, and tornadoes). The principal challenge for disclosure in this area is the difficulty in predicting these events generally, and in tying them to human-influenced climate change specifically.
Confidence in the reliability of the new field of “event attribution science,” which strives to identify causal links from human-influenced climate change to extreme weather events, is shaky. Steven E. Koonin (member of the National Academy of Sciences, and former Undersecretary for Science in the U.S. Department of Energy under President Barack Obama) noted in his 2021 book, Unsettled, that event attribution science is “rife with issues.” Koonin explains that most practitioners “argue that event attribution studies are the best climate science can do in terms of connecting weather to changes in climate.” He is “appalled such studies are given credence, much less media coverage.” Even staunch advocates of climate litigation admit they have had little success in getting the opinions of attribution scientists accepted by courts.
Demanding that issuers identify and quantify physical risk to their own assets and sales (much less to the risks to the myriad firms in their supply chain) in a manner that is useful to the average shareholder is therefore a tall order.
Since determining physical risk resulting from climate change is necessarily a matter of prediction, it constitutes “soft information.” Soft information involves some level of extrapolation, opinion, projection, or prediction. In securities law, the Supreme Court has held that the materiality of soft information depends “at any given time upon a balancing of both the indicated probability that the event will occur and the anticipated magnitude of the event in light of the totality of the company activity.” Given the current state of attribution science, however, it is unlikely that issuers will be in any position reliably to assign either a probability or a magnitude to the risk of a climate-change-driven extreme weather event. The substance of any such disclosure would therefore amount to little more than rampant speculation of little use to investors.
Furthermore, because attribution science is not refined enough to tie extreme weather events directly to the practices of individual issuers, physical risk disclosures would force firms to speculate about weather events generally (independent of their cause). Such speculation would not, therefore, be issuer-specific. Consequently, the data used to inform the speculation would presumably already be broadly available. Disclosure would, therefore, be pointless.
Of course, perhaps the push for mandatory disclosure of climate-change-related physical risk is less about providing useful information to Main Street investors, and more about forcing every issuer to publicly avow the link between human-influenced climate change and extreme weather events. Forcing firms to take a stand on this controversial scientific/political issue is inconsistent with the SEC’s mission for the same reasons offered above (concerning transitional risk).
What Can Possibly Go Wrong?
Eco-disclosures can only meaningfully change the behavior of issuers that are in a position to choose the lines of business in which they operate. Fossil fuel extractors, for example, can eliminate their fossil-fuel footprint only by ceasing to be fossil fuel extractors. As long as there is demand for fossil fuels, someone will have to meet it. The exception may be greenwashing, which itself is a use of investors’ assets to promote a controversial cause.
The risk created by forced eco-disclosures may also damage markets and the U.S. economy by incentivizing inefficient capital shifts. As discussed above, as long as there’s a need for energy that cannot be provided by renewable sources, eco-offending firms will continue to exist. As Professor Scott Wisor points out, as eco-conscious investors sell their shares, arbitrageurs will buy them. The result may be that shares are held by shareholders less concerned about environmental matters than those who sold.
Similarly, capital may shift abroad to nations that do not mandate eco-disclosures. This is especially true for products, like fossil fuels and many items made from them, that can efficiently be transported globally. And it is not merely the regulatory risk that may chase firms away. It is easy to imagine a situation where a firm, like a computer maker, is painted as being eco-unfriendly, even while it is meeting demand for products that enhance human flourishing.
Ultimately, firms may simply decide that the regulatory burden of going, or staying, public is not worth the hassle. The number of publicly traded companies has declined a remarkable 50 percent in the last 20 years. Most of the decline is from the disappearance of small firms, with the remaining firms having ever-larger market capitalizations. But even large firms, like computer giant Dell, may simply decide to go private.
As a possible example of Bruce Yandle’s theory of Bootleggers and Baptists, one result may thus be that average investors will have still fewer investment options while professionals and those with high-net-worth—accredited investors, in SEC parlance—get to invest privately. It is no surprise that The Economist reported that eco-disclosure mandates “appeal to financiers.” (That journal also asserted, with no further support, that eco-disclosures would be “good news for investors.”)
Capital movement problems may be exacerbated when the likely high costs of eco-disclosures are combined with an already-heavy regulatory load. At issue is information about which firms lack expertise and which they would have to create. It is not information that is already sitting somewhere in their systems. Like Sarbanes-Oxley and Dodd-Frank Act disclosures, which are within firms’ wheelhouses, eco-disclosures are likely to be particularly expensive and hit small firms the hardest. No wonder that JPMorganChase’s CEO said of Dodd-Frank that it put a “bigger moat” between his firm and the competition.
Like issuers, the SEC is not qualified to determine what should be disclosed. The EPA, which is already empowered by Congress to mandate certain disclosures, would be a better candidate. If such disclosures are to be required, it should be by explicit congressional mandate. Relatedly, positive law already regulates environmental impact. Legislative acts are more likely to get societal buy-in than decrees by an unelected, revolving-door regulator. A firm attempting to hide illegal pollution is unlikely to disclose its wrongdoing. An issuer complying with existing law, by contrast, should not be punished for doing what the law permits.
Without addressing the above concerns, compulsory disclosures pertaining to transitional or physical climate-related risk would likely be either redundant; unhelpful; and may be outside the SEC’s authority. In addition, they could harm the economy, issuers, and average investors. The bracketed language is included only in the ‘34 Act.