Why climate disclosure is the SEC’s job – Not investors’

The US Securities and Exchange Commission (SEC)’s proposed climate disclosure rules are expected to be released soon in final form.  Although I and others have argued that the rules fall squarely within the SEC’s long-standing regulatory authority and should easily pass constitutional muster, litigation is inevitable, possibly on both of these grounds. 

Assuming investors are right when they say they need climate risk information that companies aren’t telling them, then an obvious question for skeptics of the SEC’s authority to mandate climate disclosure is, “If the SEC can’t do it, who can?”  In the US system, the next best option would be the Environmental Protection Agency (EPA), but the EPA isn’t authorized to regulate how information reaches the capital markets – not to mention that the Supreme Court decided last summer that the EPA isn’t even authorized to protect the environment by regulating emissions. (This context explains why a post that is about the SEC’s climate disclosure rules is not, in fact, about climate change.  To stay at the core of its clear statutory authority, the SEC has taken pains to stress that its rules do not address climate issues generally.)

The status quo -- and what investors are left with if the new rules cannot survive court challenge -- is to look to investors themselves. Reliable opponents of disclosure rulemaking like the US Chamber of Commerce have long argued that shareholders proposals and other forms of private ordering are better ways for investors to get information than imposing more transparency on all companies as a condition for access to the public capital markets (though the US Chamber also argued for tighter limits on shareholders’ access to these tools). 

The suggestion that investors are the answer has been extended in a recent paper by Scott Hirst, who argues that the SEC could (and in Hirst’s view, must) use shareholder voice to prove that climate risk is material to a given firm’s investors.  This proposal could also make the SEC’s climate disclosure rules more flexible and thus more defensible.  Specifically, Hirst argues that the SEC should let each company opt out of all or part of the climate disclosure rules if investors vote to do so.  Management would start the process by deciding what rules to put to an opt-out vote.  If investors think climate risk is material and the benefits of transparency outweigh the compliance costs, they won’t support an opt-out.  If they do, so the argument goes, then the costs of climate risk disclosure outweigh the benefits, and the firm shouldn’t have to report.  Hirst rightly observes that an opt-out would be preferable to an opt-in, where the default position for most firms would be to not provide any specific climate risk disclosures.

Investors cannot and should not do the SEC’s job, and there are high costs to making them try.

Leaving the tough questions up to shareholders has a certain appeal.  Giving firms more flexibility could well stave off the more far-reaching administrative and constitutional arguments that, were they to stick, could invalidate not only climate risk disclosure but most of the existing federal disclosure regime as well. This would be a death knell for investor confidence in the U.S. capital markets.  And since US investors already get a “say on pay,” why not a “say on climate disclosure”?[1] But investors cannot and should not do the SEC’s job, and there are high costs to making them try. 

One reason not to just leave it to investors is that this is the approach the SEC, along with the rest of the world’s major capital markets, has been taking for years.  It is now over a decade since the SEC issued guidance urging companies to assess the materiality of climate-related information under the existing reporting rules, but the level of climate-related reporting in corporate filings is low.[2]  More importantly, most companies still report climate information, if at all, outside their public filings based on disparate, self-selected standards.  This makes it difficult for investors to see what’s missing and to compare information across sectors and over time.  Leaving disclosure demands to investor self-help is also costly not just to investors, but to companies too.

The second reason is that disclosure is about more than materiality.  Even if climate risk were not material to investors and important to helping markets efficiently price climate risk, the SEC has clear authority and justification to adopt climate risk disclosure because of the systemic risk that climate risk poses to the capital markets as a whole. The SEC is charged with maintaining orderly markets, which includes using disclosure to mitigate systemic risk.  This responsibility cannot be left to investors.

But the main reason that investor (read “corporate”) opt-outs, like voluntary disclosure and shareholder proposals, aren’t reasonable or acceptable alternatives to SEC-mandated climate disclosure is that they don’t advance the same goals.  The core goal of the SEC’s rules, like the standards coming out later this year from the International Sustainability Standards Boards (ISSB) and the European Union, is in fact to standardize climate disclosure across firms and sectors.  All three use the baseline framework of the Task Force on Climate-Related Financial Disclosures (TCFD), which it’s worth noting, aligns with financial materiality as defined under the US securities laws. 

It is hard to see how a system that makes it impossible for the rules to achieve their most basic purpose would survive challenge, even if the courts take a liberal view of the SEC’s cost-benefit analysis.

Flexibility is necessary but it impedes standardization.  In fact, as I’ve argued in recent work, the SEC’s rules already build in flexibility, maybe too much flexibility.  Corporate disclosure opt-outs would go further, tuning the SEC’s rules into a menu from which a new generation of case-by-case exemptions would emerge. If their goal is to help the SEC’s rules survive as Hirst argues, it is hard to see how a system that makes it impossible for the rules to achieve their most basic purpose would survive challenge, even if the courts take a liberal view of the SEC’s cost-benefit analysis.

Shareholder referenda, like shareholder proposals, ultimately push the regulatory burdens of investor protection – a clear responsibility of the SEC – onto investors themselves.  Outsourcing disclosure regulation to investors (or voluntary standard setters) also pushes the costs of getting information on risk – something companies are loathe to disclose voluntarily – onto investors as well.  This is because the real cost of any shareholder vote is the cost of ensuring that the vote is informed.  Management is unlikely to present to investors the informational benefits of the information the firm hasn’t and won’t produce if the opt-out passes.  Nor is management likely to divulge the value of the compliance cost “savings” investors should weigh against those benefits unless another new SEC disclosure mandate compels them.  Since more information disclosure would be needed to make voting on climate disclosure informed, shareholder disclosure referenda would be unworkable, not readily administrable, and far more costly to investors than a straightforward, but flexible, disclosure mandate such as the SEC has proposed.

Blocking mandatory climate disclosure or subjecting it to opt-outs will make the U.S. the only major market in the world where investors do not have reliable, comparable climate risk information as a matter of course.  This comes at a high cost to the reputation, competitiveness, and stability of the U.S. capital markets.  Investors are already paying the costs of climate risk transparency that companies should have to bear.  They shouldn’t be asked to take on the SEC’s job as well.