A recent report indicates that there is a debate within the Securities and Exchange Commission (SEC) over its forthcoming climate disclosure rulemaking—specifically about disclosure of Scope 3 greenhouse gas emissions. Scope 3 emissions are associated with a company’s value chain, such as emissions from purchased goods (upstream) and from use and disposal of its products (downstream). Apparently, all three Democratic commissioners support a requirement that companies disclose their Scope 3 emissions but differ in how this requirement should be implemented. The SEC should adopt the stronger approach and release the proposed rule without delay, which would allow the public to weigh in on the issue.
In crafting a disclosure rule for Scope 3 emissions, the SEC can choose from two paths: It could impose a prescriptive and exacting standard, or it could use a broader, more open-ended standard that relies on the concept of materiality. The latter effectively means a company discloses what it thinks investors will consider important—a determination that investors can later challenge in court. According to the report, there is a fear among the commissioners that selecting the wrong implementation standard will increase litigation risk.
The SEC should articulate a clear, concrete and specific Scope 3 reporting standard that does not rely on materiality. Implementing a concrete standard is no more likely than a materiality standard to result in the final climate rule being overturned by the courts and could even result in less litigation in future years. It would also ensure that investors and other market participants have companies’ reliable, comparable Scope 3 emissions information—information that is critical to evaluating risks as the physical impacts of climate change increase and the economy continues to transition away from fossil fuels.
According to the commonly accepted legal definition, a piece of information is material “if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote.” Ironically, companies initially determine what information investors will deem material when making their disclosures. Subsequently, if a failure to disclose is challenged in court, judges decide if a company’s materiality decision was valid. It can take years of litigation on a case-by-case basis to flesh out the specific disclosures that are needed to meet a materiality standard.
Many policymakers believe—and many issuers assert—that the securities laws already require companies to disclose all material information to investors. This assertion, however, is inaccurate. The disclosure of material information is only required where there is a duty to disclose, such as where the SEC has promulgated a rule requiring the disclosure of material information or where additional disclosure is needed to render disclosed information not misleading.
Under the securities laws, the SEC is not required to base its disclosure rules on materiality. It can simply require that certain pieces of information be disclosed if those disclosures are “appropriate and necessary in the public interest or to protect investors.” So, while the SEC could determine that the materiality standard is all that is needed in a given situation, it could instead decide that a different standard is more appropriate, for example, in order to maintain reliable, orderly, and efficient capital markets or to promote well-informed capital formation.
Traditionally, SEC rules have combined these approaches by implementing exacting disclosure standards accompanied by a requirement that companies also disclose other material information. The SEC does this, in part, because certain kinds of information are necessary to ensure that the securities markets function well and to protect the public interest and investors—regardless of whether the information is material to a specific investor in a specific company. For example, while the SEC requires a corporate issuer to file a registration statement that describes the business and how the company will use the sale’s proceeds, among other details, it also requires issuers to provide “such further material information, if any, as may be necessary to make the required statements, in light of the circumstances under which they are made, not misleading.” In another example, the SEC requires companies to disclose information about share buybacks, even if a particular company only buys back a single share. In all of these examples, the SEC has determined that the specific information sought is so important that all investors and market participants need to have it as a baseline of disclosure while remaining information need only be disclosed if material.
Scope 3 emissions are a perfect example of information that all investors and other market participants need to know in order to be protected. Both the physical risks of climate change—for example, damage to facilities from floods or fires—and the risks associated with the transition to a low-carbon economy—such as government policies requiring a shift away from fossil fuels, disruptive energy technology innovations, or simply changes in consumer demand—can also affect entities up and down a company’s value chain. Transition risks are particularly important when it comes to Scope 3 emissions because transition risks are so diverse and may have serious financial, liability, competitive, or reputational impacts, even for entities with very low carbon emissions. So, even low emissions of entities a company relies on up and down its value chain (Scope 3) can have significant knock-on effects. Scope 3 emissions are all the more important precisely because they cannot be gleaned without inside information about a company’s suppliers and customers and because nearly all of some fossil fuel producers’ emissions are in Scope 3. Thus, the SEC is highly justified in requiring the disclosure of Scope 3 emissions at least in high-emission industries or with respect to certain high-emission Scope 3 activities.
This is not to say that the SEC should necessarily require all securities issuers to disclose their Scope 3 emissions immediately, even if their activities only result in extremely low emissions (although the SEC could do that). It could pursue a narrower, concrete Scope 3 emissions rule initially by beginning with the largest (and easiest to calculate) Scope 3 emitters. For example, the SEC should require fossil fuel producers to disclose the amount of greenhouse gas emissions that would be emitted upon combustion of their products. This specific type of downstream Scope 3 emissions is straightforward to calculate, and there is no reason to allow companies the discretion to omit, obscure, or vary the way these emissions are reported to investors. In addition, it could require all other issuers to disclose the Scope 3 emissions for which the Greenhouse Gas Protocol provides data and methodologies for calculating. And it could signal in its rule that additional Scope 3 emissions disclosure will be required as data and methodologies are developed. Such a rule would not only be feasible but would be legally permissible as well.
Importantly, reliance solely on a materiality standard for Scope 3 emissions—that is, effectively leaving each company to decide what is important—may reduce court challenges from issuers, who would prefer this weaker rule. However, it would likely lead to a drawn-out period of litigation in the future by investors seeking, on a company-by-company basis, to establish more specifically what should be considered material under the rule. Reliance solely on a materiality standard would also deprive the capital markets of critical and timely information necessary for them to function properly and for capital to move to its best use.
The climate disclosure rule is an opportunity for the SEC to require companies to disclose important information on Scope 3 emissions rather than leaving it to litigants to determine in court over the next few decades what companies should disclose—a process that is both legally unnecessary and dangerous for the markets and the economy. The SEC should expeditiously release the climate rule with a concrete and specific requirement that companies begin disclosing Scope 3 emissions. This approach to implementing a Scope 3 emissions disclosure rule would ensure that investors have reliable, consistent, and comparable information on this critical aspect of climate risk in the capital markets. Comments on the proposed rule will guide the SEC on how to implement the final rule. But, without a strong approach in the proposed rule, investors and other market participants have little chance of getting the information they need anytime soon.