Water Implications and Likely Legal Challenges

The world is seeing the impacts of climate change. The Northern Hemisphere just had its hottest summer on record, and the Southern Hemisphere just had its warmest winter on record.  In the midst of climate disasters, the Securities and Exchange Commission (SEC) finalized a new rule to standardize public company climate-related disclosures for investors.  The SEC is an independent government agency that Congress tasked with protecting investors, facilitating capital formation, enforcing federal securities laws, and regulating securities markets.

The SEC proposed this rule against a backdrop of renewed discussion regarding ESG investing. ESG refers to environmental, social, and governance standards used by investors to select socially responsible investments. Currently, the Biden Administration faces legal challenges regarding a Labor Department rule allowing retirement plans to consider ESG issues when making investment decisions. Proponents for ESG investing argue that it is a positive way to bring about social change while increasing company profits. Opponents argue that ESG issues are better handled by government agencies, not corporate America, and that these “sustainable” companies are simply greenwashing–overstating their sustainability practices to attract investors.

The SEC requires public companies to provide investors with periodic reports to ensure investors can review a public company’s financial statements, possible risks, and executive compensation packages.  This information allows investors to analyze whether they should continue to invest in a specific company.  The SEC requires all public companies to make disclosures so that investors can compare information across industries or companies.  For example, if an investor is interested in purchasing shares of oil and gas companies, periodic reports allow investors to compare companies’ financial statements within the oil and gas industry.  Investors can compare risks, costs, revenue, and profit among several companies because the SEC requires standardized disclosures according to generally accepted accounting principles (GAAP).  The more information an investor has, the better they can analyze their investments, which in turn leads to a predictable and stable financial system.  Investors can find information regarding company filings on the SEC’s EDGAR search platform. 

The Proposed Climate Change Rule

The SEC originally proposed a more robust climate change rule in 2022.  The proposed rule would have required public companies to make the following disclosures to investors:

• The registrant’s governance of climate-related risks and relevant risk management processes;
• How any climate-related risks identified by the registrant have had or are likely to have a material impact on its business and consolidated financial statements, which may manifest over the short, medium, or long-term;
• How any identified climate-related risks have affected or are likely to affect the registrant’s strategy, business model, and outlook;
• The impact of climate-related events (severe weather events and other natural conditions) and transition activities on the line items of a registrant’s consolidated financial statements, as well as on the financial estimates and assumptions used in the financial statements;
• Disclosure about direct greenhouse gas (GHG) emissions (Scope 1) and indirect emissions from purchased electricity or other forms of energy (Scope 2); and
• Disclosure of GHG emissions from upstream and downstream activities in its value chain (Scope 3), if material or if the registrant has set a GHG emissions target or goal that includes Scope 3 emissions.

The SEC’s goal was to ensure that investors had information pertaining to all climate-related risks necessary to make informed investment decisions. Specifically, these disclosures will help investors select companies that mitigate climate risk.  This rule would have standardized climate disclosure, making it very easy for investors to compare information across companies.

The proposed rule was criticized by corporate America. Many companies argued that these requirements were too burdensome and costly to implement. Specifically, companies argued that it would be very difficult to calculate the indirect greenhouse gas emissions (referred to as Scope 3 emissions) from upstream and downstream activities, such as shipping.  However, some companies supported this rule. Apple was the first major company to support the proposed mandatory climate change disclosure rule.

How Does This Rule Address Water Risk?

Climate-related risk includes water risks.  Certain companies may be more susceptible to drought, rising ocean temperatures, and rising sea levels, for example. The SEC’s disclosure rule would require companies to disclose plans to address their water-related risks.

When preparing reports, companies may look to the CEO Water Mandate, a special initiative of the UN Secretary-General and UN Global Compact, aimed to address “development, implementation, and disclosure of corporate water sustainability policies and practices.” The Mandate platform provides guidelines for business reporting on water-related issues. According to the Mandate, industries expected to experience high exposure to water-related risks are agriculture, beverage producers, biomass power production, chemicals, clothing and apparel, electric power production, food producers, food retailers, forestry and paper, freshwater fishing and aquacultures, hydropower production, mining, oil and gas, pharmaceuticals and biotech, technology hardware and equipment, and water utilities and services. Broadly, companies will need to evaluate which water-related risks will apply and the implications of those risks.

The Final Climate Change Rule

The SEC released the final climate change rule in March 2024 after reviewing 24,000 comment letters. Below are the new requirements for climate-change disclosure for public companies:

• Climate-related risks that have had or are reasonably likely to have a material impact on the registrant’s business strategy, results of operations, or financial condition;
• The actual and potential material impacts of any identified climate-related risks on the registrant’s strategy, business model, and outlook;
• If, as part of its strategy, a registrant has undertaken activities to mitigate or adapt to a material climate-related risk, a quantitative and qualitative description of material expenditures incurred and material impacts on financial estimates and assumptions that directly result from such mitigation or adaptation activities;
• Specified disclosures regarding a registrant’s activities, if any, to mitigate or adapt to a material climate-related risk including the use, if any, of transition plans, scenario analysis, or internal carbon prices;
• Any oversight by the board of directors of climate-related risks and any role by management in assessing and managing the registrant’s material climate-related risks;
• Any processes the registrant has for identifying, assessing, and managing material climate-related risks and, if the registrant is managing those risks, whether and how any such processes are integrated into the registrant’s overall risk management system or processes;
• Information about a registrant’s climate-related targets or goals, if any, that have materially affected or are reasonably likely to materially affect the registrant’s business, results of operations, or financial condition. Disclosures would include material expenditures and material impacts on financial estimates and assumptions as a direct result of the target or goal, or actions taken to make progress toward meeting such target or goal;
• For large accelerated filers (LAFs) and accelerated filers (AFs) that are not otherwise exempted, information about material Scope 1 emissions and/or Scope 2 emissions;
• For those required to disclose Scope 1 and/or Scope 2 emissions, an assurance report at the limited assurance level, which, for an LAF, following an additional transition period, will be at the reasonable assurance level;
• The capitalized costs, expenditures expensed, charges, and losses incurred as a result of severe weather events and other natural conditions, such as hurricanes, tornadoes, flooding, drought, wildfires, extreme temperatures, and sea level rise, subject to applicable one percent and de minimis disclosure thresholds, disclosed in a note to the financial statements;
• The capitalized costs, expenditures expensed, and losses related to carbon offsets and renewable energy credits or certificates (RECs) if used as a material component of a registrant’s plans to achieve its disclosed climate-related targets or goals, disclosed in a note to the financial statements; and
• If the estimates and assumptions a registrant uses to produce the financial statements were materially impacted by risks and uncertainties associated with severe weather events and other natural conditions or any disclosed climate-related targets or transition plans, a qualitative description of how the development of such estimates and assumptions was impacted, disclosed in a note to the financial statements.

Changes between the Proposed and Final Rule?

The most notable changes between the proposed and final rules are (1) companies only need to disclose climate-related risks which are material and (2) companies do not need to disclose Scope 3 emissions.

The new rule is a step in the right direction for investors and the environment, but many environmentalists and investors will argue that it does not go far enough. It is possible that requiring public companies to disclose their material climate-related risks and direct greenhouse gas emissions will incentivize companies to implement sustainable practices.  While the SEC does not typically prohibit conduct, the agency often relies on public disclosure requirements as a method to change company behavior.  Investors may not choose to purchase shares in a company if the company discloses that it has a comparatively larger carbon footprint than other companies in the industry.  However, how will companies determine which climate risks are material?  Materiality is typically defined as something that impacts an investor’s decision to buy, sell, or maintain shares.  However, material risks will vary by company and industry, making this data less comparable for investors.

Additionally, environmentalists will likely critic the SEC’s failure to require disclosure of Scope 3 emissions.  Emissions stemming from supply chains were found to be 11.4 times higher than emissions from operational business—meaning that failure to disclose Scope 3 emissions leaves the majority of carbon emissions undisclosed by public companies.  The burden of Scope 3 emissions does not fall on large companies, but on suppliers and customers.

Expected Legal Challenges

The SEC’s new rule will likely be challenged on several fronts. Courts may overturn certain disclosure requirements if they are too burdensome. Specifically, courts may decide that the SEC made an arbitrary and capricious decision under the Administrative Procedure Act if it failed to make sufficiently detailed findings necessary to protect investors without placing an undue burden on companies. However, given that the SEC reviewed 24,000 comment letters and subsequently dropped the requirement for companies to disclose Scope 3 emissions and only require disclosure of material climate-related, the rule is unlikely to be found arbitrary and capricious.

Opponents to the rule may also argue that it exceeds the SEC’s statutory rulemaking authority. Jacqueline Vallette and Kathryne Gray outlined several likely legal challenges in their article. Specifically, these authors state that the SEC’s enabling statute could be interpreted narrowly to only protect investors from “inflated prices and fraud.” Providing investors information regarding environmental initiatives may fall outside of the SEC’s duties of enforcing and regulating the U.S. securities market. The SEC has two enabling statutes, the Securities Act of 1933 (1933 Act) and the Securities Exchange Act of 1934 (1934 Act). These statutes require the SEC to obtain company disclosures to protect the public interest and investors. Those opposed to the rule will argue that Congress only intended the SEC to require companies to disclose material financial information when protecting investors.  However, the SEC will argue that climate related risks have a material impact on financial information and investors’ subsequent decisions.  Investors likely want to know if a public company is spending money to mitigate climate events because it adds security to their investment.

The SEC’s rule may also be challenged under the major questions doctrine. Specifically, opponents will argue that Congress is better suited to regulate climate change disclosures. The final rule requires disclosures from public companies regarding their material climate-related risks.  These disclosures may be burdensome and expensive for public companies, which could impact the economy. Further, the issue of addressing climate change itself may be a major question.  However, the SEC will argue that the rule only mandates disclosures and findings, not action. The SEC has historically required public companies to comply with periodic reporting requirements. The SEC will argue that disclosures are not a major question because it has always required public companies to disclose information to investors, and climate-related risks are material to investor decision-making.

In line with the major questions doctrine, an agency can only use delegated legislative authority if Congress has provided that agency an intelligible principle to guide legislative rulemaking.  Arguments regarding improper delegation will focus on the level of instruction Congress gave to the SEC when requiring disclosures to protect investors. This rule may be an impermissible delegation of legislative power depending on the consequences of nondisclosure of material climate-related risks. If non-disclosure implicates the fraud provisions of the 1933 and 1934 Acts, then heavy civil penalties will attach to noncomplying companies and their boards of directors. A court would ask whether Congress provided the SEC with an intelligible principle regarding public companies’ necessary disclosures. The Supreme Court has rarely ruled against administrative agencies when looking for an intelligible principle. However, given the current makeup of the court, this judicial approach could change. 

Finally, the rule may be challenged under the First Amendment.  Companies opposing the rule may argue that the rule compels disparaging speech related to climate change.  However, the SEC has historically required different forms of disclosure, which have not yet been challenged as a violation of the First Amendment.  If the Supreme Court were to hold that disclosure of negative information about a company is subject to the First Amendment, several other SEC disclosure requirements may be at risk in the future.

As of now, at least nine lawsuits have been filed challenging the new rule by both Republican-led states and business lobby groups. Environmental groups such as the Sierra Club and Natural Resources Defense Council are also challenging the rule, arguing that the rule does not go far enough to protect investors. The less burdensome final rule is more likely to succeed against its upcoming legal challenges.  The Supreme Court likely will need to weigh in on the SEC’s new climate change disclosure requirements.

SOURCES

• Benjamin Mullin, U.S. Judge Denies States’ Bid to Block Biden Rule on E.S.G., N.Y. Times (Sept. 21, 2023), https://www.nytimes.com/2023/09/21/business/texas-judge-esg-biden.html.  
• Clark Mindock, Challenges to SEC's Climate Rules Sent to Conservative-leaning US Appeals Court, Reuters (Mar. 22, 2024), https://www.reuters.com/legal/challenges-secs-climate-rules-sent-conservative-leaning-us-appeals-court-2024-03-21/.
• David Colvin et. al., Get Ready for SEC Final Rule on Climate Disclosures, J.D. Supra (Oct. 6, 2023), https://www.jdsupra.com/legalnews/get-ready-for-sec-final-rule-on-climate-7695075/.
• Declan Hartly, SEC’s Gensler Weighs Scaling Back Climate Rule as Lawsuits Loom, Politico (Feb. 4, 2023), https://www.politico.com/news/2023/02/04/sec-climate-rule-scale-back-00081181.  
• Defining What to Report, The CEO Water Mandate, https://ceowatermandate.org/disclosure/prepare/define/ (last visited Oct. 10, 2023).
• E. Napoletano, Environmental, Social And Governance: What Is ESG Investing? Forbes (June 22, 2023), https://www.forbes.com/advisor/investing/esg-investing/. 
• Hazel Bradford, Apple Backs SEC Mandate on Climate Disclosure, Pensions and Investments (Apr. 13, 2021), https://www.pionline.com/esg/apple-backs-sec-mandate-climate-disclosure.  
• Jacqueline M. Vallette and Kathryne M. Gray, SEC’s Climate Risk Disclosure Proposal Likely to Face Legal Challenges, Harvard L. Sch. Forum on Corp. Governance (May 10, 2022),  https://corpgov.law.harvard.edu/2022/05/10/secs-climate-risk-disclosure-proposal-likely-to-face-legal-challenges/#:~:text=There%20are%20at%20least%20four,major%20questions%20of%20climate%20change.
• Jean Eaglesham and Paul Kiernan, Climate Disclosure Poses Thorny Questions for SEC as Rules Weighed, The Wall Street J. (Feb. 18, 2022), https://www.wsj.com/articles/climate-disclosure-poses-thorny-questions-for-sec-as-rules-weighed-11645180200.
• Major Questions Doctrine and Canons of Statutory Construction, Cornell L. Sch., https://www.law.cornell.edu/constitution-conan/article-1/section-1/major-questions-doctrine-and-canons-of-statutory-construction (last visited Oct. 10, 2023).
• Press Release, U.S. Sec. and Exch. Comm’n, SEC Proposes Rules to Enhance and Standardize Climate-Related Disclosures for Investors (Mar. 21, 2022), https://www.sec.gov/news/press-release/2022-46.  
• Press Release, U.S. Sec. and Exch. Comm’n, SEC Adopts Rules to Enhance and Standardize Climate-Related Disclosures for Investors (Mar. 6, 2024), https://www.sec.gov/news/press-release/2024-31.
• Corporate Water Disclosure Guidelines (2014), The CEO Water Mandate, https://ceowatermandate.org/disclosure/about/ (last visited Oct. 10, 2023).
• The World Just Sweltered through its Hottest August on Record, N.O.A.A. (Sept. 14, 2023), https://www.noaa.gov/news/world-just-sweltered-through-its-hottest-august-on-record#:~:text=June%2DAugust%202023%20was%20also,a%20degree%20C)%20above%20average.
• U.S. Securities and Exchange Commission, https://www.sec.gov/ (last visited Oct. 10, 2023).