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E-MailCydney S. Posner is special counsel at Cooley LLP. This post is based on her Cooley memorandum. Related research from the Program on Corporate Governance includes The Illusory Promise of Stakeholder Governance (discussed on the Forum here) and Will Corporations Deliver Value to All Stakeholders?, both by Lucian A. Bebchuk and Roberto Tallarita; For Whom Corporate Leaders Bargain by Lucian A. Bebchuk, Kobi Kastiel, and Roberto Tallarita (discussed on the Forum here); and Restoration: The Role Stakeholder Governance Must Play in Recreating a Fair and Sustainable American Economy—A Reply to Professor Rock by Leo E. Strine, Jr. (discussed on the Forum here).
Who doesn’t love the latest gossip—I mean reporting—about internal squabbles—I mean debate—at the SEC? This news from Bloomberg sheds some fascinating light on reasons for the ongoing delay in the release of the SEC’s climate disclosure proposal: internal conflicts about the proposal. But, surprisingly, the conflicts are not between the Dems and the one Republican remaining on the SEC; rather, they’re reportedly between SEC Chair Gary Gensler and the two other Democratic commissioners, Allison Herren Lee and Caroline Crenshaw, about how far to push the proposed new disclosure requirements, especially in light of the near certainty of litigation, and whether to require that the disclosures be audited. Just how tough should the proposal be? The article paints the SEC’s dilemma about the rulemaking this way: “If its rule lacks teeth, progressives will be outraged. On the flip side, an aggressive stance makes it more likely the regulation will be shot down by the courts, leaving the Biden administration with nothing. Either way, someone is going to be disappointed.”
According to the article, the issues center around “how much information the agency can force companies to divulge without losing an almost certain legal challenge brought by Washington’s business lobby or a Republican-led state. Another flashpoint involves whether auditors should sign off on the disclosures, ensuring they would be vetted by the same independent watchdogs who review corporations’ financial statements.”
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And the SEC seems to be under some, uh, pressure to move a proposal forward. On February 9, Senator Elizabeth Warren, citing the Bloomberg article, sent a letter to Gensler, expressing her dismay over delays in the rulemaking process.” She made clear her view that the “delays are unwarranted and unacceptable, and violate the commitment, which you made seven months ago, ‘to develop a mandatory climate risk disclosure rule proposal for the Commission’s consideration by the end of’ 2021.” Warren observed that the SEC “is now overdue in meeting these commitments. The lack of a rule means that shareholders and investors are left in the dark about the significant long- and short-term climate risks facing public companies, including supply chain disruptions, infrastructure risks, costs from storms, sea-level rise and weather-related crop or equipment failure, and economic or national security instability.” She also expressed concern about the reasons for the delays—the internal debate about the extent of the requirements to be imposed, as described in the article—and contended that the SEC “has a responsibility to put in the place the strongest rule to ensure that investors are adequately informed about the threats the climate crisis poses to their investments and the broader economy. Having the Commissioners litigate against themselves and issue a watered-down proposal is at odds with that responsibility, and I urge you to act quickly and to release the strongest requirements possible to begin the formal rulemaking.” She asked that the SEC provide to her, no later than February 23, 2022, “(1) a clear timeline for publication of the climate disclosure rule and the rulemaking process that will be kicked off with its release; (2) a summary of any concerns regarding the agency’s statutory authority to impose a climate disclosure rule; and (3) a staff-level briefing on the development of the rule and the rulemaking and implementation process.”
Fundamental to the debate, Bloomberg indicates, is the question of “materiality.” The authors report that Gensler “has been cautioning agency staff to make sure the climate proposal adheres to a legally defensible definition of materiality. He contends that only this approach can survive a legal challenge.” According to the reporters’ sources, “[t]ensions over the divergent approaches have reached a tipping point….At one meeting,… Gensler told SEC lawyers that their work must conform with the interpretation of materiality that has been laid out by the U.S. Supreme Court—a standard that underpins the SEC’s guidance. Gensler made clear that, as far as he was concerned, there would be no more debate on the issue,” the sources told Bloomberg.
Is litigation inevitable? The authors report that “[m]ost Republicans insist that regulating global warming is outside the agency’s jurisdiction, and business groups have already been discussing a litigation strategy.” (See this PubCo post.) But, sources told the authors, Lee and Crenshaw “are less worried about a lawsuit…. Instead, they say the dangers posed by climate change are too serious to take small steps, especially because the disclosures will blaze a new path in securities oversight. Any rule, they maintain, should be broad and not tied to a narrow definition of materiality.”
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Gensler certainly supports a broader definition of “materiality” than some. To be sure, some believe that “materiality” refers only to “financial materiality,” while others take a much broader view, looking instead to the type of information that reasonable investors consider important in making investment decisions. What’s the difference between these two materiality standards? During Gensler’s confirmation hearing, Senator Pat Toomey, an advocate of “financial materiality,” asked Gensler how he would apply the concept of “materiality” in practice? For example, if a big public company spent an insignificant amount on, say, electricity, is it material whether that electricity came from renewable sources? Gensler replied that, according to SCOTUS, the test is whether it’s material to a reasonable investor in the context of the total mix of information. So, in the hypothetical, the information about renewable sources may or may not be material, depending on the total mix of information. Often a financially insignificant amount may be immaterial, but it must be viewed in the broader context of the mix of information. Toomey responded that, if the amount was financially insignificant, he did not see how it could be material. Throughout the discussion, Gensler indicated that he would be grounded in economic analysis and the courts’ views of materiality as the information reasonable investors want to see as part of the total mix of information. Why not leave it up to the companies to decide, Toomey asked? Gensler repeated that it’s a really a question of investors making the choice about the information they want. (See, this PubCo post.)
Lee also believes that investors, not companies, determine materiality. In keynote remarks in May at the 2021 ESG Disclosure Priorities Event, Lee observed that “investors, the arbiters of materiality, have been overwhelmingly clear in their views that climate risk and other ESG matters are material to their investment and voting decisions.”
But Lee goes even further. In those same remarks, Lee contended that SEC disclosure requirements do not need to be strictly limited to material information. Lee viewed that concept as a “widely held assumption. However, this is affirmatively not what the law requires, and thus not how the SEC has in fact approached disclosure rulemaking.” Rather, the SEC has broad statutory rulemaking authority that is not qualified by “materiality.” Where materiality does come up is in connection with the anti-fraud rules, “such as Rules 10b-5 and 14a-9, where it plays a role in limiting how much information must be provided. In other words, materiality places limits on anti-fraud liability; it is not a legal limitation on disclosure rulemaking by the SEC.” Historically, she observes, Reg S-K has always required disclosure that is “important to investors but may or may not be material in every respect to every company making the disclosure.” For example, the requirement to disclose environmental proceedings has a bright-line threshold of $1 million—and, until recently, it was $100,000—without regard to materiality. (See this PubCo post.)
At the end of Lee’s remarks, the moderator asked Lee about the move in the EU to “dynamic materiality” and “double materiality.” In Lee’s view, it was not clear that these standards were all that different from our own concept of materiality. With regard to dynamic materiality, she also viewed materiality as flexible and changing over time. As for double materiality, in Lee’s view, external impacts will be internalized at some point, so even the concept of double materiality may not be all that different from our own perspective.
What is “double materiality”? As discussed in the European Commission’s Guidelines on reporting climate-related information, the Non-Financial Reporting Directive requires that a company “disclose information on environmental, social and employee matters, respect for human rights, and bribery and corruption, to the extent that such information is necessary for an understanding of the company’s development, performance, position and impact of its activities.” In essence, the NFRD “has a double materiality perspective:
- “The reference to the company’s ‘development, performance [and] position’ indicates financial materiality, in the broad sense of affecting the value of the company. Climate-related information should be reported if it is necessary for an understanding of the development, performance and position of the company. This perspective is typically of most interest to investors.
- “The reference to ‘impact of [the company’s] activities’ indicates environmental and social materiality. Climate-related information should be reported if it is necessary for an understanding of the external impacts of the company. This perspective is typically of most interest to citizens, consumers, employees, business partners, communities and civil society organisations. However, an increasing number of investors also need to know about the climate impacts of investee companies in order to better understand and measure the climate impacts of their investment portfolios.”
Not surprisingly, Lee’s fellow commissioner, Hester Peirce, has expressly eschewed the European concept of “double materiality,” arguing that it “has no analogue in our regulatory scheme.” (See this PubCo post.)
Commentators cited by Bloomberg suggested that, at issue may be disclosure of Scope 3 GHG emissions, which some companies contend is too remote from their businesses to be material because the information doesn’t relate to their “core operations.” What’s more, companies don’t control the information, which “unfairly makes companies vulnerable to shareholder lawsuits and government enforcement actions.”
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The EPA defines Scope 3 emissions as emissions that “are the result of activities from assets not owned or controlled by the reporting organization, but that the organization indirectly impacts in its value chain. Scope 3 emissions include all sources not within an organization’s scope 1 and 2 boundary.”
In the article, the authors quote former Corp Fin Director Keith Higgins, who suggested that the SEC needs “to think about how difficult it is for companies to get this information…. It’s a real challenge, and companies are rightfully concerned.” The issue is contentious, however, because often Scope 3 “emissions account for the bulk of a company’s pollution.”
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This article in the WSJ reported about “[o]ne problem facing regulators and companies: Some of the most important and widely used data is hard to both measure and verify.” According to an academic cited in the article, the “measurement, target-setting, and management of Scope 3 is a mess….There is a wide range of uncertainty in Scope 3 emissions measurement…to the point that numbers can be absurdly off.” In one example described by the WSJ, a company was able to cut its GHG emissions in half in just a few years—“with a wave of a calculator.” The change came as the company “doubled down on driving accuracy” in its calculations, revising its Scope 3 emissions, which accounted for 97% of its total emissions for the year. The company’s original report published several years before indicated that its estimates might be off “by as much as 50 percent.” In another instance identified by the WSJ, Scope 3 data relied in part on outdated numbers, using data from three or four years prior to the fiscal year of the report. (The company responded that the outdated numbers were not material to the total footprint and that it had updated other categories of emissions that accounted for an aggregate of 99% of the Scope 3 total emissions.)
According to Bloomberg, the internal debate also concerns whether the climate data should be audited and whether an audit requirement would survive a standard cost-benefit analysis. The authors report that “Lee and Crenshaw argue that step is necessary to assure investors that the disclosures are accurate….Gensler, however, is concerned that forcing audits as opposed to other types of assessments won’t pass muster with a legal requirement that the SEC show the benefits of its rules outweigh the costs, a mandate that opponents often sue over. The chair also has noted that there are no official standards for auditors to follow. Writing those would likely take more than a year and give foes another forum to fight the requirements.”
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The SEC’s request for public comment on climate disclosure sought views on how climate disclosures should be enforced or assessed and, if there were an audit or assurance process or requirement, what organizations should perform those tasks. In remarks last year to the Center for American Progress, Lee indicated that verification of climate and other ESG disclosures, including potentially auditor attestation of sustainability reporting, was under consideration. In her view, symmetry around ESG and financial reporting, such as through attestation, should be the “ultimate goal.” (See this PubCo post.) Then-SEC Commissioner Elad Roisman, on the other hand, contended that companies may not be in a position to make some types of climate disclosure with much precision. He cited as an example the difficulty of obtaining reliable information about Scope 3 GHG emissions, which depends on the company’s “gathering information from sources wholly outside the company’s control, both upstream and downstream from its organizational activities.” Companies may not be in a position to disclose that type of information with much precision. As a result, he expressed concern about requiring verification through an audit or an attestation. (See this PubCo post.)
A report from the Center for Audit Quality showed that just over half of the companies (264) in the S&P 500 had some type of independent verification of their climate data. Around 235 used an engineering or consulting firm; only 31 used an accounting firm. In addition, the scope of assurance varied. The vast majority of assurance from engineering or consulting firms related solely to GHG metrics, with 123 covering only GHG, 79 covering GHG plus a select number of additional metrics (“GHG+”) and only 23 covering multiple metrics related to a broad range of topics. Assurance provided by public company auditors was generally broader, with nine related only to GHG emissions, 13 covering GHG+ and nine covering multiple metrics related to a broader range of topics. The standards employed also varied. Among audit firms, 27 applied the AICPA attestation standards, and four referenced the International Standard on Assurance Engagements 3000. Among engineers and consultants, 162 applied ISO 14064-3 for greenhouse gases and 72 applied their own methodology, which they often indicated was based on ISAE 3000.
Notably, regardless of the provider, the CAQ reported that the levels of assurance were, for the most part, not comparable to the levels provided in a financial statement audit. Among audit firms, 25 provided “limited assurance,” that is, they typically involved limited procedures and included reports that were framed in the negative—e.g., nothing has come to our attention to cause us to believe that the sustainability report has not been prepared, in all material aspects, in accordance with XYZ standards, or we are not aware of any material modifications that should be made to the schedule of sustainability metrics for it to be in accordance with XYZ criteria. Only two provided “reasonable” assurance (a positive opinion) and three were mixed. Similarly, among consultants and engineers, 174 provided “limited” assurance, 17 “reasonable” assurance, 17 “moderate” assurance and 15 were a mix. Why the less rigorous levels of assurance? The engagement may provide only “limited assurance” because of time and cost constraints or, perhaps as explained by the Institute of Chartered Accountants in England and Wales, it may be because, in contrast to financial statements that are “extracted from a double entry bookkeeping system,” a non-financial assurance engagement may address a subject that is “less well defined and for which the control environment is far less mature and robust. For example, the calculation of a company’s carbon footprint may have been performed by an individual and the results collected on a spreadsheet and supported by files of memorandum information.” (See this Pubco post.)
3 Comments
What does all this portend for the March 21, 2022 SEC open meeting? Will the Commission be voting on proposed regs that will proceed through the public notice and comment process? Or will the Commission be adopting policy approaches to a rule with the direction that the SEC draft proposed rules that implement the policy? For all of the reasons stated in this excellent article, the SEC appears to be no where near issuance of proposed regs with such major policy issues unresolved.
The above does not mention the newly formed International Sustainability Standards Board (ISSB) and their progress in creating “ a comprehensive global baseline of high-quality sustainability disclosure standards to meet investors’ information needs.” Additionally, this article does not speak to the European Commision’s Corporate Sustainability Reporting Directive (CSRD). I would like to see an analysis of the CSRD and their definition of materiality relative to the SEC’s. I would also like to read commentary on the various working documents that the ISSB has issued to date and whether or not the SEC should or could adopt similar standards for sustainability reporting.
I draw attention to reasons why I do not support the proposal in its entirety as it stands.
•The core idea behind corporate disclosure is to inform financial investors of risks and opportunities that affect a company’s performance and valuation. Enforcing this proposal pushes the SEC’s role outside its prescribed remit to foster capital formation and improve the functioning of markets into climate change advocacy. It is much too prescriptive, treats materiality too broadly and ambiguously, and panders to non-shareholder stakeholder constituency special interests. It will also impose huge reporting burdens on registrants without commensurate benefit. Additional disclosure, as required, will do little to improve transparency into a firm’s operations, financial situation, outlook or assist ordinary investors in deciding to lend, to invest or disinvest in a company. The proposed rule also puts to question the role and limits of government and regulation in a market economy.
•It attempts to bring, without stating so explicitly, a common measurement thread across firms operating in very different sectors, stages of maturity and geographies. If seeking comparable data and statistics that may be aggregated to foster advancing national goals on climate change is one peripheral objective, the proposal is unlikely to catalyze that. Reporting and disclosure are outputs from scenarios and stress tests which in turn are heavily predicated on assumptions and methodological choices. Unlike the more mature sphere of financial accounting, within climate change, uncertainties and assumptions are far larger and harder to estimate. This is exacerbated by inherent risks embedded in climate’s longer time horizon. Climate effects vary widely by sector, industry, geography and within these and other categories individual entities vary widely in carbon intensity. The level of climate damage at different levels of intensity and time frames varies hugely, is non correlated making additive aggregation of exposure a spurious exercise. At a systemic level to arrive at a macroprudential view, problems arise between the desired level of granular risk differentiation between firms and the need to aggregate millions of exposures (all arrived at separately) across firms.
•The nonlinear behavior of climate effects on specific categories have been near impossible to model over time using stocks, flows, internal feedback loops and the many unknown interconnections that exist. An interaction in which a change in one climate quantity causes a change in a second, and the change in the second quantity ultimately leads to an additional change in the first, multiplied multiple times adds to complexity. There exists no proven modelling framework that captures, even with reasonable accuracy, effects of climate scenarios over medium and long-time frames, much less attuned to the specifics of a particular company. We are still years away bridging features of climate modelling with economic and financial modelling, as well as incorporating methods which account for system dynamics, complex feedback, and amplification effects. Consulting firms have started new work in arriving at climate-related ratings, but these ratings are widely off the mark. One reason is we lack standardized metrics and definitions, and scores are based on proprietary methodologies.
•Projections are heavily driven by changes in methodologies as new data becomes available, as uncertainty from data and models changes and as future developments unravel. Climate change drivers continue to change which generate, increase, or reduce climate transition risks. Furthermore, evolution in government legislation, consumer tastes, regulation, market prices and other assorted factors effect changes in the carbon economy. These in turn affect causal chains and transmission channels to the real economy and ultimately to registrant corporation reporting and disclosure.
•In the absence of better answers, we see increased reliance and fallback on The Task Force on Climate-Related Financial Disclosures (TCFD) to develop consistent climate-related financial risk disclosures. However, this reliance is misplaced faith for purposes of fiduciary SEC reporting, as we do not have appropriate frameworks to systematically translate climate change scenarios into standard financial risk. Much work still remains to be done to further identify important risk drivers, their applicability, their transmission channels, and mapping those into measurable and reportable financial metrics.
•Corporate financial reporting horizons have tended towards three-year forecasts, but climate risks are expected to increase in materiality over a much longer horizon. Climate effects linkages and magnitude affects to credit, market, operational, liquidity risk have yet to be understood. Moreover, in the absence of consensus, individual firms can arrive at their own estimations which will vary widely, making comparable near impossible.
This proposal, whilst well intentioned, is a case of regulation getting ahead of the science.