[Editor’s Note: We present this and the following two pieces as a symposium on the U.S. Securities and Exchange Commission’s proposed climate-disclosure rules released on March 21, 2022.]

After a considerable delay, the SEC finally told us last week in SEC Release No. 33-11042[1] where it is going on climate-risk disclosures. The business community’s reaction was predictable and seemingly orchestrated: “We are shocked and dismayed!” “The costs are enormous!” The Wall Street Journal described the SEC as the pawn of the “left-leaning” BlackRock (ignoring that it is hard for radicals to attract the nearly $10 trillion in assets that BlackRock now manages for investors). This may be how the debate plays out — much like the Senate Judiciary Committee grilling a Supreme Court nominee with conspiracy theories and preferring hyperbole to close analysis.

But the SEC’s proposals do not come out of the blue. They are directly derived from the Task Force on Climate-Related Financial Disclosures (“TCFD”), whose recommendations came out in 2017, and the Greenhouse Gas Protocol, which dates back to 1997. The latter document introduced a new concept: “scopes” of emissions in order to distinguish those emissions that are directly attributable to the corporate issuer from those that are indirectly attributable. This concept is at the core of the SEC proposed rules, which are clear and forthright on Scope 1 and Scope 2 emissions, but more ambiguous on how to treat Scope 3 emissions.

This brief column will basically focus on where the SEC has compromised (and indeed it has, with the SEC remaining a good distance behind Europe). In particular, it will examine: (1) the SEC’s uncertain position on the materiality of Scope 3 emissions; (2) the SEC’s proposed safe harbor from liability; (3) its concept of “Assurance” — that is, how the SEC proposes to develop an auditor for climate data disclosures; and (4) whether  the SEC’s position will stand up in court.

The Scope of Scope 3

Scope 1 emissions are GHG emissions that arise from sources owned and controlled by the corporate registrant. Scope 2 emissions are those primarily resulting from the generation of electricity purchased and consumed by the company (they are a separate category mainly because they are easy to calculate). Scope 3 emissions are all other indirect emissions that arise in the company’s upstream and downstream value chain — for example, the emissions of suppliers to the company, of wholesalers and retailers of its products, and of the customers who use them.[2]

The implications here are that Scope 3 emissions can easily exceed the sum of Scope 1 and Scope 2 emissions — depending on the industry. For example, take the auto industry. The Scope 3 emissions of General Motors will include the tailpipe carbon emissions of all its customers, which will predictably exceed the emissions associated with producing cars. In addition, they cannot be easily estimated. Although accountants can audit the books and records of the company to establish its earnings, none of that data bears on the company’s emissions, and any inquiry into these numbers goes well beyond the company’s books and records.

So, what has the SEC required? All registrants would be required to disclose their Scope 1 and Scope 2 emissions (on a disaggregated basis, both for the current year and for the prior fiscal years that must be included in their financial statements). But a slow phase-in (and some other features next discussed) arguably reduce the burden, and smaller registrants are substantially exempted. In the case of Scope 3 emissions, a registrant must disclose its “total Scope 3 emissions if material” or “if it has a GHG emissions reduction target or goal that includes its Scope 3 emissions.”[3] This will obviously chill registrants in the future from establishing targets or goals that include Scope 3 emissions. That seems undesirable, but perhaps the SEC thinks it is too late in the day for registrants to exclude Scope 3 emissions from their “targets or goals.” Still, the larger question is, when are Scope 3 emissions “material”? Suppose we learn that a hypothetical auto company has Scope 3 emissions that are three times the sum of its Scope 1 and Scope 2 emissions. Does this make its Scope 3 emissions material? If this Scope 3 number is largely the product of its customers’ tail pipe emissions, why is this material? The auto company does not today have any obvious liability to its customers because its products produce carbon emissions. Conceivably, high consumer emissions could suggest that its products may soon encounter reduced demand (as consumer preferences shift) or increased regulation by the EPA or other environmental regulators, but that is speculative. The high consumer figures could instead reflect that its products have high respect from consumers (possibly because its cars are more efficient and less polluting on a per unit basis).

In contrast, high carbon emissions in the supply chain could be more material because the company’s suppliers may soon have to revise prices upward because regulators are likely to soon impose costly restraints on them. Or, their suppliers may soon raise their prices to the registrant for a variety of reasons. Again, this is speculative.

What seems relatively clear, however, is that any disclosure standard left as vague as Release 11042 leaves the materiality of Scope 3 will cause many companies to simply decide that the Scope 3 emissions of those persons upstream or downstream to them in their value chains are not material to them. Little in SEC Release 11042 attempts to examine why the high carbon emissions of a supplier or a customer are material to the registrant. There are vague references to “transition risks,” but these will not motivate most companies to undertake the costs of calculating and verifying Scope 3 data. I suspect the SEC realizes this and has knowingly conceded that Scope 3 will receive little attention from registrants for the time being.

The SEC’s “Accommodations” and the “Assurance” Requirement

Scope 3 emissions normally result from the activities of third parties in the registrant’s value chain. Thus, calculating the data on Scope 3 emissions is both more difficult and less easily verifiable. In this light, the SEC has proposed several “accommodations” with respect to Scope 3 disclosures, including (i) a special safe harbor from liability, (ii) an exemption for smaller reporting companies, (iii) delayed compliance dates for Scope 3 emissions disclosure, and (iv) different “attestation” standards for Scope 3 data.

Of these “accommodations,” the most important are likely to involve the concept of “assurance.” Under the SEC’s proposed rules, a registrant that is an “accelerated filer” or a “large accelerated filer” must include in its filings an attestation report covering the disclosure of its Scope 1 and Scope 2 emissions.[4] This requirement does not apply to smaller registrants or to Scope 3 disclosures, but it does extend the concept of assurance to information that is outside the financial statements, which is unusual for the SEC because such data are not derived from the books and records used to generate the registrant’s audited financial statements.

As the SEC points out, “large accelerated registrants” accounted in 2020 for roughly 31% of all registrants that filed annual reports (and 93.6% of market capitalization), and “accelerated filers” accounted for another 10% and nearly 1% of market capitalization on the same basis, thus totaling 41% of registrants filing an annual report and nearly 95% of market capitalization.[5] On this basis, the SEC gives up relatively little by sparing small issuers from its assurance requirement.

But who is to give this “attestation report”? Auditors traditionally audit only the company’s books and records, and thus the SEC is here forced to create a new functional equivalent to an auditor for climate-related disclosures. This new expert is called the “GHG emission attestation provider,” and it is required to be “an expert on GHG emissions by virtue of having significant experience in measuring, analyzing, reporting or attesting to GHG emissions.”[6] The problem is that such an expert may not yet exist — at least not in quantity. Even when such experts do appear (as they certainly will if these proposed rules are adopted), they may be costly (and certainly much more costly than the SEC estimates in Release 11042). In all likelihood, major accounting firms will extend their reach to cover this new market, forming affiliates to provide this new service of measuring and attesting to GHG emissions.

In a final accommodation with respect to assurance, Release 11042 contemplates a phased transition. The service providers to accelerated filers and large accelerated filers would not be required to meet any minimum level of assurance for the first year after Release 11042’s adoption, and then would scale up to, first, “limited assurance” and, second, “reasonable assurance” after two more years.[7] Possibly, this will translate into some cost savings, but it will not appease the Release’s critics.

The SEC’s Proposed Safe Harbor

Release 11042 proposes a safe harbor for Scope 3 emissions disclosure from certain forms of liability under the federal securities law.[8] This makes sense given the difficulties in securing reliable information from the third parties in a registrant’s upstream and downstream value chain. But the safe harbor so proposed is a shallow one. Under proposed 17 C.F.R. 229.1504(f)(1), a statement regarding Scope 3 emissions made in a document filed with the SEC pursuant to these new disclosure requirements will not be deemed to be a “fraudulent statement” (as defined) “unless it is shown that such statement was made or reaffirmed without a reasonable basis or was disclosed other than in good faith.”

Consider what this means. A plaintiff in a Rule 10b-5 action cannot succeed simply by proving negligence or the lack of a “reasonable basis.” Rather, the plaintiff must prove scienter, and, under the Private Securities Litigation Reform Act, to survive a motion to dismiss, it must plead with particularity facts giving rise to a strong inference of fraud. Thus, this safe harbor will likely only have impact in litigation brought under Section 11 of the Securities Act or Section 18 of the Securities Exchange Act. Even in these cases, its real impact is only to change the burden of proof because both these sections already give the defendant an affirmative defense.

In sharp contrast, Section 21E of the Securities Exchange Act provides a much stronger safe harbor for “forward-looking” statements, which is ironclad if the registrant surrounds its statement with “meaningful cautionary statements.” What then has led the Commission to propose a safe harbor that is too shallow to be useful? One possibility is that the Commission was internally divided over this safe harbor and so compromised on a very weak one. If so, the Commission might yet consider deepening this safe harbor if there is pressure from the Bar.

What Will Courts Do with Release 11042?

Many believe that the SEC is vulnerable because appellate courts may find that the climate-risk disclosures are not material to investors and that they were mandated to please stakeholders and activists.[9] Judicial invalidation is conceivable, but not a likely outcome in my judgment. The test of materiality, under Basic v. Levinson, is whether reasonable investors would want the information in making an investment decision.[10] Because a substantial majority of the stock in public corporations is now held by institutional investors (most of which are vocal in their desire for more climate-related disclosures), it would be myopic for a court to ignore their strong preferences. If the majority of the market wants the information, it presumptively should be material.

But there is another theory that the Supreme Court might adopt to overturn the SEC. Known as the “major questions doctrine,” it holds that if an agency’s regulatory action “brings about an enormous and transformative expansion in [the agency’s] regulatory authority,” there must be “clear Congressional authorization” of the new regulatory action.[11] Should this doctrine be applied to reverse Release 11042? Certainly, business group plaintiffs will raise this theme (and could succeed, at least with the court’s most conservative justices). But the SEC has been requiring environmental disclosures for decades, and this entire issue falls under the heading of defining what information investors need. That has always been at the core of what the SEC does, and it hardly represents a “transformative expansion.”

But if the Supreme Court wants to freeze disclosure policy — like a fly in amber — and treat the issue of what is material as fixed and static, they will have the opportunity to do so when, and if, they review Release 11042.

What Grade for the SEC?

In terms of what must be disclosed, the SEC has accomplished a lot and deserves an “A.” The toughest issue was probably Scope 3, and here the Commission has largely ducked and deserves an “Incomplete.” With respect to assurance, they were right to focus on this issue and deserve an “A for effort.” On their illusory safe harbor, they need to do further work to make it real.

ENDNOTES

[1] The full title of Release No. 33-11042 is “The Enhancement and Standardization of Climate-Related Disclosures for Investors,” and it was released on March 21, 2022. Essentially, the Release adds a new subpart to Regulation S-K, 17 CFR 229.1500-17 CFR 229.1507, which describes the climate-related information that registrants must file in SEC reports and prospectuses.

[2] For a fuller definition of “scopes,” see Release No. 11042 at pp. 41 to 42.

[3] See proposed 17 CFR 229.1504(c) (Release No. 11042 at p. 489).

[4] See proposed 17 CFR 229.1505 (“Attestation of Scope 1 and Scope 2 emissions disclosure”).

[5] See Release No. 11042 at p. 376.

[6] See proposed 17 CFR 229.1505(b)(1).

[7] See proposed 17 CFR 229.1505(a)(1).

[8] See proposed 17 CFR 229.1504(f).

[9] Release 11042 works very hard to state — over and over — that “the Commission’s mission [is] to protect investors, maintain fair, orderly and efficient markets, and promote capital formation, not to address climate-related issues more generally.” (Release 11042 at p.10). This is the SEC’s classic mantra. Like a criminal defendant, the SEC has its story, and it is sticking to it.

[10] See Basic, Inc. v. Levinson, 485 U.S. 224, 231-32 (1988).

[11] See Util. Air Reg. Grp. V. EPA, 573 U.S. 302, 304 (2014).

This post comes to us from Professor John C. Coffee, Jr., the Adolf A. Berle Professor of Law at Columbia University Law School and Director of its Center on Corporate Governance.