CLS Blue Sky Blog

Climate Disclosure Line-Drawing and Securities Regulation

In 2022, the Securities and Exchange Commission (SEC) proposed climate disclosure rules requiring each public company to tell investors specifically about the financial effects of climate risk on the company and how the company assesses those risks. The rules will be released soon in final form.  Separate rules  would require investment advisers to tell investors how ESG financial products and investment policies take account of ESG factors or achieve ESG-related goals.  These rules would help combat “greenwashing” for investment products that incorporate ESG factors.  The corporate and investment adviser rules are related, since funds can back up claims about how they integrate ESG factors only if they have accurate information on ESG matters, including climate risk, from companies themselves.

Both sets of rules have generated nationwide controversy and put companies and leading financial institutions at the center of a political maelstrom.  Political polarization within the U.S. over ESG investments comes at a time when investor demand for these products is rising exponentially and when there is international consensus around the need for mandatory climate risk disclosure.  Debates over the future of the proposed rules have become so strident in part because of confusion about the meaning and reach of terms like “climate risk,” “sustainability,” and “ESG.”  Such questions go directly to fundamental concerns about how broadly new disclosures may sweep and whether ESG information is financially significant or relates only to the social or policy preferences of certain investors or asset managers.

In a recent article, I respond to these debates by placing the SEC proposals in the context of developments across capital markets worldwide and explaining the line-drawing choices that the SEC and other regulators are making when they consider whether and how to mandate climate risk disclosure.  For example, the rules define climate risk as financial risk to the company itself, rather than leaving disclosure largely up to however companies choose to define ESG.  Understanding where the SEC has drawn these lines can shed light on the evolving global landscape of ESG disclosure for U.S. companies and on the justifications for the SEC’s final rules.

First, as many readers are aware, the SEC proposal follows decades of corporate experimentation with voluntary sustainability reporting and more than a decade of regulatory efforts in other capital markets to mandate corporate climate reporting.  In fact, the SEC rules promise to lower compliance costs by building on established voluntary frameworks – namely the Task Force on Climate-Related Financial Disclosure (TCFD) framework and the Greenhouse Gas ProtocolAs I have explained elsewhere, the demand for standardized reporting frameworks is growing precisely because private standard-setting and investor self-help have proven costly for investors and companies. There is also international consensus about the nature of the financial risks that climate change pose to companies and economies.  Financial regulators and stock exchanges have therefore been at the center of efforts to standardize corporate climate reporting so that all investors will have access to reliable, comparable information.

Second, the SEC’s approach is far narrower and more flexible than the standards the European Union and the International Sustainability Standards Board (ISSB) plan to release later this year, even though all three build on the TCFD framework and other widely used voluntary reporting standards. To be sure, the rules ask companies to do more than specifically identify their material climate-related financial risks and describe how corporate boards and management monitor them. More controversially, companies would also be required to report greenhouse gas emissions for themselves and for their suppliers and other companies in their “value chain” (an effort to deter evasion and under-counting).  But the most prescriptive disclosures – for instance, about a company’s climate risk transition plans, progress toward specific targets or goals, and related measures — are only required for companies that have already adopted such practices.  It is worth noting that here and elsewhere the SEC’s “mandatory” rules give companies a choice. And while many governments have gone further to mandate other sustainability disclosures, the SEC’s proposed apply only to climate.  The limits to the SEC’s regulatory authority also mean that the rules will not reach private companies, in contrast to the rules in the U.K., Europe, and elsewhere.

Third, the rules do not redefine materiality as that concept has long been understood under the federal securities laws.  Because much of the information required under rules is risk-related, companies will be able to rely on existing SEC guidance for how material risks are identified and reported in management’s discussion and analysis (MD&A). As my article explains, there are also good reasons to believe that companies are not likely to be exposed to higher liability risk for securities fraud given the burden plaintiffs will have to meet to plead claims based on allegedly misleading information about climate risk. Safe harbors for good-faith projections, estimates, and other forward-looking statements will still apply. At the same time, companies’ risk of facing litigation is likely to rise even though private lawsuits over climate risk reporting will be tough to win.  I therefore argue that companies may need stronger protection from private lawsuits while they get up to speed.

The flexibility of the SEC’s rules may mean that they do not go far enough to ensure that investors get the information they need on material climate-related financial risk.  Still, the SEC has taken important first steps. Understanding its rulemaking choices matters as climate risk disclosure becomes part of the corporate compliance and investment landscape globally.

This post comes to us from Professor Virginia Harper Ho at City University of Hong Kong School of Law. It is based on her recent article, “Climate-Disclosure Line-Drawing & Securities Regulation,” available here.

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