Two years ago, the U.S. Securities and Exchange Commission (SEC) proposed new rules with a robust set of climate-related metrics for publicly-traded companies to disclose in their annual filings. The Sierra Club, our members and supporters, and many other investors and groups submitted comments at the time in support of the draft rules.
Last month, the SEC released its final rule, which was significantly and arbitrarily weakened, seemingly in response to opposition from corporate and politically-motivated interests tied to carbon-intensive businesses. The rollbacks were a significant disappointment and could lead to investors lacking critical information about corporate climate risks – which is why the Sierra Club is going to court. Nonetheless, the final rule is a step forward for what it does include, what it stands for, and for how it could be utilized in the future.
For those who don’t want to read the 886 page final document, this blog provides an overview of the most important provisions that are in and out of the rule, and their implications. (For a more in-depth analysis of the new rule, see our recently published memo.)
Why does this rule matter?
The SEC is a federal regulatory agency that is tasked with protecting investors, maintaining fair, orderly, and efficient markets, and facilitating capital formation. Those who benefit from the SEC’s oversight of securities markets range from individuals saving for retirement to large institutions, such as pension funds, foundations, asset managers, and more.
As the impacts of climate change escalate, and as the energy transition accelerates, climate-related financial risks are also increasing. These risks can have significant impacts on the performance of companies and create risks for investments, both in individual companies and across entire investment portfolios. Unfortunately, fossil fuel companies and other big polluters have a long history of concealing from investors their climate risks and lack of credible transition plans. It is therefore more important than ever that investors have information on how publicly-traded companies are—or are not—assessing and managing climate-related risks so they can make informed investment decisions.
The SEC’s Climate Risk Disclosure Rule was intended to do just that. Despite extensive (and unwarranted) backlash, the SEC’s final rule on climate disclosures represents just the next chapter in a decades-long investor effort to secure more robust climate-related disclosures from publicly-traded companies. With implementation guidance expected from the SEC, the rule will help to standardize disclosures and provide investors with information that makes understanding and comparing companies easier. However, as we explain more below, a number of critical (and, in our view, legally necessary) provisions were weakened in the final rule or left out entirely, which is why we’ve decided to take legal action.
The Good
Let’s start with the good. This rule will require most large companies that are publicly traded in the US to annually provide information on a wide range of metrics regarding their climate risk management strategies, including some greenhouse gas emissions. For more than two decades, investors have been asking companies to voluntarily disclose climate-related information through initiatives like CDP or the Task Force on Climate-Related Financial Disclosures (TCFD). The rule will now make those disclosures more widespread, more readily available, and easier to compare.
Despite the rollbacks, the final rule includes, to various degrees, key reporting requirements for companies, including: Scope 1 and 2 emissions, transition plans and climate targets; identification of and response to physical and transition climate risks; climate-related expenditures; and the use of carbon offsets as part of a company’s climate strategy. If a company reports any climate targets or transition risks, it will also be required to provide annual updates of the actions taken to achieve the targets and address the risks, providing investors with critical information on the company’s efforts to implement its climate risk strategy.
However, as discussed below, a company will only be required to report on many of these metrics if it determines that they have “material” impact on its operations, strategy, or future financial prospects, meaning disclosures may not be as forthcoming as needed.
By mandating the release of this information, the rule helps to normalize and standardize climate-related disclosures in the US, creating a foundation that can be built on. By gaining access to annual reports on companies’ climate-related risks , investors will now be better positioned to manage their portfolios and to understand how many of the world’s biggest corporations are managing the transition to a decarbonized economy and the financial threat posed by climate change.
The Bad
Unfortunately, despite these positive developments, the SEC implemented a number of significant changes that made the final rule much weaker than the proposed version, and much weaker than investors need it to be.
The Rollback of Greenhouse Gas Reporting
One of the most contentious changes was the removal of requirements to report Scope 3 emissions. Unlike emissions in Scope 1 (which are caused directly by the company) or Scope 2 (which are related to direct energy purchases), Scope 3 emissions are those that occur upstream and downstream in a company’s value chain. They encompass a wide range of activities, such as deforestation-related emissions from food companies, tailpipe emissions from car companies, and financed emissions from big banks or investors that provide capital to polluting companies and projects. The majority of emissions for most public companies are in Scope 3, and many of the industries most opposed to the rule, like oil and gas companies and agribusinesses, have some of the largest proportions of Scope 3 emissions.
The removal of Scope 3 disclosure requirements was an unjustified move seemingly intended to avoid political and legal opposition from special interests (which has, predictably, happened anyway). Greenhouse gas emissions reporting requirements are among the most important climate risk disclosures to investors: 97% of investors who commented on the rule supported requiring material Scope 3 disclosures. The failure to include Scope 3 shortchanges investors’ interests by depriving them of valuable information about a company’s exposure to transition-related risks that is otherwise difficult or impossible to obtain.
The final rule still includes disclosure requirements for Scope 1 and 2 emissions, but they are now subject to a crucial qualifier: companies only need to report emissions to the extent that they deem them to be “material,” Moreover, only the largest companies are subject to this requirement. By contrast, the proposed rule would have applied to all publicly traded companies, and would have required Scope 1 and 2 disclosures without any materiality stipulation.
The Great “Materiality Threshold” Caveat
The final rule’s materiality qualifier applies not just to the Scope 1 and 2 emissions reporting requirement, but to a much broader set of climate-based metrics that companies are required to report. This is troubling for two key reasons. First, without further guidance and oversight from the SEC, this leaves determinations on what to report entirely up to the company. This will likely result in a more fragmented reporting landscape, rather than more standardized and comparable disclosures that would have been expected under the initial proposal. This will make it more difficult for investors to reliably compare companies’ relative exposure to litigation as well as regulatory and other climate-related risks based on their emissions profiles. Of course, given that climate change and the net-zero transition are expected to have material impacts in all aspects of the economy, one would expect to see increased disclosures relative to the status quo. Nevertheless, the materiality component gives companies an unnecessary amount of discretion that runs counter to the interests of investors.
Second, the current framework creates the risk that investors may not have access to all information that is, in fact, material. For example, under the final rule, companies that use scenario analysis to assess impacts to their business or financial condition must disclose each scenario, but only if they determine that a climate-related risk is likely to have a material impact. However, as CDP notes, failing to use appropriate scenarios could result in inaccurate findings about the impacts of climate on a company's business, and a company may fail to adjust appropriately. Thus, if the company is using the wrong models or assumptions, it may end up declaring its scenario analysis non-material and not reporting critical information to investors.
Beyond the Scope 3 and materiality issues, there are some other components of the rule that have raised concerns about its efficacy for investors. For one, the SEC ultimately did not require the explicit disclosure of how climate change mitigation or adaptation affects communities or human capital management, overlooking important social dimensions of climate-related risks. Also, the final rule moved much of the required reporting into documents that receive less attention from auditors since they are outside of a company’s financials. Auditing is an important safeguard that helps ensure that information is represented fairly and accurately.
The major takeaways
On the whole, the final rule does not go far enough to properly inform and protect investors on climate-related risks. However, it is a step in the right direction, and represents an improvement for investors and capital markets relative to the status quo. Just how much of an improvement will depend greatly on forthcoming guidance and implementation from the SEC.
Climate-related disclosures are necessary to protect investors in the rapidly changing economy and climate. Today’s markets are plagued with inconsistent and unreliable climate risk disclosures by public companies, to the detriment of investors and the efficient allocation of capital, and this rule helps to at least partially address those challenges.
In addition, this rule-making affirms that mandatory climate-related disclosures are squarely within the SEC’s authority and mandate. This fundamental fact is being challenged by corporate polluters and their political allies who are trying to undermine or erase the SEC’s authority to require any type of climate disclosures. The Sierra Club and others are going to court to challenge the ways the final rule was arbitrarily weakened, but inherent in that is the affirmation that the SEC can and must require climate risk disclosures.
While there is still much more that the SEC must do to provide investors with accessible, comparable, and consistent information on climate risks, this rule is an important step forward that we will continue working to protect and strengthen.