The Securities and Exchange Commission’s proposed rule to require disclosure by corporations on climate-related financial risk creates a gray area for how suppliers and other third parties address their own emissions and may limit its benefit for the environment, according to advocates and corporate attorneys.

Spanning more than 500 pages, the rule published Monday largely satisfies calls from transparency advocates, investors concerned with environmental, social and governance issues, and Democrats to address the lack of standardization of information on emissions by big companies.

If finalized, public companies would have to report on Scope 1 and Scope 2 greenhouse gas emissions, which address direct and indirect emissions from purchased electricity and other forms of energy. Companies would also have to disclose the oversight and governance practice and how climate risks have had or will have a material impact on business.

However, the proposed rule stops short of requiring disclosure about Scope 3 emissions by partner companies down the supply chain for all issuers. It contains multiple caveats and provisions aimed at balancing the interests of progressives and environmentalists who want full disclosure on all emissions and the concerns from companies about possible legal liabilities of data on indirect emissions.

“The SEC made a concerted effort to support its rationale for requiring Scope 3 disclosures, mentioning ‘Scope 3’ over 400 times” in the proposal, while also acknowledging the “unique challenges associated with their measurement,” said Cynthia Mabry, a partner and co-head of the ESG practice at Akin Gump Strauss Hauer & Feld LLP, in an interview.

“Whether or not Scope 3 disclosures are required by any final rule, today’s announcement is only the first step in what could be a long process — and likely not the final effort by the SEC— to address investors’ appetite for transparency regarding climate change risks and impacts,” she said.

The SEC’s regulation addresses a cornerstone issue in ESG activism. According to a report led by shareholder advocacy group As You Sow, investors filed a record 529 shareholder resolutions on ESG issues for the 2022 proxy season, up by 22 percent from last year. Of those filed, more the one in five were related to to climate change.

“Clear and standardized reporting of greenhouse gas emissions is the bedrock of sound investor decision-making,” said Danielle Fugere, As You Sow’s president and chief counsel. “The new rule provides investors with more robust, complete, and comparable disclosure of risk and the emissions data to determine which companies are aligning their business activities with Paris targets and minimizing transition risks.”

Voluntary disclosure

Hundreds of U.S. public companies have already adopted voluntary disclosure frameworks from the Task Force on Climate-related Financial Disclosures, and the GHG Protocol, a global standardized framework for measuring and managing greenhouse gas emissions from private and public sector operations, value chains and mitigation actions.

The SEC may face few compliance issues with the proposed regulations, given that the proposed rules are rooted in those guidelines.

“The consistency and breadth of these comments comport with our understanding that the TCFD framework has been widely accepted by issuers, investors, and other market participants and reinforce our view that the framework would provide an appropriate foundation for the proposed amendments,” the SEC said in the proposed rule.

According to the TCFD’s 2021 annual report, some 345 organizations support its framework. A wide range of firms, from companies such as Apple Inc., Chevron Corp. and Walmart Inc. to ESG proponents including Ceres and the Natural Resources Defense Council advocated that the SEC model its rulemaking after the TCFD and other voluntary disclosure frameworks.

Industries such as the energy and materials sectors have higher levels of disclosure that align with the TCFD framework, given that the businesses have prominent exposure to climate-related risks. The SEC notes that research shows many companies, including firms that are in industries with high climate risks, lack credible and sound disclosure. 

“Registrants would face increased compliance burdens in meeting the new disclosure requirements,” the agency said. “In some cases, these additional compliance burdens could be significant while in others relatively small if companies already provide information similar to that required by our rules.”

Yet the biggest hurdle for a final SEC rule on climate disclosure will be on how the eventual regulation handles Scope 3 indirect emissions traced back to suppliers and other third parties.

Scope 3 liability

During the agency’s information-gathering period, companies voiced concerns that they could face lawsuits over emissions outside of their direct control. Under the proposal, registrants would only have to report Scope 3 emissions if they are material or if companies have set reduction goals that include Scope 3. The proposal contains a broad safe harbor from liability for Scope 3 emissions disclosure, as well as an exemption for smaller issuers.

“Without this new safe harbor, companies could be subject to litigation for the Scope 3 information provided by third parties and largely outside of the company’s control,” Akin Gump’s Mabry said.

Howard Fischer, a partner in the securities litigation practice at Moses & Singer LLP and a former senior trial counsel at the SEC, said the proposed rule’s provisions on Scope 3 reporting may ensnare third-party non-public companies that work with public companies. 

Fischer said it’s possible that non-public companies could challenge the SEC on the rules in court on the basis that the proposal would impose disclosure requirements on non-public companies and could create other liabilities for them.

“While non-public companies do not have to make their own climate-related disclosures, economic pressure to sustain their business relationships will likely require them to do so,” Fischer said. “Thus, the practical effect of requiring some filers to include Scope 3 disclosures — relating to the emissions of their suppliers, downstream users, and similarly placed parties — will be to bring many otherwise non-public entities into the SEC disclosure framework.”

The SEC recognized some of those challenges by including multiple caveats on Scope 3 emissions, plus additional time for compliance for companies that need to report such emissions.

Reporting may improve with advances in emissions data or using Scope 1 and 2 data as input for other companies’ Scope 3 calculations, though it will take some time to happen.

“Notwithstanding these anticipated developments, calculating and disclosing Scope 3 emissions could represent a challenge for certain registrants, in particular those that do not currently report such information on a voluntary basis,” according to the proposal.