Low-Energy Fridays: The SEC’s Damp Squib

The U.S. Securities and Exchange Commission (SEC) has released its long-delayed final rule requiring climate change emissions disclosures from publicly traded companies. If one were to think emissions disclosures sound like a more appropriate tool for an environmental regulator than a financial one, they’d definitely be on to something. In fact, the rule’s merits largely depend on how one views the relationship between emissions and financial risk since the SEC’s purview is ensuring disclosure of “material” (lawyer-speak for “financially useful”) information to investors. The SEC’s overt focus on emissions rather than risk led to worse policymaking.

The debate over whether emissions are material explains, in part, why the final rule was pared back from the proposed rule. The final rule includes only “Scope 1” and “Scope 2” emissions relevant to a firm’s business practices. Scope 1 emissions refer to direct emissions, such as those from a factory owned by the company; Scope 2 emissions refer to indirect emissions from energy use, such as power-plant emissions caused by a company consuming electricity. Scope 3 emissions—included in the proposed rule but excluded from the final—are emissions related to assets a firm does not own or control, such as employees’ transportation to and from work.

Conceptually, emissions translate into financial risk when governments or market actors penalize firms for their emissions. For example, profits for fossil companies decline under tighter environmental regulation. These increased costs due to changes in law or policy are often referred to as “transition risk.” The SEC’s emphasis on transition risk runs its own risk of displacing the market’s judgment of future climate policy with that of a regulator.

Transition risk is difficult to predict. For example, the early 2000s saw strong political momentum for emissions cap-and-trade policy. If the SEC rule had been published then, it likely would have incorrectly mandated that all companies prepare for the policy, which has never since passed. Nobody, especially regulators, has a crystal ball to foretell future policies.

The materiality of Scope 2 emissions disclosure remains unclear, but it imposes compliance costs. Further, the SEC never clarified how knowing a firm’s indirect emissions would help investors gauge portfolio risk. Additionally, the availability and quality of Scope 2 emissions data is suspect as the methodology alone is unresolved, given the complexity of calculating the marginal emissions of energy consumption. Specifically, the emissions a consumer causes depend on granular grid conditions that vary substantially within a matter of minutes.

Let’s ignore for a moment that financial regulators struggle to unpack this concept. Even electric industry insiders are unclear on the proper accounting framework. And there is no useful data to even begin the calculation in locations outside of organized wholesale electricity markets.

It’s too early to determine if and how Scope 2 emissions are material, not to mention the reporting accuracy problems. They are more relevant to firms that have made public commitments to reduce those emissions. The SEC’s proposed rule included additional disclosure requirements for corporations that made public climate target commitments. This actually would have discouraged private-sector climate action by making it more costly and burdensome.

Fortunately, the SEC dropped many unfounded or counterproductive pieces of its proposal to focus on material disclosures. While many are celebrating (or vilifying) this decision, the truth is that those disclosure requirements have been on the books since 2010, and emissions reporting has been required since 2011. Publicly traded oil companies already had public energy transition plans. Ultimately, the new rule might not change much other than compliance behavior.

Broadly, climate change disclosures were already occurring without an SEC mandate. Climate financial risk takes two forms: transition risk and physical risk. The latter is most impactful to industries like insurance and reinsurance, where incorrect long-term projections of weather volatility can profoundly damage their business. Other industries manage physical risk through conventional mechanisms. For example, farmers use insurance and physical mitigation means to manage flood risk, while property owners use them to manage hurricane risk.

Overall, R Street’s position is that financial climate risk is real, and while the SEC’s approach missed the mark, the narrower scope of the final rule is much better. One positive development could be standardization among existing disclosures, but we won’t find out until the rule is implemented and companies begin to comply with it. This may give investors more accurate comparisons between firms. But any good from this rule could have been accomplished by merely updating existing SEC guidance. And it’s a real problem that the SEC started from such a flawed position, taking two years to figure out how to make it legal. Their focus should be promoting risk-informed markets—not fulfilling political fantasies of widespread emissions disclosure.