Will the SEC’s Proposed Climate Disclosure Rule Come Up against Legal and Economic Challenges?

For this fourth article in our series about the proposed climate disclosure rule from the US Securities and Exchange Commission, experts answer: What are some potential concerns about the legal basis for the rule or its economic costs and benefits?

James D. Cox, Duke University

The Securities and Exchange Act defines the SEC lane by stipulating, “Whenever … the Commission is engaged in rulemaking … the Commission shall … consider … in addition to the protection of investors, whether the action will promote efficiency, competition, and capital formation” (emphasis added). By repeatedly anchoring its proposed climate disclosure rule in investors’ use and needs for such information, presented in an understandable and comparable format, the SEC would seem to be within its lane. That is, the SEC argues that economically significant amounts of capital are managed with a keen eye on how climate risk might impact the amount and timing of an investment’s future cash flow. Meanwhile, the agency points out that companies vary greatly in the climate risks they report and how that information is presented. In this way, the SEC has leaned equally on standardizing both the presentation and appropriate metrics for assessing climate risks in its justification for the disclosure rule. It is on this comparability front that I offer some cautionary suggestions for the SEC as it moves forward to final action on climate risk disclosures.

The proposed rule carefully makes the case that disclosures of climate risk are well within the criteria that the SEC considers when it designs disclosure requirements, i.e., information that enables investors and voting shareholders to assess a firm’s financial position, operational performance, and stewardship, in a way that’s consistent across firms. These themes are set forth not only in the lengthy introduction of the proposed rule but also in each explanation of the directives for climate risk disclosures. No fair reading of the drafted rule suggests that the objective is to rid the planet of greenhouse gases, stop sea levels from rising, or return rains to arid lands. Instead, the rule recognizes that climate risk is a broad concern among investors, and that investors (along with voting shareholders) are genuinely eager to learn about how their portfolio of companies is or might be impacted, how the firms’ management assesses climate risks, and any strategies those firms have to address the risks.

Nevertheless, staying in one’s lane when proposing far-reaching climate disclosure requirements is a necessary (though not sufficient) step toward valid rulemaking. So much depends on how the SEC responds to the commentary it receives in response to its thoughtful proposals.

In the language from the Securities Exchange Act quoted above, I emphasized the operative verb “consider.” Courts that evaluate whether the SEC has stayed in its lane have carefully distinguished “consider” from, for example, “conclude” or “find” when the agency has sorted through comments that have been submitted in response to proposed rulemaking. The choice of verb matters—and matters a lot. The SEC needs to demonstrate not just factual support for a proposed rule that addresses a problem, but also its reasoning based on its understanding of the facts for preferring the course it adopts over alternatives raised in the comments, and furthermore why its choice is in the public interest. Take, for example, a rule change that has been recognized to have costs associated with it. The SEC would need to gather and consider evidence about the source and amount of the costs, the likely effect on firms, differences among firms in terms of the potential impact, and more—but data alone would not drive the SEC’s ultimate decision about the rule.

The vast difference between “consider” and “conclude” may well prove an important issue with the SEC’s proposed climate disclosure rule. In American Equity Investment Life Insurance Company v. SEC, the US Court of Appeals for the District of Columbia Circuit struck down an SEC rule that rendered fixed indexed annuities a regulated security. Among the justifications advanced by the SEC was that, through regulation, this type of annuity would lead to better pricing and market depth, because it would be subject to stronger disclosure requirements and increased transparency; ergo, the rule would “promote efficiency, competition, and capital formation.” To this claim from the SEC, the court replied that the justification could support any new SEC rule, so long as the rule promoted clarity; the court thus required the SEC to consider “whether the specific rule will promote efficiency, competition, and capital formation” (emphasis in original). As discussed here, a key justification for the proposed climate disclosure rule is to enhance consistent disclosure practices (in terms of content and format), such that climate disclosures can be compared effectively across firms.

Can the pursuit of consistency justify any new SEC rule that requires disclosures? The SEC should avoid falling into the trap it laid for itself in American Equity Investment Life—that is, presenting an argument so broadly defined that the agency could not defend its applicability, or failing to justify how the disclosure requirement relates to fundamental investment analysis of the amount and timing of cash flow, or insufficiently demonstrating that the disclosures provide information that is material to shareholder voting. The agency has begun to address this concern by emphasizing in the proposed rule that many firms currently do not provide climate disclosures, and when firms do, their methods vary widely. Further, emerging evidence has shown that many climate disclosures to date are not well-founded in fact or science. Using data to demonstrate these points would allow the SEC to lay a foundation both for defining a regulatory problem and for resolving the issue.

The desire for consistency in disclosures across firms, again, is necessary but not sufficient on its own. To support its rule, the SEC systematically can determine how the current hodgepodge of climate disclosures is material in the sense that even the most resourceful investors cannot compare disclosures effectively. Or, if comparability is possible by placing the burden on investors rather than the firms themselves (e.g., via third-party providers), what is the cost and accuracy? Perhaps the SEC can examine why alternative solutions fail, so it can make the case that mandated uniformity is necessary. Such an inquiry would be consistent with the so-called “hard look” approach for reviewing agency rulemaking—to determine, as best as it can, the economic implications of the rule it has proposed.

Joseph E. Aldy, Harvard Kennedy School and Resources for the Future

This proposed climate disclosure rule presents a thorough, informative, and specific economic analysis on disclosure. More than 15 percent of the SEC’s March proposal discusses the benefits, costs, and impacts on efficiency, competition, and capital formation of climate-related disclosures. In synthesizing rich literatures on disclosure in equity markets—along with information related to climate and environmental, social, and governance considerations—the SEC makes a compelling, albeit qualitative, case for the benefits of mandating climate-related disclosures. Drawing from recent survey evidence, the agency provides quantitative estimates of the costs that firms will incur when compiling and disclosing climate risk information.

Given the acknowledged gaps in quantifying the benefits of climate-related disclosure to investors, the SEC could formally plan to conduct retrospective analysis of the regulation after its implementation. Such an analysis could draw from rigorous studies of the benefits of disclosure in other contexts. For example, Michael Greenstone and coauthors estimate the benefits to investors that are associated with changes in disclosure rules (i.e., expanding the set of firms covered by financial disclosure requirements) under the 1964 amendments to the Securities Exchange Act. The authors compare the returns of the newly covered firms, which changed after the implementation of new disclosure rules, to the returns of firms whose disclosure status did not change under the law. Analogous to a randomized control trial, the newly regulated firms were “treated” by the regulation and compared to the “control” firms without changes to disclosure. These comparisons enable rigorous estimation of the causal impacts of disclosure.

The proposed climate disclosure rule likewise creates opportunities for comparing the outcomes observed for covered firms (which will transition into mandatory disclosure) to the outcomes of other firms that either are not covered by the rule or are subject to the regulation at a later date. The SEC’s climate disclosure rule staggers implementation by size and type of firm, which enables such comparisons. Likewise, discrete thresholds for reporting requirements—such as the conditions for foreign private issuers and the 1 percent financial impact minimum for reporting in consolidated financial statements—also can serve as the basis for estimating the impacts of disclosure. The agency could modify the proposed implementation to craft further opportunities for rigorous performance evaluation.

Developing and implementing a regulatory performance evaluation plan would provide quantitative evidence of the benefits, costs, and impacts on efficiency, competition, and capital formation. Such retrospective analysis could enhance trust, legitimacy, and credibility of the agency’s action, and could inform future efforts to improve climate-related disclosure.

For more information, contact Marc Hafstead, the director of RFF’s Climate Finance and Financial Risk Initiative.

Browse the articles in this blog series about the SEC’s proposed climate disclosure rule.