Regulating The Environment Through The Securities And Exchange Commission

Apparently, it is not enough for the Securities and Exchange Commission (SEC) to simply maintain fair, orderly, and efficient financial markets. The agency is now considering becoming a climate regulator with a new rule whose comment period ends tomorrow (June 17, 2022).

That is not how the SEC frames the issue, of course. According to the Chairman, the proposed rule would mandate climate related disclosures that will “provide investors with consistent, comparable, and decision-useful information for making their investment decisions”. Such an outcome is improbable.

If implemented, companies would be required to conduct a specific and detailed carbon accounting that reports to the SEC their own direct emissions, as well as the emissions by the company’s suppliers and customers.

It should be noted upfront that, to the extent that emissions create potential risks for investors, companies are already legally liable for reporting this information. Consequently, the new rule is unnecessary. The rule’s proponents who claim that the disclosures improve investors’ ability to assess climate related risks fail to recognize this fundamental reality – companies already face penalties for failing to report this information when relevant. There are, consequently, no potential benefits created by the rule.

There are many costs, however.

To start, a detailed accounting of companies’ emissions requires additional human and financial resources that will increase companies’ cost structures. Reports that provide no benefits, but certain costs, harm investors’ interest, it does not promote them.

The regulations also incentivize public companies to consider a supplier’s emissions when choosing their business partners. Fundamental business considerations – such as choosing the supplier that produces the right inputs, at the right price, that meet the necessary delivery schedule – are consequently deemphasized. By disincentivizing the creation of the most efficient supply chain possible, the mandate will have deleterious impacts on corporate costs and/or profitability.

Beyond these tangible costs, there are fundamental problems with carbon accounting that undermines its value. It is an imprecise and inaccurate exercise plagued with verifiability issues and accuracy problems. One oft-cited concern, organizations often take credit for the same emissions reductions creating a problem of double counting the savings. Consequently, carbon accounting provides investors with imprecise information that fails to improve investors’ understanding of the potential risks that companies face.

These problems are amplified by the rule’s requirements that companies include the emissions of their suppliers and customers. It is simply impossible for companies to accurately report the emissions from their suppliers and customers, and it is unclear how companies can obtain all the relevant information – particularly from their customers. Without direct access to this information, companies will have to rely on proxy information to comply with the mandate that is just as likely to provide misinformation as information.

Including the emissions of their suppliers and customers in the rule is also inconsistent with the SEC’s mission. Based on the mission of ensuring that investors are appropriately informed of all material financial risks, only a company’s direct emissions matter. The emissions of customers and suppliers are outside of the firm’s control and, most importantly, not a direct investor risk. It is, consequently, simply inappropriate for the SEC to include these emissions in their proposed rule.

The inclusion of suppliers and customers is also improper because it raises concerns that, even if unintentional, the regulations are primarily an environmental regulation rather than a regulation geared toward ensuring efficient financial markets.

It is the legislative branch of government that is responsible for making the laws, including the laws that govern the national approach to global climate change. Consequently, the establishment of emission requirements should be left to Congress to design. Multiple Congresses have had the opportunity to pass global climate change policies such as imposing a federal carbon tax or implementing cap and trade regulations. These policies have not been implemented because they come with large economic costs. These trade-offs are inherently political questions that are appropriately addressed by the legislative branch.

A final risk arises should the reports enable outside public interest groups to micromanage corporation’s emission reduction programs. These programs often lead to corporate actions that harm investors’ interests. Even Blackrock, a supporter of corporate Environmental, Social, and Governance (ESG) initiatives, has acknowledged the potentially negative impact from outside interest groups on investor returns. In its 2022 investment stewardship report, Blackrock noted that

having supported 47% of environmental and social shareholder proposals in 2021 (81 of 172), BIS (BlackRock Investment Stewardship) notes that many of the climate-related shareholder proposals coming to a vote in 2022 are more prescriptive or constraining on companies and may not promote long-term shareholder value.

These concerns demonstrate that the proposed rule mandates unachievable reporting requirements, imposes costly new burdens on companies, inappropriately enables a financial regulator to conduct environmental policy, and provides information of dubious value to investors. Consequently, there is little doubt that investors will be harmed should this rule be implemented.