What SEC's Rule Means



Fortnightly Magazine - November 15 2022

The history of ESG, short as it is, is told here, and its swift rise on the radars of C-suites at major energy and utilities companies is beyond noteworthy. This talk serves as a guide as to how all industries got here.

That "here" is a place where in 2021, over ninety percent of the public companies in the S&P 500 released a sustainability or ESG report intended to communicate with investors on these metrics. That is according to an authority on this subject and much more.

That expert, Evan Williams, knows all about the U.S. Securities and Exchange Commission, and especially about its proposed rule that would require public companies to provide climate-related financial data. Listen in on this important conversation, which ties much together, as the U.S. Chamber of Commerce Director for Capital Markets Competitiveness provides insights on where the SEC may be going with that proposed rule.

PUF's Steve Mitnick: Why has ESG captivated the SEC?

Evan Williams: It's captivated the hearts and minds of capital markets both from an endorsement and an aversion sort of perspective. In 2010, under the direction of Mary Schapiro, who was then SEC Chair, the SEC issued a set of guidelines for public companies to disclose climate-related information.

Guidance to this effect does not have the force of rulemaking but was intended to help companies discern what information is relevant to investors as they consider making decisions based on a set of metrics. ESG was intended to be this extra evaluation set that could be used to make determinations about the investment worthiness of a company beyond its core valuation and information. At the outset of ESG, about fifteen years ago, it had more of a moral tie-in than it necessarily does today.

Then in 2010, this guidance came out and public companies began to disclose information more fulsomely around climate voluntarily, to more of a format following the SEC guidelines that answered the call of investors as to what kind of information was relevant and important when making investment decisions.

To be clear, not all investors were or are interested in making decisions based on ESG metrics. However, some large investors lined up behind ESG goals — at first especially around the environment — and ESG became more entrenched as a force in the market.

PUF: I heard that increasingly European investors were asking tough questions of U.S. utilities on ESG. It was a trend.

Evan Williams: Absolutely. ESG can be viewed as an outgrowth of developments in the European regulatory space, particularly pertaining to the Paris Climate Accord. The Europeans began to implement principles of the Paris agreement into their own regulations and influence the multinational investment community.

That began to mold itself into compliance with European regulatory standards, especially in terms of environmental-related determinations. All of that came back to the United States, partially through multinational investors.

Those threads have resonated with activists and others in the U.S. who see what's happening in Europe and want to facilitate those criteria and investment determinations here domestically.

PUF: A few years ago, EEI and AGA built common templates to make ESG information readily available.

Evan Williams: It's important to emphasize that the ESG conversation doesn't apply only to the energy sector, that it's not just oil and gas nor public utilities being scrutinized. It's big tech and heavy manufacturing, but increasingly also services and other industries that you might not immediately think would have a link for investors in environmental investing, but some investors now want to know the climate information of a broader universe.

In the last year, over ninety percent of the public companies in the S&P 500 released some kind of sustainability report or ESG report intended to communicate with investors on these metrics.

PUF: We've been talking about the E, and E is prominent in climate, but it's ESG. How are S and G folded in?

Evan Williams: Again, the genesis of ESG is a particular set of metrics intended to be a basket that investors could look through the lens of to make determinations about a company's investment worthiness. It was intended to be a set of metrics purposefully outside of the core metrics that were typically relied upon.

As soon as you talk about environment, you almost out of necessity need to start talking about corporate governance. Look at the ways in which shareholder proposals have been harnessed at public companies, as often environmental initiatives manifest in attempts to make changes to corporate governance.

The E and G are inextricably linked. Then as you start to think about company policies and where companies are going on some of these issues, you naturally think about the people and employees meant to implement those policies.

That's where you begin to implicate the social aspect of ESG and the employee aspect of ESG. It's not just E and G, but it's also E, S, and G all tied together. There are some who think the acronym shouldn't be ESG, it should be EESG, Environmental, Employee, Social, and Governance.

The people who tend to make suggestions to that effect are often academics, but you can begin to see how it's all tied together. Plus, there is a trend — particularly in companies that are not immediately profitable — in wanting to forecast future value based on the employees, incentives, and metrics that build up how you retain employees. The S piece began to fit naturally into the whole of ESG.

Two years ago, when you talked about ESG in Europe, you were mostly talking about the E aspect of ESG. Now, Europeans have started to move in the direction of focusing on the S and G in regulatory proposals.

The EU recently issued their Corporate Sustainability Reporting Directive, which is also an outgrowth of the Paris Climate Agreement, with broad and far-reaching core metrics. It was passed through the regulatory process, and it is now up to member states to implement the Directive at the beginning of next year.

That's their core environmental reporting piece. But as soon as they began to be comfortable with those metrics, they also issued their Corporate Sustainability Due Diligence Directive, which begins to contemplate director duties of care related to social issues and supply chains.

When I say social issues in the European context, they're empowering stakeholders and creating imperatives to identify and de-risk supply chains' interactions with human rights abuses and other issues. That's a trend to watch regarding the future of ESG and ESG's trajectory.

PUF: Going forward, the SEC has proposed rules that might embed extensive requirements into the 10-K. Where is that now?

Evan Williams: Predicated on the 2010 guidance, in 2021 the SEC came forward with a request for information on ESG disclosure, generally. That started the process that led to the March 2022 proposed rules on climate disclosure. The SEC did a lot of information intake as a result of the request for information.

The Division of Corporation Finance also sent many letters to companies asking specific questions about why they voluntarily disclosed what they did related to climate and why it may have been incorporated in a filing versus not.

Then in March of 2022, SEC issued this proposed rule that frankly is broad, overly prescriptive, and is built from the Task Force on Climate-Related Financial Disclosures (TCFD) and the Greenhouse Gas Protocol, both of which are European constructs.

Companies that voluntarily disclose this information often disclose to their own industry standards within a standard-setting body. They are disclosing to standards established based on different industry segments.

What the SEC's rule doesn't contemplate at all is variation in industry. Essentially, the SEC's mandate would begin to apply to all public companies in 2026.

The biggest public companies, those above seven hundred million — Large Accelerated filers — under the SEC's proposed rules or timeline, would have to comply with the rule beginning in 2024 and then Accelerated filers would have to comply in 2025.

Then the rest of the public company sphere would have to comply in 2026 with some exceptions, but for the most part, everybody's in by 2026, under the SEC's current timeline put forward in its proposed rules.

PUF: The utilities industry feels transparent because it is regulated, so the SEC perhaps is making the rule too broad.

Evan Williams: That is one of the problems with the proposal. But beyond not contemplating industry, other pieces that are problematic include issues like ZIP code-level disclosure of where your assets are that you've determined to be at risk related to climate.

The rule calls for Scope 1 and Scope 2 emissions disclosures. But in certain circumstances, also Scope 3. Particularly if you've made a net-zero commitment as a company, the SEC calls on you to disclose Scope 3 because it becomes, in the SEC's view, the measure by which you're assessing your progress against your net-zero goal.

PUF: That a tough one for the energy and utilities industry because again, those commitments are public and transparent. It imposes extra requirements.

Evan Williams: Certainly, and it's one of the areas of most concern for the business community that is non-public, as well. Think about how to make a Scope 3 evaluation. There are fifteen categories of Scope 3 metrics to begin with.

In order to report to the level of liability consummate with filing in a 10-K, effectively an estimate is not going to be good enough. Maybe in the first year of reporting it would be okay, but moving forward, an estimate is not going to be sufficient to satisfy and alleviate the concerns of the legal department in filing that information with the SEC in such an important document.

The concern of the agricultural community, vocalized in the SEC's comment file, and also the Small Business Administration's Office of Advocacy came forward and said, we're worried about the implications for small companies up and down supply chains as a result of such a broad Scope 3 mandate.

In the interpretation by a lot of public companies, even those that have not made net-zero commitments, they feel as though they would fall under the Scope 3 requirement in the SEC's proposed rule and would therefore have to report Scope 3 information.

Then the natural thing to do, in order to get a better estimate of your aggregate Scope 3 emissions, is to survey those in your supply chain and ask them what their Scope 1 and Scope 2 emissions are. By effect, you've got this indirect mandate on the entire country for anybody who does business with a public company to track and report Scope 1 and Scope 2 information.

PUF: Where does this stand now?

Evan Williams: I believe the SEC is thinking about how to moderate its rule. There are those who have raised the specter of litigation against the SEC, should they finalize the rule as proposed. In particular, a number of state Attorneys General have raised serious questions about the rule and may look to sue the SEC in the next chapter of the Major Questions Doctrine expanded in the Supreme Court's decision in West Virginia v. EPA.

Therefore, the SEC is thinking carefully about its statutory authority and how it should proceed. The SEC said it wants a rule that can withstand a court challenge and that will be preserved for the next chair of the SEC to expand upon.

There is a vested interest at the SEC in trying to get a rule that will withstand court challenge, which falls within the core authority of the organic authority of the SEC. The SEC does have relatively broad authority to compel information from public companies, but it must think carefully about how climate-related information may bump against the outer limits of that authority.

That's one of the core principles of our capital markets, is that the companies provide information to investors that's relevant to their determinations related to investment decisions.

It's part of the SEC's remit to protect investors. It's one of the three planks of the SEC's mission.

But the SEC does not have the authority to be a climate regulator. The EPA has the authority to be a climate regulator. The Department of Energy, to a certain degree, has the authority to be a climate regulator.

The Securities and Exchange Commission does not have a congressional mandate to be a climate regulator. There's a fine line between compelling information that's relevant to investors in making an investment decision and overstepping the SEC's authority.

What the SEC should do currently is think carefully about what naturally falls within its authority, especially in light of West Virginia v. EPA, versus going out on a limb in terms of interpretation of its authority.

The SEC is thinking about how it might reinterpret its authority to cover more entities in both public and private companies. There are all kinds of legal theories about whether the SEC has the right to do that or not.

In terms of the climate rule, the SEC should look at well-understood authorities and see how what they've proposed fits with those and try to make changes that would organically match the SEC's understood authority and better steep the rule in concepts of materiality, so there is protection from a lawsuit, should they finalize the rule and draw lines.

PUF: A lot of the big financial players are drivers on ESG, they're the ones who have been pushing.

Evan Williams: In broad strokes, they have recognized there's a responsibility to help bring about the change in climate financing, so the future is greener than it is today. That's also as you look at some of the European regulations, and at what's being contemplated at the FDIC, Office of the Comptroller of the Currency, and other places.

Banks and other financiers are being asked by the Biden Administration to evaluate their exposure to climate-related risks and take steps accordingly. A lot of the big financial houses feel it's incumbent upon themselves to help foster the necessary change. There are internal and external pressures driving those policies within those entities.

However, they've begun to recognize, at least in the context of annual general meetings, that matters related to ESG, or that would be labeled ESG, have the potential to detract from long-term value. Some of the shareholder proposals at those meetings are now distracting from a company's ability to implement change and bring about change to their business model and other kinds of initiatives that would lead to effective implementation of a net-zero commitment or other societal-related achievements.

PUF: A distraction from financial performance too?

Evan Williams: Yes. In the eyes of the large asset managers, their evaluation now is asking, is this an ESG initiative or is this an ESG micromanagement initiative?

There's growing concern that micromanagement is, one a distraction, but two, potentially could inhibit the ability to bring about the macro changes they want to see companies make. So, they've actually shied away from supporting shareholder proposals that would implement niche governance changes at public companies.

PUF: Where's this going to end up?

Evan Williams: At this juncture, given that the SEC received fourteen thousand comments in its file on climate disclosure, they've got some work to do, including a one hundred forty-one page comment from the U.S. Chamber of Commerce.

The SEC has its work cut out for it under the Administrative Procedure Act to demonstrate that it has been responsive to the comment file that has come in. The business trades, the audit and preparer community, some of the financial houses, and others have raised alarm bells about the SEC's rules as proposed, that they are unimplementable.

PUF: The Administrative Procedure Act requires they read all the comments and take them into account. They can't say, we don't like this and throw it out.

Evan Williams: They have to be able to justify why some of the comments are acceptable or could be incorporated versus why others are not meritorious in consideration. Because of the level of pushback in the comment file, the SEC is going to have to take its time, and slowdown in finalizing this proposal.

The thought here is — at least from where I sit — that core compliance with the rule could move out of the 10-K. The SEC now seems to acutely understand that the process at the EPA for finalizing emissions for heavy emitters takes their process into the Fall before those numbers are ready.

The thought is, you could move Scope 1 and Scope 2 emissions disclosures, and some other additional climate-related metrics out of the 10-K. Leave the core risk assessment to businesses related to climate within the 10-K because it naturally fits within that context, and then establish a discrete form for climate reporting that would be due, say, a hundred and eighty days after you file your 10-K.

What this would mean in the context of initial compliance with the rule is the SEC would theoretically finalize before quarter one of 2023, and court compliance with the rule would begin in quarter three or four of 2024, depending on when you file your 10-K.

Some of the more prescriptive aspects of the rule could also fall away in a final rule. For instance, the ZIP code disclosure could fall away and lead to a rule that's narrower, more tailored, and easier to comply with.

The SEC should also think about the line-item disclosures in regulation S-X. The SEC proposed requiring public companies to evaluate each line item of their financial footnotes, to see if their climate-related expenditures and losses equaled more than one percent of that particular footnote.

That's the part of the rule the financial services community took the most issue with. Based on the comment file, the SEC should end up with a final rule that hopefully is less prescriptive and more intuitive to companies in terms of compliance, and they should give companies a little while to pull themselves into compliance with the rule.