I review the nine objections I have come across: this is Congress’ or the EPA’s job, the SEC caters to large indexers and climate activists, it throttles competition in reporting frameworks, disclosures are too general or represent progressive aspirations, the SEC compels political speech and scope 3 emissions are not material. Critics might want to actually read current climate disclosures for 50 odd firms in an industry. That might convince some of the need for comparable, consistent, verified disclosures that the SEC advocates.
The U.S. Securities and Exchange Commission headquarters in Washington, D.C., U.S.,. Photographer: ... [+]
A passionate investor asked the titular question at the dinner table. I said something about the SEC understating compliance costs, but my investor friend did not sound too impressed. So, I set out to find out what the objections were and my proposed counterpoints to these claims. To clarify, my responses are not grounded in securities law as that is not my wheelhouse. Instead, they appeal to common sense and incentives and provide a user’s perspective to the problem. Here is what I came up with:
1.0 This is Congress’ job
Jay Clayton and Patrick McHenry write in the Wall Street Journal, “setting climate policy is the job of lawmakers, not the SEC, whose role is to facilitate the investment decision-making process.” They go on to say “the body that the Constitution prescribes for weighing the relevant trade-offs in this area is Congress. Congress, duly elected by and responsible to the people, is precisely where climate policy, in all its complexities and consequences, should be resolved. Yet over decades, elected leaders have pushed hard policy questions to federal agencies staffed by unelected bureaucrats, whose decisions are reviewed only by unelected judges. This is at best bad for democracy and at worst unconstitutional.”
Counter point to this idea:
Congress does not appear to be able to get much done in general, not even make daylight savings time permanent at the time this piece was written. Does this objection simply pass the buck to an institution that has a dispiriting aversion to acting on the climate problem?
2.0 EPA is the appropriate agency
CEO Dan Eberhart of Canary LLC, on the Hill.com has stated, “the right forum should be with the Environmental Protection Agency” not the SEC.
Counter point to this idea:
It is interesting that this comment comes at a time when the Supreme Court is considering a complaint about the EPA’s alleged overreach related to two cases: (i) a challenge to the EPA’s authority under the Clean Air Act to require the nation’s energy producers to shift from fossil fuels to “renewable energy;” and (ii) pushback against the EPA’s authority to regulate private property under the Clean Water Act. The allegation is that with every successive definition of “navigable waters” the EPA has put forward, it has stretched federal authority beyond anything Congress envisioned under the statute by roping in more and more acres of mostly dry land as federally protected waterways.
So, what chance does a new set of reporting rules with the EPA, instead of the SEC, stand? Moreover, the enforcement jurisdiction of the EPA is restricted to the continental United States and will hence cover, at best, scope 1 and 2 emissions and a limited aspect of scope 3 such as domestic travel. A vast majority of the world’s emissions (60%) come from Asia because most of the world’s production occurs in Asia and is imported into the United States. Such imported scope 3 emissions, which constitute a bulk of many U.S. companies’ emissions, would fall outside the purview of the EPA.
3.0 SEC overemphasizes the interests of institutional investors who are indexers and ignores millions of individual investors
Professors Paul Mahoney and Julia Mahoney argue that the adoption of ESG disclosure mandates in order to serve environmental or social goals is not well-aligned with the SEC’s stated mission of protecting Main Street investors.
I have some sympathy for the argument that we have not invested enough in identifying what individual shareholders actually want from CEOs of the companies they hold. Having said, my guess would that most individual shareholders who invest their retirement accounts are indexers themselves. Moreover, I would guess that most individual shareholders would probably support some version of climate disclosure rules. Public support for climate rules is probably higher than such support in Congress. However, I wonder how the concern for individual investors gels with attempts to dismiss or discredit proxy proposals put out by a few individuals (“gadflies”) such as John Chevedden, William Steiner and James McRitchie who do initiate proxy proposals in several companies. Perhaps the gadflies do not represent the view of the average individual investor. Do we have evidence to support that conjecture?
4.0 SEC kowtows to climate change activists and throttles competition in climate measurement frameworks
The Competitive Enterprise Institute (CEI) states:
“The real goal is to create a framework by which corporations can be pressured, threatened, and cajoled into adopting operations consistent with the political demands of climate change activists.
“The SEC rule would use regulations to guarantee that the political interests of massive activist investment funds, such as CalPERS and BlackRock, take precedence over the interests of those shareholders still interested in return on investments.”
“what capital markets need is a competitive, evolutionary process for information discovery that can only exist with multiple, competing frameworks that firms can join or leave voluntarily. If environmental, social, and governance (ESG) investing is really about creating value for investors rather than mandating progressive policy goals, competition is essential to high quality outcomes, as it is in the market for any other product or service.”
Counter point to this idea:
The claim that CalPERS and BlackRock are not interested in returns is a bit hard to swallow. Both have a fiduciary duty to do so. It is ironic that in 2020, CalPERS had been accused of over investing in risky assets because it had promised higher returns to their pensioners.
Moreover, is it reasonable to label all these institutional investors climate activists motivated by political goals. Could the idea of an “universal owner” or the notion that they own the whole market via index funds and are unlikely to exit their positions for decades make them interested in climate risk faced by companies?
The SEC’s draft clearly lays out that investors that represent trillions of dollars of AUM (assets under management) are asking for standardized disclosures on climate. It is true that there are several competing frameworks for ESG reporting such as the SASB, GSSB, ISSB, TCFD, PRI, the UN’s SDG goals and so on. In fact, there is so much competition among these NGOs that investors need someone like the SEC to standardize these somewhat un-comparable frameworks. Page 327 of the SEC’s rules cites survey evidence that 59% of respondents follow one or more of the voluntary NGO proposed frameworks. Among these respondents, 44% use the SASB, 31% use the GRI, 29% use the TCFD and 24% use the CDP. These frameworks are reasonably different to not allow cross-company comparability.
It is also important to point out that we do not have such competing frameworks for financial reporting except perhaps for the IASB. That was one of the most important things the FASB and the SEC addressed in its early days. Some of us wish there were competing frameworks for financial reporting but that is a separate conversation.
5.0 Disclosures too general and far-reaching to be meaningless
The Manhattan Institute’s City Journal writes, “the proposed rules fail to distinguish between macro and micro-climate risks. For example, the SEC’s press release states that the proposed changes would require firms to disclose “how any climate-related risks identified by the registrant have had or are likely to have a material impact on its business and consolidated financial statements, which may manifest over the short-, medium-, or long-term.” The same formulation could, in theory, mandate disclosure of the risks of future thermonuclear conflict, solar flares, or viral pandemics. Such information is so general and far-reaching as to be effectively meaningless for assessing the risks to a specific company.”
Counter point to this idea:
I have some sympathy for this argument. My guess is that the SEC will eventually back off from asking firms for climate impact on specific line items of financial statements and eventually settle for scope 1 and 2 and a version of scope 3 disclosures with caveats. And, there does not appear to be as much investor push for disclosure related to every existential threat such as thermonuclear conflict, solar flares and the like as there is for climate.
6.0 Disclosures reflect progressive aspirations not foreseeable risks
The Manhattan Institute’s City Journal goes on to argue that the SEC asks “to assess a registrant’s exposure to, and management of, climate-related risks, and in particular transition risks.” “The notion of an inevitable “energy transition” may be championed by policymakers and opinion leaders, but it’s not foreordained. When and whether an ultimate transition away from carbon-based fossil fuels to renewable energy sources will happen is unknowable, rendering such disclosures wholly speculative. Any disclosures would be more reflective of progressive aspirations than of material, foreseeable risks from existing or contemplated regulation or law.”
Counter point to this idea:
Transition can also involve adaptation not necessarily a move away from oil and coal and adaptation can be as or more expensive than mitigation. Is this disclosure that different from the SEC asking for disclosures around businesses and securities markets readiness around the Y2K crisis? I am also not sure that climate change is a political or a progressive opinion unless one believes the IPCC’s reports, the work of thousands of scientists, is also completely political.
7.0 Compliance costs estimates are understated
Price Waterhouse recently announced that they plan on hiring 100,000 employees over the next years in a push for ESG business. Other Big Four accounting firms are similarly bulking up. This probably implies high compliance costs for public firms. I have written about this before and continue to believe that the SEC has under-stated the costs of complying with the rules. This may not be as trivial as it sounds. Back in the day, Dodd-Frank Act had asked for expand proxy ballot access for shareholder-nominated candidates for boards of directors. In 2011, the U.S. Court of Appeals for the District of Columbia threw out an SEC rule on the grounds that it failed to adequately consider economic costs of compliance.
The U.S. Supreme Court seems sympathetic to the excess compliance cost argument stating that the EPA “refused to consider cost when making its decision. It estimated, however, that the cost of its regulations to power plants would be $9.6 billion a year, but the quantifiable benefits from the resulting reduction in hazardous-air-pollutant emissions would be $4 to $6 million a year.”
8.0 Scope 3 materiality
Commissioner Hester Pierce, in her dissent to the proposed climate rules, argues, “Scope 3 data is really about what other people do. The reporting company’s long-term financial value is only tenuously at best connected to such third-party emissions. Hence, the Commission’s distorted materiality analysis for Scope 3 disclosures departs significantly from the “reasonable investor” contemplated by Justice Marshall.”
Earlier in her dissent, she states what a “reasonable investor” would expect: “Justice Thurgood Marshall described our existing materiality standard in TSC Industries v. Northway: an item is material if there is a substantial likelihood that a reasonable investor would consider the information important in deciding how to vote or make an investment decision. The “reasonable investor” Justice Marshall referred to in TSC Industries is someone whose interest is in a financial return on an investment in the company making the disclosure. Thus, there is a clear link between materiality of information and its relevance to the financial return of an investment”
Counter point to this idea:
Again, I am not a lawyer but to me as a user and a investor, it is not entirely obvious that scope 3 is irrelevant to an investor either. Imagine a world where scope 3 carbon imported from Asia is taxed in the U.S., a proposal similar to the one that the EU has been actively debating for months. Even without such a tax, influential investors seem to routinely consider emissions in their voting decisions. Numerous proxy proposals are filed by investors every year asking management to disclose scope 3 emissions. Critics, have, however, argued that very few of these proposals muster support. I am not sure that’s entirely surprising. Which CEO or shareholder actually wants to pay for the negative externalities that her firm imposes on society?
As Commissioner Lee has pointed out, the automobile industry is gearing up in a substantial way to respond scope 3 emissions emitted by fossil fuel powered cars and trucks. A company’s customers producing lots of carbon will challenge its business model as consumers move away from them so the company should have a good sense of magnitude of scope 3 emissions.
Moreover, if scope 3 is exempted, companies will have incentives to repackage scope 1 and 2 emissions as scope 3. For instance, Nature Climate Change reports an interesting case where a company starts by purchasing its own equipment and signs contracts for electricity from a co-location facility. That company’s IT (information technology) emissions fall under Scope 1 or Scope 2. However, the IT workload can easily be moved to the cloud, after which it is no longer directly generating emissions under Scope 1 and is not purchasing energy under Scope 2. Therefore, all those emissions move to Scope 3. Dropping scope 3 reporting will lead to many such shenanigans. Oil and mining companies that are associated with large scope 3 emissions have been reluctant to disclose them voluntarily.
9.0 Compels political speech
The Attorney General of West Virginia has argued that climate is a highly political issue and the SEC’s rules would compel companies to regularly speak on these issues. The Supreme Court rebuked Congress and the SEC for its attempted compulsion of political speech on the topic of conflict minerals, and that rule was eventually revoked by the SEC.
Counter point to this idea:
I am no lawyer and I sympathize with the idea of avoiding compelling CEOs to political speech but I am not sure the SEC’s rules really force CEOs to do this. All they are asking for is disclosure of scope 1, 2 and some version of scope 3 emissions along with management and the board’s assessment of likelihood that the company’s future cash flows and/or cost of capital would be affected by climate risk and the potential transition to a low carbon world.
On top of that, CEOs are increasingly volunteering to make political statements on their own for purely business reasons. The modern workforce is increasingly educated and unafraid to voice their political inclinations. CEOs that do not voice some support for their workers political views may have a hard time retaining such a workforce. Moreover, political risk is routinely considered a part of the risk assessment before investing in any overseas project.
So, that is my quick summary of the challenge against the SEC’s new climate risk rules. I will try adding to this list as I become aware of new sources of pushback.
Why do I support the SEC’s disclosures?
My perspective was informed by a research project where my colleagues and I tried to assess whether the net zero pledges promised by oil and gas firms are credible. To keep the project focused, we worked only with 57 exploration and production companies. It took us close to six months to code what these companies were doing. The underlying data is scattered across press releases, websites, 10-Ks and sustainability reports. There is tremendous variation in the path followed to a net zero promise, on the reporting thereof and the verifiability, if any, of such a path. Companies routinely follow multiple private frameworks such as the TCFD, GRI, CDP and the SASB’s templates. On top of that, the four rating agencies, ISS, Sustainalytics, Bloomberg and MSCI provide environmental ratings that do not converge and are all over the map.
Informed by that experience, I, for one, would like to see some rigor, consistency, comparability, verifiability in these disclosures, backed by the SEC’s enforcement arm. Hence, on balance, I support the SEC’s attempt to (i) make climate disclosures somewhat comparable across the several private frameworks suggested by NGOs; and (ii) enforce such disclosures given rampant greenwashing, relatively empty pledges made almost every day by companies to go net zero, and self-proclaimed ESG funds that barely hold stocks that are consistent with the goals articulated in their prospectuses.
I am out of my depth when it comes to comparing the SEC’s authority vs the EPA’s and so on. However, an interesting challenge for the lawyers might be to suggest a proposal that will actually pass and not get the pushback the current proposal has/and is likely to attract.
Having said all that, sometimes, I wonder whether the battle surrounding the SEC rules is almost the wrong fight. The new IPCC report, which represents the consensus view of thousands of scientists, lays out the profound changes related to adaptation, transition, and mitigation that are needed to avert radical climate outcomes. Reporting might even be three orders of action removed from fundamental changes we need to make to our lifestyle to deal with the impending climate threat.
One consolation might be that reporting is almost a necessary condition to make progress on the climate question as we usually cannot manage what we cannot measure.
