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Bernard Sharfman: The SEC’s Proposed Rule on Climate-Change Disclosures: A Material Fail

There is no evidence that the proposed disclosures are material to investors, and a reviewing court would likely end up vacating most if not all of them. 'Materiality has been the hallmark of the Securities and Exchange Commission's disclosure regime since the Supreme Court's 1976 decision in TSC v. Northway. Materiality limits disclosures to those matters to which there is a substantial likelihood that a reasonable investor would attach importance in determining whether to purchase the security registered. In the SEC's recently proposed rule on climate-change disclosures, the SEC tries, but fails, to make the argument that the proposed disclosures will provide investors with material information that is critical to their investment decisions. That the SEC even tries to make a materiality argument may surprise many readers, as it is made so indirectly and done so poorly that readers may have missed it.

The materiality argument in the proposed rule revolves around the term transition risk. As defined in the proposed rule, this term includes increased operating and investment costs resulting from stricter climate-related regulations, reduced demand for carbon-intensive products, and the potential for stranded assets such as oil and gas reserves.

There are over 100 mentions of transition risk in the proposed rule. It is mentioned so often because the SEC is using it to create the necessary link between its legal authority to require public companies to make disclosures and the disclosures found in the proposed rule. This legal authority requires the SEC's mandated disclosures to be for the protection of investors, a term that requires such disclosures to be directed at informing investors of the firm-specific financial risk that they take when investing in public companies.

As the SEC states in the proposed rule, Understanding the extent of this potential exposure to transition risks could help investors in assessing their risk exposures with respect to the companies in which they invest. For example, the SEC tries to justify the need for companies to provide data on Scope 1 (carbon emissions that come directly from sources owned by a company) and Scope 2 emissions (resulting primarily from the generation of electricity purchased and consumed by the company) in the following manner: Should a transition to a low-carbon economy gain momentum, registrants with higher amounts of Scope 1 and 2 emissions may be more likely to face sharp declines in cash flows, either from greater costs of emissions or the need to scale back on high-emitting activities, among other reasons, as compared to firms with lower amounts of such emissions. Therefore, transition risk can be thought of as another type of firm-specific financial risk.

The problem with this argument is that transition risk, as defined by the SEC, is not material for most companies and their investors, including companies that focus on the production and refinement of fossil fuels. The materiality of transition risk rests on the false premise that the world is rapidly moving to net-zero carbon emissions and therefore presumably presenting all public companies with a significant amount of such risk.

Why this premise is false is easy to see. According to ExxonMobil's latest forecast, world oil demand in 2040 is expected to be at the same level as it was in 2013 or 2014, even though new passenger-car sales will be all electric (worldwide) by 2040. Unfortunately, this transition to all electric vehicle sales does not get rid of the over 900 million gas-powered cars that will still be on the road in 2040.

Moreover, as Vaclav Smil points out in his recent book, How the World Really Works, the world must continue to use four key carbon-intensive materials – cement, steel, plastics, and ammonia – to provide economic prosperity for the several billion people who currently live in relative affluence as well as to eventually raise up the living standards of those billions who do not. These materials account for 25 percent of the world's carbon emissions. As stated by Smil, Requirements for fossil carbon have been–and for decades will continue to be–the price we pay for the multitude of benefits arising from our reliance on steel, cement, ammonia, and plastics.

According to leading economists, the adoption of an effective carbon tax in the U.S. and in other major carbon-emitting countries, such as China, India, and Russia, is the best way to speed up the world's ability to reach net zero. However, there is no evidence that this will become reality anytime soon.

The inescapable fact is that global greenhouse-gas emissions will continue to be at historically high levels for decades to come. As James Copland (Manhattan Institute) and I point out in our comment letter to the SEC: Even assuming that it is possible to bend or reverse this trend, there is every reason to believe that the move to [global] net-zero emissions will be a slow slog, perhaps taking us a number of decades past 2050. This is simply based on an objective reading of the facts.

It is easy to understand why the proposed rule does not bother to provide any type of evidence, empirical or otherwise, that shows the world is rapidly moving toward net-zero carbon emissions. There simply isn't any. On the contrary, as Copland and I argue, a reality-based definition of transition risk might include the risk that a company will not adapt quickly enough to a warming climate and the resulting impact it would have on its operations. In sum, if transition risk is not material, then there is no legal rationale for the proposed rule, and a reviewing court would likely end up vacating most if not all of the proposed rule.

Bernard S. Sharfman is a senior corporate governance fellow at RealClearFoundation and a research fellow with the Law & Economics Center at George Mason University's Antonin Scalia Law School.

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Posted: July 25, 2022 Monday 06:30 AM