Monday, April 26, 2021

CRS report surveys SEC’s current guidance on climate risk disclosures

By Brad Rosen, J.D.

Observing that potential risks to the U.S. financial system from climate change have attracted growing attention in government, academia, and media, as well as raising questions about the roles of financial regulators in addressing such risks, the Congressional Research Service (CRS) issued a report titled Climate Change Risk Disclosures and the Securities and Exchange Commission. The CRS paper points to the groundbreaking report, Managing Climate Risk in the U.S. Financial System, issued by CFTC’s Market Risk Advisory Committee September 2020. That report concluded the SEC’s 2010 climate change guidance has not resulted in high-quality disclosure of climate change risks across U.S. publicly listed firms, and that it should be updated in light of global advancements over the preceding 10 years.

The CRS paper focuses on the SEC’s current guidance and standards for climate change risk disclosures as well as the agency’s application of the "materiality" standard for disclosure of material risks under federal securities laws. The report also provides an analysis of how the SEC is addressing climate change’s impact on global supply chain risk, together with an overview of the SEC’s current regulation for investment management companies and environmental, social, and governance (ESG) funds relating to climate change.

The 2010 SEC climate change guidance and its limitations. In 2010, the SEC issued Guidance Regarding Disclosure Related to Climate Change (the "Guidance"). Key points expressed in the Guidance include the need to disclose, if material:
  • the impact of climate change legislation and regulation;
  • the impact of international accords on climate change;
  • climate change-based disruptions in supply chains;
  • indirect consequences of regulation or business trends; and
  • physical impacts of climate change.
Although the Guidance has been central to policy on corporate reporting of climate-related risks, its efficaciousness has been limited. In 2018, agency senior staff told the Government Accountability Office (GAO) that they had no expectations the Guidance would result in changes to companies’ climate-related disclosures because the Guidance did not involve new disclosure requirements. In January 2020, then-SEC Chairman Jay Clayton observed that SEC staff had issued comments questioning the sufficiency and consistency of the disclosures in certain instances,

In February 2021, Acting SEC Chair Allison Herren Lee stated that investors are increasing their consideration of climate-related issues when making their investment decisions, and that it was the SEC’s responsibility to ensure that the investors had access to material information when planning for their financial future. As part of these efforts, Lee then directed the Division of Corporation Finance to enhance its focus on climate-related disclosure in public company filings, including review of the extent to which public companies were addressing the topics identified in the Guidance. She also indicated that the SEC staff would be moving to update the 2010 Guidance to reflect developments in the past decade.

Materiality and climate change risk disclosure. While federal securities law does not explicitly require disclosure of specific climate-related risks, the SEC’s 2010 Guidance provides that a public company may need to disclose climate-related risks that are "material" to investors. Generally, publicly traded companies must disclose in their periodic filings certain information such as financial statements and other business information specified by SEC regulations. SEC regulations also require disclosure of "such further material information, as may be necessary to make the required statements, in light of the circumstances under which they are made, not misleading." The U.S. Supreme Court has defined a material fact as follows: "An omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote." The Court explained "there must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available."

Case-by-case inquiries and a lack of consistency. The courts and the SEC make materiality determinations on a case-by-case basis, using a principles-based approach rather than prescribing bright-line rules. As such, courts have not identified a quantitative threshold for the impact of a misstatement or omission in order to make it material. Even so, the SEC’s default position has been that the materiality standard should be understood in terms of the information’s economic or financial impact.

There have been relatively few decisions specifically analyzing the materiality of a company’s disclosures concerning the impacts of climate change. However, in two relatively recent cases, courts have analyzed the materiality of Exxon Mobil Corporation’s (Exxon’s) disclosures and omissions relating to its "proxy cost of carbon" measure—a metric which, in this situation, approximates the cost of potential government-related climate change actions in connection with certain transition risks in financial projections. In each of those cases, the plaintiff alleged that Exxon’s public disclosures of its proxy cost of carbon were materially misleading because they differed from some of Exxon’s internal estimates of the relevant costs. The courts, opining at different stages of the litigation process, reached disparate results as to the misstatements’ and omissions’ materiality.

Investment manager climate-related disclosure requirements lack clarity. ESG funds are portfolios of equities and/or bonds for which environmental, social, and governance factors have been integrated into the investment process. Investor interest in these vehicles has grown significantly over the years. For example, according to Morningstar, the mutual fund researcher, ESG mutual funds received $51.1 billion of net new funding from investors in 2020. That reportedly represented the fifth consecutive annual increase, and more than double the $21 billion in 2019.

As is the case with its approach to reporting companies, the SEC does not have rules, regulations, or requirements that specifically govern investment companies’ or investment advisers’ use of ESG principles or their disclosures of ESG-related strategies that may impact climate change. There is no universally agreed-upon, or legally-binding, definition of what constitutes ESG, or an ESG fund. While no standardized requirements currently exist for such ESG funds’ investments, there are certain fundamental regulations within the federal securities laws that have an indirect impact on ESG disclosure-related practices. For example, if an investment company’s manager, an SEC-registered investment adviser, incorporates ESG principles as a primary investment strategy, disclosure of the strategies and risks associated with them must be in the investment company’s registration statements under the Investment Company Act of 1940.

The SEC recently announced creation of an ESG Task Force to analyze disclosure and compliance issues relating to ESG strategies. In April 2020, the SEC’s Division of Examinations warned that its review of ESG funds had found a number of misleading statements regarding ESG investing processes and adherence to global ESG frameworks, among other issues. In today’s environment, the SEC’s increased involvement and scrutiny with respect to issues around climate-related risks and disclosures appears to be a certainty.