SEC climate rule would hack away at materiality standard

The Securities and Exchange Commission’s new climate rule will hack away at the SEC’s already well-established materiality standard and will mandate disclosure rules that work for Wall Street banks but have little relevance to many public companies across the country.

That’s according to local leaders from Tennessee testifying during the House Financial Services Subcommittee on Oversight and Investigations field hearing discussing how the SEC’s new rule will allegedly harm Americans. 

The hearing as well as the newly finalized SEC climate rule don’t touch on municipal securities directly but many have noted that such a rule will eventually be used as a standard applied to the muni market, and could eventually see at least an effort to alter disclosure standards in Rule 15c2-12 to include climate risk events.

“The SEC’s climate disclosure rule blatantly undermines the Commission’s existing materiality standard,” said Rep. Bill Huizenga, R-Mich., chairman of the Subcommittee on Oversight and Investigations. “Under the principles based materiality standard, a company must disclose information to prospective investors and shareholders so that they can make informed investment decisions. The SEC should not statutorily redefine the materiality standard to prescribe climate-related disclosures for all public companies, even when a reasonable investor would not find it important to their investment and voting decisions.”

The Commission also borrows language from other places to establish the standard in the final rule, and legally, is being viewed by some as an attempt to shoehorn standards from existing rules and bring it to climate disclosures.

“First and foremost, that language they’re quoting is clearly tied to other express categories of information that the SEC is allowed to mandate disclosures around,” said Whitney Hermandorfer, director of the Strategic Litigation Unit and assistant solicitor general in the Office of the Tennessee Attorney General. “All of that information relates to business books of companies and even though there’s general language, you can’t just pluck one sentence out of context,” she added. “That’s what the major questions doctrine helps confirm, you can’t use a generalized language to enshrine this type of industry altering regime.”

She also noted that the Commission has not proven that the alteration of materiality is going to further an investor’s interest. “By undoing the materiality limit, companies or investors aren’t going to be able to decide which of this is actually material to my investment and which is just unrelated climate puffery.”

“The costs related to severe weather events that are subject to disclosure expressly do not have materiality limit,” said Hermandorfer. “Right there is just a bevy of information that on its face is not material to investors.”

One of the major concerns passed around surrounding materiality in this rule is that public companies are usually responsible for deciding what is material to them, and this rule tells companies what is material, members of the subcommittee said.

“The SEC then plays games with things, saying the business uses this as a material factor in evaluating a component of the business,” Hermandorfer said. “That’s not materiality. Materiality is a significant likelihood that a reasonable investor would view this as material and whether to invest. It’s not whether a business uses certain inputs to some small segment of its operations.”

Many who joined in the pile on expressed admiration for SEC Commissioner Hester Peirce and her dissenting opinion when the final rule was passed. “While the Commission has decorated the final rule with materiality ribbons, the rule embraces materiality in name only,” Peirce said. 

But that wasn’t the only praise being passed around. They also commended the scaling back of Gensler’s initial proposal to focus only on Scope 1 and Scope 2, or disclosing emissions from their operations and energy purchases and removing Scope 3 requirements, which would have required public companies to disclose emissions from their supply chains.

“Today I can confidently say that we have already secured a victory for farmers and small businesses across the country by forcing the SEC to remove the Scope 3 provisions of the proposed rule,” said Rep. John Rose, R-Tenn. “But our work is not done.”

Some expect Gensler to eventually load Scope 3 provisions on eventually and others, noted that the elimination of Scope three may create some unintended incentives.

“These are often the largest source of emissions across the supply chain,” said Alex Scott, associate professor of supply chain management at the University of Tennessee, Knoxville. “I’ve seen estimates that Scope 3 emissions account for as much as 80% or 90% of the emissions in the entire supply chain of a product. This provides a direct incentive for companies to outsource their production and distribution to other companies, because doing so immediately reduces the Scope 1 and Scope 2 emissions of the focal company.”

“However, this does not mean that the emissions were reduced, but merely recategorized into Scope 3 emissions,” Scott said. “If the production or distribution method of the supplier is more pollution intensive than that of the focal company, then not only did emissions not decrease, but they could potentially increase. The SEC’s rule, however, would show a reduction in Scope 1 and Scope 2 in this example.”