This post overviews a comment letter that was submitted to the SEC by Alan L. Beller, Daryl Brewster, Robert G. Eccles, David A. Katz, Carmen X. W. Lu, and Leo E. Strine, Jr.
We are a group of commentators with diverse experience in securities and corporation law, business management, accounting, and corporate governance generally. Combined, we bring to bear well over a century’s work in areas bearing on these important issues, and although we have diverse experiences and viewpoints on many issues, we have a shared interest in helping the Securities and Exchange Commission (the “Commission” or the “SEC”) grapple with, and propose a cost-effective approach to, the urgent issue of providing American investors with important information on the effect climate change has on the companies in which they invest.
It is in that spirit that we express our gratitude for the opportunity to comment on the Commission’s proposal to require public disclosure to investors of meaningful information about the substantial risks that climate change poses for the issuers of publicly traded securities. These important disclosures will protect investors in those securities and help promote efficiency, competition, and capital formation.
To frame our comments, we wish to underscore our starting position. If the only choice were to have the rule adopted as proposed, or to not have the rule, we would support adoption of the rule “as is.” Our reasoning is simple. The rule as proposed will help provide investors with uniform, more comprehensive disclosures and greatly enhance the availability of comparable, reliable data and information regarding climate change and its risks. A more than sufficient number of investors of all types have credibly claimed and demonstrated that these disclosures will allow them to make more informed and better decisions regarding risks facing and valuation of the companies making these disclosures, and are therefore material to them and appropriate for their protection.
In our view, the proposed rule is a core exercise of the SEC’s well-established authority to require disclosure necessary and appropriate to protect the integrity of our nation’s securities markets and the investors in those markets. Indeed, to conclude otherwise would upend settled understandings of securities law, and deny investors of all classes access to quality disclosures to make prudent investing and voting decisions on issues that affect the future of American companies and the American economy.
It is in that supportive spirit that we advance the following comments, recognizing that the choice presented to us and the Commission is not between this rule and no rule, but also includes what we believe is a better rule. We are therefore taking up the Commission’s invitation to provide recommendations that will make the substantial benefits of the proposed rule even greater, while also reducing the implementation costs the proposed rule will impose on registrants. Put simply, our view is that a rule of this kind will have substantial value for investors, and that if the suggestions we advance are adopted, the value of this rulemaking to investors will substantially increase, and be achieved at a much lower cost, and the Commission’s important investor-protection objectives will be better served.
I. The SEC’s Statutory Authority to Require Climate Disclosure Important to Investors Is Well-Established and Should Continue to Be Respected by the Judiciary
The SEC’s statutory authority to require disclosure about the effect of climate change on issuers and the climate impact of issuers is firmly rooted in the statutory text. A fundamental power of the SEC since 1934 has been its authority to authorize the Commission to promulgate rules for registrant disclosure “as necessary or appropriate in the public interest or for the protection of investors.” That grant of authority was intentionally broad and designed to give the SEC, which regulates dynamic aspects of a market economy, the power and “flexibility” to address “the complicated nature of the problems” that Congress aimed to resolve, including inadequate disclosure. For that reason, in keeping with Congressional intent, and without further explicit Congressional direction, the SEC has used its authority over the near-century since its creation to require disclosures on topics that have emerged as salient to the integrity of markets and prudent investing, such as the: interests of affiliates in material transactions involving an issuer; performance and background of management; management discussion and analysis (“MD&A”); indemnification arrangements for officers and directors; executive compensation; mergers and acquisitions; disclosure controls and procedures; selective market disclosures; compensation discussion and analysis; board oversight of risk management; mining properties; human capital management; and most recently, form and content of financial statements. As noted above, some of these topics and disclosures were or have become among the most salient to investors, and it has never been seriously suggested that the SEC’s otherwise unquestioned broad disclosure authority should stop at the water’s edge of the most important disclosure subjects. That would be perverse and undermine the clear intent of the statutory scheme.
Consistently, and importantly, the Commission has for nearly a half century properly used its authority to require disclosure regarding environmental and climate-related issues of importance to investors. During the early 1970s, the Commission first required specific disclosure by public companies of information about the environment. The Commission has continued to require environmental disclosures and to further refine those requirements over time. More recently, in 2010 the Commission issued guidance that made clear that issuers should consider more carefully whether matters relating to climate change fall within the categories of information required to be disclosed in public filings under existing disclosure requirements.
In the mid-1970s, the Commission, after extensive consideration including public hearings, determined that investor protection interests would not at that time be further served by extensive additional disclosure requirements regarding environmental matters, and also concluded that the National Environmental Protection Act did not require adoption of such rules. Relevant to the current rulemaking proposal, the Commission stated that its reasons not to engage in the requested extensive rulemaking included, first, the almost total lack of investor interest in the requested extensive additional information, attributable in part to the absence at that time of an appropriate uniform method for disclosure of environmental effects on issuers, and second, the excessive cost and administrative burdens. At the same time the Commission made clear that its broad discretion to require disclosure, including in the environmental area, would provide a statutory basis for expanding or contracting disclosure rules if warranted to address changes in the relevant business dynamic in which American public companies conduct their business.
Times change, especially so in the fast-moving arena of commerce. To that point, we underscore that in making the current proposal, the Commission has concluded that there are currently the sorts of uniform methods that can frame disclosure mandates covering climate-related matters and that there is current broad support for disclosure of climate-related matters from investors of all types. Although some commentators have disparaged as irrelevant the views of institutional investors, we do not, nor do the financial markets. In our experience, institutional investors are fierce competitors, unlikely to take a monolithic view, and, even more important, investors like mutual funds and private equity funds are not known to, because in reality they do not, focus on issues unrelated to profit for themselves and their investors. When leading investors have focused on climate recently, they have therefore done so within the context of focusing on sustainable returns for their investors, which they believe are threatened by the adverse effects of climate change.
Many institutional investors are also the managers of large pension funds and have multi-decade investment mandates that require them to consider and mitigate risks that could impair their ability to deliver sustainable long-term returns necessary to ensure payment of their beneficiaries’ pensions. To that point, climate change is also recognized by scientists, economists and actuaries as a systemic economic, not just social and human and environmental, problem.
Every class of investor has expressed support for better climate disclosure, and the growing interest of individual investors in funds that take climate change into account evidences that ordinary American investors understand the economic importance of this issue. In our collective view, when institutional investors of all diverse kinds—from public and private pension funds, to charitable funds, to private equity funds, to actively traded mutual fund complexes, to index funds —consider consistent, comparable, and reliable information about climate-related risks important, that buttresses the SEC’s determination that climate-related disclosures are appropriate to protect investors and thus within its core statutory authority to mandate.
The SEC is authorized to be responsive when there is broad demand in the investor community for information on an important topic relevant to the viability and prospects of public companies. Although it is of course the right of anyone to oppose the merits of an SEC-proposed rule, it would, in our view, be inconsistent with settled law, and an exercise in unprincipled judicial adventurism, to conclude that the SEC’s broad authority to require disclosures “necessary or appropriate in the public interest or for the protection of investors” does not include the power to require disclosures on a topic universally considered important by investors themselves.
II. Universal Disclosure by All Public Companies of Scope 1 and 2 Emissions Is Transformational and the Proposal Underestimates Its Benefits—Especially If the Commission Addresses Outsourcing of Core Economic Functions and Requires Apples-to-Apples Reporting on Scope 1 and 2
The SEC’s requirement that all public companies disclose Scope 1 and 2 greenhouse gas (“GHG”) emissions in substantial alignment with the well-recognized GHG Protocol promulgated by the World Resources Institute and the World Business Council for Sustainable Development and provide assurance for such disclosures will be incredibly valuable to investors. Some observers, and the Commission itself, appear to underestimate how meaningful this portion of the proposed rule is. For example, some observers seem to assume that all companies already disclose their Scope 1 and 2 GHG emissions. That is not close to true. It is far from universal for public companies to disclose their Scope 1 and 2 emissions; not all that disclose do so in accordance with the GHG Protocol, and it is even rarer for companies to provide assurance or verification for such metrics. Admittedly, one valuable study of a random sample of one-fifth of the biggest public companies—i.e., the S&P 500—found that eighty percent were reporting some measure of Scope 1 and 2 GHG emissions, but one of the study’s main conclusions was that this reporting was done under a wide variety of different criteria, which diminished the ability to determine its accuracy and comparably rank similarly situated companies.
The transformative value of Scope 1 and 2 disclosure has been underestimated in the proposal for another reason. Quality disclosure of Scope 1 and 2 emissions will work in concert with standards in other nations and markets—for example, the European Union and International Sustainability Standards Board (the “ISSB”) which takes as a starting point for its future standard setting activities the standards of the Sustainability Accounting Standards Board (the “SASB”) to enable investors and regulators to hold issuers accountable for accurate and prudent narrative disclosure about their climate impact. Internationally, Scope 1 and 2 disclosure is becoming more standardized and will also be spurred if the European Union’s proposed Carbon Border Adjustment Mechanism (“CBAM”) regulation is adopted. Thus, the proposal builds and is designed to cohere with emerging private sector and international frameworks, in particular the Task Force on Climate-related Financial Disclosure (“TCFD”), the GHG Protocol, and the ISSB. This approach is beneficial to investors and registrants alike. Demand by U.S. global investors is for global comparability of climate-related disclosures. Multi-national registrants, likewise, will appropriately demand one set of reporting requirements, not several, and substantial work has already been done to embed emerging best practices. In addition, the approach of sector-specific reporting—pioneered by SASB and adopted by ISSB—is very much in line with the informational and organizational structure of capital markets.
Thus, the proposed rule’s encouragement for all public companies to use the GHG Protocol, or something close to it—by basing many of the GHG emission definitions and concepts in the proposal on those of the GHG Protocol—will substantially improve the data available to investors compared to the current situation, where many companies do not report this data at all and those who do use a cacophony of incomparable reporting standards.
The proposed rule, however, does not mandate that the GHG Protocol be followed, and that is something we think should be reconsidered. In an admitted departure from our general dislike of prescriptive approaches, in this case we believe the proposed rule would be even more beneficial if it hewed closer to the GHG Protocol and provided for its use in determining organizational boundaries, with as few variations as possible. The Commission’s proposal in effect calls for a more prescriptive approach to setting organizational boundaries. The GHG Protocol permits an issuer to use either the “equity share” approach (under which an issuer is required to include in its emissions its proportional share of the emissions of an entity, based on its equity ownership interest therein) or the “control” approach (under which an issuer is required to report all of the emissions of an entity which it controls). The Commission requires an issuer to use the same concepts in setting its organizational boundaries as it uses in the accounting principles that it uses to prepare its financial statements. Under U.S. GAAP, an issuer would generally be required to report all of the emissions of an entity that it majority-owned or controlled (and thus also consolidated in full into its financial statements), as well as its proportionate percentage share of entities as to which it reported under the equity method.
We understand the reasoning behind the proposed departures from the GHG Protocol to require issuers to incorporate current GAAP consolidation concepts in their methodology and to allow investors to make comparability determinations on the same basis. But the uncertain benefits that would result from requiring departures from the GHG Protocol to accommodate accounting rules do not justify divergences in critical disclosures from what would otherwise be a single uniform global framework.
We also appreciate that the Commission must make a choice where there is not a perfect solution or even an obvious first-best option for reconciling existing GAAP reporting principles and the GHG Protocol. But all solutions will lead to some non-comparability, including that which can result from the approach of the GHG Protocol and that which can result from differences in accounting principles. But mitigating this concern is the reality that there has not been a large amount of comment from investors that any non-comparability resulting from this aspect of the GHG Protocol outweighs the GHG Protocol’s advantages.
Similarly, there is no solution to reconciling differences between the GHG Protocol and GAAP that will not involve additional work for issuers. There may be some advantage to the Commission’s approach for some issuers of starting with their existing accounting records, but this will be mostly true of issuers not currently engaged in making climate disclosures. And issuers for which climate disclosure is brand new will face implementation costs in any event, whatever approach is taken. But for those issuers that have already embarked on efforts to provide their investors with climate information, the costs of deviating from the GHG Protocol may be more substantial than any benefit from attempting to conform climate reporting to U.S. GAAP. The reason for that is that many, and more likely most, of the issuers currently doing some form of climate disclosure are basing their efforts on the GHG Protocol and thus the Commission’s deviations from it will force them to make changes that will impose additional costs on them.
We acknowledge that it is difficult to predict with confidence which approach is least burdensome. But in the face of this uncertainty and the lack of a perfect approach, we believe that there is an important guiding principle that the Commission should keep in mind: there is a huge advantage for investors, preparers, and markets from using a single high-quality global framework to address the critical business risks climate change poses. The Commission has laudably proceeded from recognizing that TCFD and the GHG Protocol represent such frameworks. We respectfully ask that the Commission consider extending the same advantage in adopting organizational boundaries in the rule, and then using its leadership in key international forums to help improve and better standardize those frameworks so that consensus over time on an ultimate best approach emerges.
At the very least, if the final rule does not go further to adopt the GHG Protocol, we would urge that the Commission adopt an additional requirement that issuers identify and explain any differences between their methodology and the GHG Protocol. The final rule should both effectively further encourage use of the GHG Protocol and provide better appreciation for comparability, if not comparability itself, to investors by including in the requirement to disclose methodology a specific requirement to disclose departures from the GHG Protocol. The additional complexity and messiness of such a requirement is itself an argument for adopting the GHG Protocol as the standard.
Having argued that the Commission should follow the GHG Protocol, we nonetheless strongly support a departure from it in one critical respect. The Commission has proposed an anti-evasion provision tied to Scope 3 involving future outsourcing. The Commission should follow a rationale based not on anti-circumvention, but on a general approach to outsourcing that would level the disclosure playing field for similar businesses, with climate considerations that are also similar, and accordingly adopt a provision requiring reporting of emissions of core outsourced activities. To the extent this apples-to-apples approach itself varies with the GHG Protocol, we believe the benefits of the more coherent disclosure of these risks is worth any additional cost, and that the Commission’s exercise of leadership in coming to grips with this key issue and moving the international debate forward in a positive way to address it would be valuable to investors. In the long run, it is inefficient and unwise to have companies’ reported Scope 1 and 2 emissions vary, not by virtue of whether their performance of a substantive economic function has more or less carbon impact but whether the company chooses to do that function directly or have it outsourced and performed by a contractor.
This proposal would enhance the value of the proposed Scope 1 and Scope 2 disclosures by adding a separate element of comparability, and would lessen the need for the more general, and more difficult and expensive, Scope 3 disclosures that the Commission proposes at this stage. Our proposal would maintain an issuer’s Scope 1 reporting requirement, but would also require an issuer to disclose the Scope 1 GHG emissions of other entities for their conduct in conducting material aspects of the issuer’s core operations. The Commission already uses the concept of outsourcing in its anti-circumvention provision. The outsourced operations that would be captured under our proposal would be core and material to the issuer’s business.
Among the factors that the Commission could use to cabin the requirement are whether the operations contracted out cover a material amount of goods or services comprising the issuer’s business and whether they are obtained under contractual or similar arrangements that are long-term and contain individually negotiated terms regarding the specifications of the goods and services, their provision or delivery or the personnel who fulfill the contractual or other arrangements, as opposed to contracts where the issuer is essentially trading in off-the-shelf or commoditized goods or services. Activities that would be expected to be captured by this provision include manufacturing of a material amount of products an issuer sells under its brand name, franchising out by an issuer of the operations of restaurants, hotels, or other consumer outlets that operate under its name and standards and where ownership of the precise outlet is not distinct to consumers, or core functions such as customer service or data operations of an issuer that are material and where customers are directed to buy or address concerns with the company’s services or products. This proposed requirement could operate either upstream or downstream in an issuer’s value chain. For investors, the Scope 1 and 2 impact of different hotel companies should vary because of their different climate impact, not because one chain directly operates all its hotels, and another franchises out a substantial number of them (downstream).
The same is true of manufacturing firms. The fact that one company manufactures its own branded products, such as shoes, and another contracts out the manufacturing does not meaningfully distinguish its exposure to climate risk (upstream). Much of the argument regarding the importance of requiring Scope 3 relates to this issue, and if the rule were to require that the core functions of registrants be reported under Scope 1 and 2 regardless of whether registrants choose to perform those functions directly or by outsourcing, it would improve the comparability of disclosure while reducing the need to impose the more tangential requirements of Scope 3 reporting on registrants.
By this means, a level playing field would be established in reporting, and investors could make more reliable comparisons of the Scope 1 and 2 impact of companies in an industry and across industries. Our suggestion would provide comparability between companies that conduct their core functions internally and those that choose, for whatever reason, to contract them out.
Among the advantages of this rule would be its anti-circumvention effect that would prevent a company from understating the effect of climate on its operations by contracting out certain functions (and thus removing any unintentional perverse incentive to outsource that the proposed disclosures would create).
As noted above, we recognize that our suggestion regarding outsourcing is inconsistent with our position that the Commission should closely hew to the GHG Protocol. But in our view, this is a crucial issue that must be grappled with for two reasons. The first is that from an investor climate risk standpoint, it does not matter whether a product manufacturer—such as a sneaker company—makes its own products directly, makes some of them directly and contracts some of their manufacture, or contracts all of them, in terms of reporting their GHG emissions. The same is true for hospitality companies like hotels and restaurant chains, many of which use a combination of these techniques. To move toward truly comparable climate-related impact information to aid investors in assessing risks, the method by which a company carries out a core function should not drive its obligation to report. The second reason this issue is crucial is that it addresses the important reality that some companies contract out core functions whose climate impact would otherwise be reportable under Scope 1 and Scope 2, without imposing the burdensome and more attenuated aspects of Scope 3 on all companies. To the extent that companies must report the impact of core functions like making their products, running a call center, or operating hotels and restaurants under their brand—regardless of whether they perform those functions directly or by prescriptive contracts—the need to require Scope 3 at this stage goes way down, and investors benefit because like impacts of like industry conduct are reported all in one Scope, regardless of the business technique to accomplish them.
We do not pretend that there are not difficulties in coming to grips with this important issue. But we think that the effort to address it forthrightly, if necessarily imperfectly, in the proposed rule is both important and worthy of mandating. The reality is that the GHG Protocol has not wrestled with this issue, and thus has comparably situated companies in the same industries reporting comparable economic functions on different scopes. There are lines to be drawn in any reporting regime; that is inescapable. And no lines will be perfect. But, if truly comparable reporting is to be required of the ways in which companies are exposed to climate risk that are material to investors, the focus of the approach should not be on the “why” (it does not matter if you did it before the rule or what reason you do a core function by outsourcing, especially as we know most of the reason is to lower costs) or the “how” (directly or by contracting or a combination) of a core economic function, but on the “what”—is it a core function without which the business could not operate and which is central to the way the company makes money? In our view, those functions include functions such as those we have mentioned (e.g., the manufacturing of the company’s products, the operation of their consumer outlets, their interaction with their consumers), and the climate impact of those functions should be reported by all companies on Scope 1 or 2.
Much of the breadth of Scope 3, with its fifteen diffuse components (or as the Commission refers to them, fifteen non-exclusive categories), is not because of distinct functions captured by Scope 3. Scope 3, for certain, does capture issues such as worker commuting that are distinct from Scope 1 and 2 and never have to be reported on Scope 1 and 2 by any company. To be candid, these distinct categories are less important to investors in distinguishing between companies and tend to involve social conditions and information not within the company’s legitimate control, and reporting on them requires more speculative exercises, often about conduct or factors beyond the company’s influence. But Scope 3 also acts as an imperfect seine net to capture the climate impact and risks of companies—what would otherwise be reportable under Scope 1 and 2—solely because they choose to use a contractual, rather than direct, technique of performance. A main reason we do not focus on circumvention as our watchword is that the use of contracting out is already common and driven by motivations, such as cost, that have nothing to do with the proposed rule. For investors in the U.S. and internationally, ensuring that companies in similar industries report on the climate impact and risks of their core economic functions in a comparable way is critical, and should be a focus of those who promulgate use of frameworks like the GHG Protocol and TCFD for purposes of disclosure to investors. The Commission has earned great credibility with international standards-setters and should exercise its leadership here to encourage improvement of the GHG Protocol to address this central issue. Notably, this problem is not one that is confined to climate, and respected scholars have noted that similar problems confront investors in understanding other important issues, because companies are able to escape reporting on the full impact and risks of core functions solely because they use contractual, rather than direct methods, such as direct ownership and management, to carry out those functions. For an issue like climate, the risks of a function that is necessary for a company to be profitable are not minimized by the method of accomplishment. If a shoe must be made, or a hotel must be open, for the company’s strategy to be implemented, how that happens is not relevant to the climate risk that function presents to the company. In our view, this approach is more consequential and will bring more substantial benefits for investors than the departures from the GHG Protocol discussed above.
Even in its original articulation, the Commission’s proposal to have all public companies disclose the level of their Scope 1 and 2 emissions in a substantially uniform manner and provide assurance for such disclosures will seismically improve the availability and quality of material information available to investors, and importantly provide the information that will allow them, and the SEC itself, the ability to better evaluate and challenge as appropriate narrative disclosure about climate and company claims about their climate-relevant conduct—such as claims of moving toward net-zero carbon emissions. The informational base that Scope 1 and 2 disclosures provide, taken together with the narrative disclosure called for by the proposed rule and our suggestions below, helps focus attention on the key direct sources of GHG emissions in the economy that are most important to investors and has the additional benefit in our view of limiting the extent to which more burdensome narrative and Scope 3 disclosures need be mandated in the near term, thereby providing additional time to further refine current guidance on Scope 3 disclosures to address ongoing concerns such as double counting of emissions, improving the methods for identifying and measuring Scope 3 emissions and delineating appropriate organizational boundaries for Scope 3 reporting.
Scope 1 and 2 disclosures, when disclosed in substantial accordance with the GHG Protocol, will help yield high-quality, concrete, auditable data that will be critical for investors’ assessments of climate-related risks, and when disclosed over time, will also provide a basis for measuring progress and ensuring accountability as to transition plans and climate risk mitigation strategies. Scope 1 and 2 disclosures can serve as the basis for future market-led developments to improve narrative disclosure and foster more comprehensive corporate-investor dialogue.
And new software technology that is rapidly being developed by well-funded startups and large incumbent software firms will likely drive down the costs of reporting, especially as the scale of reporting increases.
When all issuers in all industries make uniform Scope 1 and 2 disclosures, the ability of an issuer to mislead investors or get a greenwashed leg up on competitors will be curtailed.
Because it will be possible for investors, analysts, the media, and the Commission to see where particular companies stand in comparison to others about their most verifiable and direct climate impact, using narrative to falsely portray company impact will be much harder. Furthermore, investors will be able to use all the information provided by the new disclosures, as well as other available information, as a check on company narrative disclosure. For example, the product mix of industries like the automobile industry is already the subject of a great deal of public information that can and will be used by investors in that industry alongside the Scope 1 and 2 data as they consider an issuer’s accompanying narrative disclosure about climate.
In this regard, the Proposed Rule Release highlights that the new Scope 1 and 2 information of other companies will help the companies that choose to report Scope 3, providing that “as more companies make their Scope 1 and 2 emissions data publicly available, these data can serve as the input for other companies’ Scope 3 calculations.” The transformational Scope 1 and 2 requirements proposed by the Commission provide significant flexibility in the event that the Commission considers our proposed approach to outsourcing and the truly distinct issues covered by Scope 3. Under either the Commission’s proposal or our suggested approach, there will be Scope 3 reporting, including under our proposal some that is voluntary. But the more effective and comprehensive Scope 1 and 2 reporting we propose will make the truly distinct aspects of Scope 3 reporting better, more meaningful to investors because reported distinctly, and easier to accomplish. By doing what we propose, the climate impact of core economic functions will be reported as a mandatory requirement on Scope 1 and 2 by all companies, allowing for better comparability. When these fundamental functions are reported in a comparable way, the Commission will be in a better position to make decisions regarding whether, to what extent, and how to mandate the truly distinct requirements of Scope 3 and, for example, whether to be industry-specific in its determinations, after the impact on investors, markets and valuation analysis of universal uniform Scope 1 and 2 reporting is understood.
Importantly, this information and experiential basis will lower the cost of any Scope 3 disclosures that may then be required as important to investors.
Under our approach, Scope 1 and 2 issuer disclosures of this kind will have another value. This approach will also enable the SEC to more fully realize its stated goal of syncing with private-sector guidance like the TCFD recommended framework and the ISSB by adopting their more streamlined and less burdensome approach to narrative disclosure. This direction builds on a traditional and effective SEC approach, exemplified by MD&A. Within the context of this vibrant Scope 1 and 2 reporting regime, narrative disclosure within a materiality-driven section of the company MD&A on climate, in close sync with emerging frameworks like TCFD, will be more helpful to investors and less burdensome to issuers to prepare than the overly prescriptive approach of the proposed rule.
III. The Proposal Can Better Encourage Useful Innovation by Not Requiring (or by Postponing) the Disclosure of Scope 3 Emissions, and by Encouraging Voluntary Disclosure by Way of a Safe Harbor for Issuers That Choose to Make Voluntary Disclosure. The Same Is True of Disclosure of Other Innovative Techniques Such as Internal Carbon Pricing
The Commission’s proposed rule requires companies to undertake serious new responsibilities, as will also be the case if our suggestions are adopted. These will involve substantial efforts by company employees and require companies to expend resources for outside advisors for help. To the extent the new requirements involve reporting Scope 1 and 2 emissions, companies may benefit from well-developed existing standards, models like the GHG Protocol and the GHG reporting requirements of the Environmental Protection Agency, and thus be able to make the new and valuable disclosures with more reliability and less burden.
The same is not true of Scope 3, for reasons we have previewed. Although the GHG Protocol reflects important progress in respect of Scope 3 and has significant detail (for example, it proceeds from fifteen defined components, or categories, both upstream and downstream), the process for developing Scope 3 reporting within those components remains more of a work in progress and in greater flux than that for Scope 1 and Scope 2 reporting. Scope 3 reporting also requires companies to obtain information from and place much greater reliance on third parties over which they often have limited or no control or even influence, or from statistical, economic, public, and other general studies that may well have nothing to do with their particular personnel or business circumstances.
We appreciate and respect the Commission’s well-meaning attempt to provide investors information that the Commission believes is important to them for investor protection purposes. If we thought that the proposed mandatory Scope 3 requirements were the best way to serve investor protection interests in this area, we would nonetheless and despite our misgiving prefer the approach. But, we believe there is a better way that in the long run will better serve the Commission and investors.
Let us be clear. We support efforts by companies, investors, and others to improve the efficacy of Scope 3 emissions measurement and reporting. We also believe that if under current law an issuer otherwise deems its Scope 3 emissions must be disclosed, the changes we suggest be made to the proposal would not result in an exemption from required disclosure that would otherwise be the case. So, for example, if disclosure by an issuer of Scope 3 matters would be required to avoid disclosure otherwise being misleading, disclosure should be required, as under current law. The same would be the case with forward-looking Scope 3 information that is reasonably likely to have a material impact on an issuer’s results of operations or financial condition.
We also support the Commission’s proposal to require companies to make accompanying Scope 3 disclosure in their SEC filings if they choose to voluntarily set public GHG emissions reductions or targets that include one or more Scope 3 categories and to voluntarily provide public reports about progress toward those goals that include one or more Scope 3 categories, so long as those filings are accorded the safe harbor protection the proposal contemplates and our recommendations to strengthen that protection and to further limit excessive litigation cost risk are accepted.
But, as to other aspects of Scope 3 reporting, the Commission is operating in a very challenging area. The Commission is properly trying to protect investors and markets by calling for disclosure in a critically important area, but one that is also characterized by more uncertainty, more flux, less hard data and less consensus as to what serves investor interests. We strongly believe that the Commission is in a position where not acting is not a responsible option. The Commission thus has to make difficult decisions in an uncertain landscape. In doing so, we believe the Commission must of course put investors first, but should not disregard the substantial commentary, including from those who support the Commission’s objective, to the effect that Scope 3 information is not currently sufficiently robust or reliable in many cases to be a proper subject today for broad Commission-mandated line item disclosure, even conditioned on materiality, with its normal attendant rigor, controls and procedures. Indeed, it is difficult to read the Commission’s proposed rule regarding Scope 3 disclosure, which would permit use of unverified (and in at least some cases unverifiable) third-party information, data derived from economic studies, published databases or government statistics, and even industry averages, and not see an agency stretching to the outer limits of, and beyond, its normal emphasis on exactitude, the high confidence levels in reliability and desire for verification of disclosed information.
As a matter of reality, we also recognize that for many companies in many industries, especially smaller companies with fewer resources and less market power or other ability to obtain information from third parties, determining Scope 3 emissions is burdensome and uncertain, and not something that they choose to do even as an internal exercise, much less use as a basis for public communication, especially in a Commission filing. At this stage in the development of climate measurement and reporting frameworks, we therefore think it preferable for the Commission to take an encouraging, not mandatory approach, to Scope 3, and to rely more on qualitative disclosures included elsewhere in the proposal or under current law. Even with a materiality trigger for Scope 3 reporting, if an issuer has one or two elements of Scope 3 emissions which rise to a level of materiality, that issuer is required to report all of its Scope 3 emissions across all fifteen components, with questionable benefits for investors. An encouraging voluntary mode and reliance on narrative disclosure is a preferable way for the Commission to start its Scope 3 journey.
A voluntary approach is also advisable because investors and companies themselves in industries with a high climate-salience are likely to drive innovation and convergence on good practices. That outcome should be more desirable for both investors and the Commission. It will happen more efficiently and with less regulatory friction if companies are not otherwise penalized for being willing to take what the Commission itself recognizes are uncertain and challenging steps with greater and uncertain reporting requirements and liability risk.
We are also concerned by the unintended disincentive the proposed rule creates for companies that are undertaking difficult, discretionary efforts to assess their climate impact, such as through internal efforts to price carbon use, and engage in scenario analyses and transition planning. We therefore do not support the provision of the proposed rule imposing greater reporting obligations on registrants that seek to be ahead of the curve, and encouraging those behind the curve to stay there. Nor do we support the proposal to make companies that have “any” climate-related goals or targets, regardless of whether they are public, provide detailed, forward-looking multi-year disclosure about the company’s plans to meet those goals (unless disclosure would otherwise be required under existing rules regarding forward-looking information).
As with our view that Scope 3 should not be a general mandate at this stage, we believe the market itself will be able to encourage good practices and police disclosures using the powerful tool the new Scope 1 and Scope 2 disclosure gives them. The market will be well-positioned to police companies that attempt to use climate goals as a branding exercise rather than a good-faith tool to reduce business risk. If the Commission wants to encourage more disclosure, we believe it should extend to issuers that choose voluntarily to make disclosures about their scenario planning or efforts to hit carbon reduction goals and price carbon internally or their scenario planning, the same safe harbor protection the Commission has proposed to give for Scope 3 disclosures.
Discouraging innovation on this important topic by subjecting those companies making the most serious effort to address the impact of climate change on their business to greater legal burden and risk should be avoided. It is not in the best interests of investors or the markets.
If the Commission decides to proceed with mandatory Scope 3 disclosures, we believe that it should only consider a more targeted approach that would be preferable for both investors and issuers. As we have discussed, if Scope 3 disclosures are to be useful to investors, they cannot be made in an undifferentiated lump covering fifteen, or more, undifferentiated categories, but must distinguish between the contribution of different categories that are covered. The Commission in its proposal in fact recognizes this reality. Although the proposal calls for reporting of Scope 3 emissions as a whole if they are material, it also calls on issuers to identify which categories of Scope 3 emissions are significant and to disclose emissions from such categories separately.
On this logic, if categories must be isolated in Scope 3 reporting to provide investor-useful information—as we agree should be the case —then our outsourcing proposal makes even more sense. But, in addition, imposing reporting by an issuer only in respect of categories that are significant or material would focus on investor-useful information and would lessen the burden on issuers. Such disclosure would also tie more directly into the other parts of the Commission’s proposal addressing material aspects of risk identification, risk management and the like. By contrast, requiring reporting of total Scope 3 emissions, as the Commission’s proposal requires, resulting in undifferentiated disclosure of a single number covering fifteen (or more) non-exclusive distinct functions with no or incomplete ability to discern the inputs, much less to compare the inputs to similarly situated industries players, would be an inferior policy decision both from the perspective of helping investors and limiting burdens on issuers.
At the very least, if the Commission is going to require Scope 3 reporting, it should phase in those requirements, starting with the largest public companies, with billions of dollars of market cap and attendant resources. We would suggest that a line at smaller reporting companies falls well below what should be considered. This approach would focus the implementation costs in the early stages on companies with the largest impact on investors and best able to absorb those costs. And, as we underscore later, companies that are required to disclose or voluntarily choose to do so should receive the protection of a meaningful regulatory safe harbor when facing government enforcement, and should not face the prospect, as we also underscore later, of enforcement by a private right of action.
For that reason, we concentrate at this point on the topic of safe harbors in proceedings initiated by the Commission itself. If the Commission adopts any version of Scope 3 disclosure, it is also essential that it adopt a genuine and not an illusory safe harbor. It gives us no pleasure to observe that the safe harbor proposed falls into the latter category; it is largely if not entirely illusory. Our reasoning is simple. The “fraudulent statement” definition from which the Commission proceeds appears to require scienter.
Our first question is whether the safe harbor has any applicability to other statements and civil liability provisions, particularly Section 11, Section 12 and Section 17 of the Securities Act. Because liability under these sections attaches without regard to whether there is a “fraudulent statement,” the safe harbor is of limited utility where those provisions are in play.
Our second question is whether the Commission intends to seek to interpret the “fraudulent statement” definition as requiring only some form of negligence, as traditional concepts of fraud have eroded in some jurisdictions to encompass negligent misstatements, not just ones made with the wrongful state of mind historically associated with the concept of fraud. If a negligence-based standard is intended and the safe harbor simply involves some modest benefit for due diligence, the Commission should say so, in which case issuers will in our view face undue risk in implementing these important new requirements, which involve the application of new and still evolving standards. If scienter is the standard, as we believe should be the case, then the safe harbor should require the government to prove a knowing or intentional misstatement, so that concepts of negligence or the intermediate state of mind of recklessness are not adequate in proving liability for complying with the new rule.
Our final and related question has to do with the notion of “reasonable basis” in the context of the Scope 3 proposal. For many aspects of Scope 3 reporting, issuers will have to rely on information provided by some third parties over which they exercise no control or market power. The Commission concedes this crucial fact. An issuer can seek verification, assurance, and any sort of comfort or support from these parties. Whether the third party, presumably informed by advice of counsel, will permit any such step is unclear. Many issuers may effectively be on their own to make judgments about reliability. The reasonable basis standard of the safe harbor is of little utility under these circumstances.
We would therefore propose that any safe harbor that the Commission proposes that will actually be useful in producing disclosure in this area require knowing or intentional fraud in the sense that the issuer have actual knowledge that the third-party information it is utilizing is unreliable. Otherwise, issuers will have an unproductive incentive to rely on published sources that provide essentially no additional decision-useful information to investors.
To the extent the Commission believes it needs the authority to require corrective disclosures, the production of certain books and records, or other similar remedial measures against companies, then it could exempt those remedial measures from the safe harbor. But to the extent that the Commission wishes to proceed against an individual or to seek penalties or damages from a company, we believe that a safe harbor requiring proof of knowing or intentional misconduct should apply.
Moreover, this entire discussion is strong evidence supporting our position that a new rules-based requirement of the Commission for disclosure of Scope 3 information is unwise and at the least premature, and our later recommendation that education and facilitation of robust disclosure be the Commission’s key focus and that any enforcement of the new rule be entrusted solely to the government.
IV. Make Narrative Requirements, Including Those Proposed in Financial Statement Notes, Sync Better With Emerging Private Sector and International Reporting Regimes, and With Principles-Based Disclosure, Such as That Found in MD&A
We applaud the Commission for recognizing the value of syncing U.S. disclosure practice with high-quality private sector and international standards, including the TCFD framework and the GHG Protocol. But, as we have previewed, the proposed rule will also be markedly improved if there is substantial simplification and closer adherence to the more streamlined approach of those standards. As important, the proposed rule could achieve its intended purpose at less cost and with more real value to investors by basing narrative disclosure more on existing principles-based disclosure practices used by companies in the MD&A sections of their annual reports. To move in that direction, by way of non-exclusive example, proposed Items 1501-1503 should be consolidated into a single more concise item that is less prescriptive, less redundant and more focused on materiality, and that item should be reportable as a section of the MD&A of the company’s 10-K (or equivalent on a company’s 20-F). An example of an item that effectively addresses the subject matter of the proposed items as suggested is attached as Exhibit 1.
The proposal falls short of its own stated goals by requiring companies to make narrative and certain quantitative disclosures in accordance with strict prescriptive line item quantitative standards and without the consideration, which the Commission is capable of and often gives, of whether the information prescribed to be disclosed is material. For example, the proposed rule includes in numerous places terms like “any” and “all” that are at odds with traditional narrative disclosure requirements and practices that recognize that it is generally best to give companies discretion to assess the significance of information and not force them with overly prescriptive rules to report information of trivial significance.
That said, we understand the Commission’s legitimate concern that some issuers have not been sufficiently rigorous in determining their existing reporting obligations under the Commission’s 2010 guidance to disclose climate-related information required under current rules, and that a quantitative trigger or backstop is helpful in ensuring provision of information important to investors. We also recognize that a one percent trigger has been used in other specific areas. Given the transformational value of the required Scope 1 and 2 reporting the proposed rule mandates, and the intense interest investors will take in evaluating (and in some cases policing) issuers’ accompanying narrative disclosures around climate, we suggest that a more balanced approach might be, if the Commission believes a quantitative trigger is necessary to prevent non-compliance, to set a basic threshold based on materiality and backstop the materiality standard with a numerical level at five percent in the short- and medium-term or ten percent in the long-term. This would limit the ability of issuers to avoid disclosure of meaningful information, while not setting an unreasonably low threshold that will lead not only to a risk but also to a certainty of provision of a massive amount of immaterial information to investors and thus more cost than benefit.
We urge similar caution about the proposed disclosure requirements regarding offsets and renewable energy credits or certificates (“RECs”). This is a level of detail appropriately determined not by a regulator but by a standard-setter (such as ISSB or the FASB). We again underscore that markets, quality certifications, data systems, and other relevant factors critical to climate reporting are still in their infancy, while also developing rapidly. We note also that the proposals, taken literally without a general qualifier making certain that only material issues need to be discussed—for example, “the source of the offsets or RECs, the nature and location of the underlying projects …”—are too prescriptive and risk overly detailed, expensive disclosure of information that is not of decision-making utility to investors and may force issuers to disclose competitively sensitive information.
Similarly, although ZIP code reporting might be relevant to substantive environmental regulators, environmental advocates, or state and local governments, geographic reporting requirements of that kind and at that level of detail seem alien to the singular purpose of the proposed rule—market and investor protection—and involve more cost than benefit. We thus believe the Commission (again as a matter of a better policy choice rather than as a matter of authority) should not require location information, at least in the absence of a geographical concentration of risk or loss that would result in a strong likelihood that such information is material. More relevant to investors are business line risks, which are already a well-recognized basis for required disclosure.
Requiring unduly detailed information of these kinds is not just unduly expensive; it harms investors because the overwhelming bulk of disclosure required can obscure the most important information. Importantly, climate information, although undeniably important, is not the only information important to investors. An overly fulsome—a word we use advisedly— approach to prescriptive climate disclosure also might result both in causing companies to treat climate disclosure as a compliance exercise, rather than a more meaningful exercise of greater utility to investors and in denying companies the opportunity, through sheer resource limitations, to provide equally meaningful disclosure on other important topics to investors.
As to this subject, we also applaud the Commission for its adherence to its precise statutory role of providing disclosure relevant to investors, and not straying into substantive environmental policy that is the responsibility of other agencies of the federal government. We underscore the Commission’s admirable recognition of this in the release discussing the proposed rule, which states “the objective of this disclosure is not to drive targets, goals, plans, or conduct, but to provide investors with the tools to assess the implications of any targets, goals, or plans on the registrant in making investment or voting decisions.” Our proposals to make the proposed rule conform more closely to emerging private sector guidance such as ISSB’s proposed framework on climate-related disclosures and to the SEC’s own model for MD&A disclosure bring the proposed rule into tighter conformity with that objective and will assure that this message is made more prominent. Rather, companies should disclose their objective impact (Scope 1 and 2) and then have flexibility to do a materiality-driven narrative tailored to their industry and company (for which frameworks like ISSB and the MD&A principles of the Commission itself provide a foundation).
V. Focus Required Attestation of Scope 1 and 2 Emissions on an Even Larger Size of Public Companies in the First Phase and Phase in Attestation Requirements as to Other Specified Companies When the Market of Providers Is Broader, Practices Are Better Established, and Implementation Costs Will Be Lower
We support the Commission’s desire to make sure that all public companies report their Scope 1 and 2 emissions in a comparable, reliable manner. That is best achieved by having reporting that is backed by attestation from qualified advisors expert in measuring climate impact. But the Commission’s approach of requiring immediate attestation by accelerated filers and large accelerated filers, strikes us as too costly and as ignoring certain important realities.
The size and market power of American public companies, even at the level of large accelerated filers and accelerated filers, from largest to smallest, varies considerably. So too does their impact on investors. If the Commission takes this into better account, it can improve the benefit to cost ratio of the rule in terms of its approach to attestation. By phasing in attestation starting with the companies that have the largest market capitalization, the Commission will ensure that the first wave involves those companies with the greatest effect on investors. As important, it will focus the first wave costs on the companies that are best able to bear those costs.
We think the proposed rule, with its overly prescriptive attestation and narrative disclosure requirements, risks subjecting both too many issuers and the few advising firms with competence in the area to stresses and imbalances that are bad for the market and hence for investors. We are concerned that the Commission will unintentionally impose professional, independence, and standards stresses on a relatively small set of advising firms, including large accounting firms, that do not have the resources in place to meet the demands the rule will create. Likewise, the requirement for the specified companies to obtain attestation will be most burdensome on mid- and small-cap companies with fewer resources in the early stages of the rule’s implementation. These mutual difficulties for providers and companies will make cost control and timely performance challenging, because a limited array of providers will have to work with diverse companies in a mutual exercise in which both the company and provider must work together to develop a reliable base of empirical data and make difficult materiality and compliance judgments.
We believe that the Commission should think in broad terms regarding participants in the attestation process, and that it is advisable to encourage the participation of environmental advisory firms as an additional source of reliable and independent attestation services, as well as traditional accounting firms. In the early stages, the limited number of firms—including the large public accounting firms, for which we have the highest respect—that certify public filings of public companies will be in high demand, and be under stress themselves to help clients comply with the new rule. In the absence of a more pronounced phase-in than the Commission proposes, this will be especially hard on smaller companies with less market power, and that also may be more likely than larger companies to be measuring their climate impact for the first time.
By contrast, following a phase-in approach, the market can adjust and the Commission can help facilitate the creation of a broader group of reliable attestation firms. As important, the experience gained in the first phase should allow attestation firms to improve their processes and to provide needed services in a more affordable fashion. Likewise, for the rule to be most cost-effective, it is important to recognize that there are other safeguards that temper any risk of a phase-in approach. For example, to the extent companies are already subject to another governmental reporting regime for Scope 1 and 2 GHG emissions, such as that of the EPA, their compliance with that government-enforced regime and the results they report under requirements of law will be reflected in their reporting of Scope 1 and 2 emissions under the proposed rule. Moreover, encouraging good but expensive practices like attestations by smaller companies during the phase-in by giving safe harbor effect for their use, rather than mandating universal use of those practices, seems likely to have more benefit at less cost to investors.
For these reasons, we advocate that the Commission require attestation of Scope 1 and 2 emissions for the first three years of implementation only of large cap companies with a market capitalization of over $25 billion. This would cover approximately 300 of the largest public companies. We would then require attestation of the remaining large-capitalization public companies with market capitalization above $10 billion, covering approximately 275 additional companies, and only after this initial five year period, require attestation by the mid-cap and small-cap public companies specified by the Commission. In the phase-in period, any company not required to use attestation that chooses to employ that safeguard, should receive the benefit of a regulatory safe harbor of the kind we have described in enforcement proceedings.
VI. Emphasize Education and Facilitation as First Priorities, and Limit Enforcement to the Government Itself, Not by Private Right of Action
Precisely because measuring and reporting on climate impact will be a novel task for many companies, and involves the applications of standards and norms that are still evolving, compliance with the rule will be challenging in the early years. Most management teams, like most Americans, take very seriously their duty to comply with the law. They will thus strive to provide investors with reliable, non-misleading disclosure in this new area. And investors themselves will scrutinize disclosures closely and provide perhaps the strongest form of accountability. Moreover, investors have made clear that climate matters to them, and companies will have to be responsive to them. And of course, the SEC and the Department of Justice have enormous authority to enforce the law.
Given these realities, we believe that the benefits of the proposed rule will markedly increase, and the costs diminish, if the Commission emphasizes that its focus in the early years will be on education and facilitation, and that enforcement will be a second-best and less-preferred alternative, at least in the absence of egregious conduct. Importantly, we also strongly believe that enforcement of the new requirements should be left solely to the government, with the stronger safe harbors for companies that we advocate. Thus, the proposed rule should explicitly provide that it cannot be the subject of a private right of action. This is within the SEC’s recognized authority, and the Commission has used that authority in the recent past when undertaking innovative new regulation. This proposal would be strengthened, too, if the Commission would require only that disclosures beyond Scope 1 and 2 and the more streamlined narrative we have suggested be furnished, not filed, with the Commission.
The benefit of private enforcement of the securities laws is questionable, to begin with, and there is great evidence of rent-seeking in private enforcement of corporate and securities laws at the expense of companies and thus their investors. Our skepticism regarding the benefit to cost utility of private rights of action is even higher where the regulation in question involves novel areas where, in order to obtain optimal results for investors, there will be a premium on issuers bringing creativity and new modes of evaluating and addressing disclosure matters. Subjecting companies to enforcement, not by legitimate government authorities, but by private class action attorneys, is likely to make companies less comfortable undertaking innovative exercises in assessing and discussing climate risk. The Commission’s goal of candid, informative disclosures about material climate impact is best achieved by encouraging companies to be forthcoming, and not risking inhibiting forthright and plain talk by creating a new product line for serial-filers of securities litigation.
With the potency of government enforcement, the vigorous input of investors themselves, and the ability of investors to recommend a government investigation if they perceive there may be wrongdoing, there is no need to subject companies to a potential wave of strike suits at a time when they are trying to implement a new and important disclosure regime.
VII. Summary of Proposals to Make the Commission’s Proposed Rule Even More Beneficial, and to Make the Costs of Implementation Even Lower
We are grateful for the chance the Commission has given us to comment on its important initiative to give American investors information critical to the future of the companies in which they invest. We support the Commission in its efforts, and propose the following constructive changes to make its excellent proposal even better:
- The Commission should recognize the power and value of high-quality Scope 1 and 2 reporting, and not require Scope 3 reporting or the reporting of innovative, voluntary efforts like internal carbon pricing, scenario analyses or transition planning, unless a company has chosen to set public targets for Scope 3 or Scope 3 emissions are required and reportable under existing disclosure requirements. Instead, voluntary disclosure of Scope 3 emissions or other innovative techniques should be encouraged by way of safe harbor protection;
- To improve the utility and efficiency of the Commission’s Scope 1 and 2 reporting requirements, the rule should require reporting in conformity with the GHG Protocol, with as little variation as is necessary to allow for investors to compare issuer emissions on an entity-wide basis;
- To further enhance the effectiveness of Scope 1 and 2 reporting, the proposed rule should have strong provisions requiring issuers that outsource material components of their operations, such as manufacturing or call centers, or through franchises, to report the climate impact of those operations within their Scope 1 and 2 disclosures and also ensure the scope of Scope 1 and 2 emissions reporting fully reflect the economic interests of the issuer;
- To further increase the coherence of narrative requirements with emerging private sector and international standards, such as those from the ISSB and TCFD, and with principles-based SEC reporting like MD&A, the requirements for narrative disclosure should be streamlined, the use of words like “any” and “all” or of de minimis quantitative thresholds like one percent should be eliminated or replaced with a more reasonable threshold of five or ten percent, and all narrative and quantitative disclosure beyond Scope 1 and 2 emissions should be subject to a materiality judgment by the issuer about the information’s impact on the company’s operations and prospects consistent with that used in the Commission’s MD&A reporting standard;
- To move in that direction, by way of non-exclusive example, proposed Items 1501-1503 should be consolidated into one more concise item that is less prescriptive, less redundant and more focused on materiality, and that should be part of the MD&A of the company. An example of such an item is attached as Exhibit 1;
- Attestation of Scope 1 and 2 emissions should be phased in rather than be required immediately by all large accelerated filers and accelerated Under this phase-in approach, for the first three years of implementation attestation should first be required for the largest public companies with market capitalization over $25 billion, and then be required by remaining large cap companies with market value above $10 billion. Only after this initial five-year phase-in period should attestation be required by smaller public companies;
- Likewise, to the extent the Commission insists on requiring the disclosure of Scope 3 emissions, or of other innovative techniques such as internal carbon pricing, transition plans, or other climate-related matters, at the very least those requirements should be phased in on the same basis as we urge for attestation; and
- Enforcement of the rule should be limited to the government itself and there should be no private right of action. Emphasis in the early years of implementation should be on education and facilitation, not And, in the context of government enforcement, the stronger safe harbor protections we advocate should apply.
The complete publication, including footnotes, is available here.