The SEC is set to decide on a contentious climate change regulation this week: What the outcome means

On Wednesday, Gary Gensler, the Securities and Exchange Commission Chair, will vote on a contentious proposal concerning corporate disclosure of climate change risks.

Climate risk is a greater threat than nuclear war, according to President Joe Biden, who labeled it an "existential threat."

The climate disclosure rule was first suggested in March 2022. At the time, Gensler stated, "Investors representing a vast amount of money, equivalent to tens of trillions of dollars, support climate-related disclosures because they understand that climate risks can pose significant financial risks to companies, and investors require accurate information about climate risks to make informed investment decisions."

He stated that the proposal would aid issuers in disclosing risks more efficiently and effectively, meeting investor demand as many issuers already strive to do.

The final proposal has not yet been released.

The initial proposal in 2022 required disclosure in three categories: Scope 1, Scope 2, and Scope 3.

The Scope 3 disclosure requirements have faced criticism from many corporations, who argue that the regulations are too burdensome. Reuters reports that the Scope 3 disclosure requirements will be removed from the final proposal, and that some of the Scope 1 and 2 disclosure requirements have been relaxed.

Proposal generates record number of comments

Over 15,000 comment letters have been submitted to the SEC regarding its proposal, which is the most received for a single proposal. While some argue that the proposal represents an example of government overreach, others maintain that publicly traded companies have long been required to disclose information about potential risks they face.

The SEC has consistently demanded the disclosure of non-financial information that is crucial for investors to evaluate a company's future financial prospects, as stated in a joint letter submitted by The Institute for Policy Integrity at New York University School of Law and the Environmental Defense Fund.

Several companies submitted letters that were generally supportive of the SEC's efforts.

Supporters argue that corporate America already collects much of this information, and this proposal would standardize the reporting process.

Walmart supports the Commission's goal of providing consistent, comparable, and reliable information on climate change and other ESG topics, as stated by Kathleen McLaughlin, executive vice president and chief sustainability officer of Walmart.

For 15 years, Walmart has been providing climate-related information and has been reporting on other ESG issues for an even longer period.

Get ready for lawsuits

The proposed rule, particularly Scope 3, is facing opposition from the business community and Republicans, who argue that it requires too much disclosure and is an example of government overreach and a backdoor means to push a climate change agenda.

If the SEC's disclosure requirements are broadened, it may face a flood of lawsuits from corporations.

An alternative way to pursue litigation is by suing under the Administrative Procedure Act, which specifies the procedures federal agencies must adhere to when making rules.

The "arbitrary and capricious" standard in the APA requires that federal agencies base their actions on connections between the facts found and the regulation created.

The agency must take into account all pertinent factors, including expenses, and obtain feedback from those impacted by their decisions.

Corporations may contend that the SEC did not adequately demonstrate the existence of a problem requiring regulatory intervention, did not conduct a thorough cost/benefit analysis, or did not take into account public opinions.

A Supreme Court case opens another litigation avenue

The Supreme Court ruled in 2022 that regulatory agencies have limits on their powers, based on the "major questions doctrine," which states that Congress has not delegated significant issues to these agencies.

Any agency must demonstrate a clear statement from Congress authorizing its actions.

The Clean Air Act and the EPA's authority to regulate carbon dioxide emissions are at issue since Congress has not passed significant climate legislation in years. As a result, opponents of the SEC's climate rule may sue the SEC and use West Virginia v. EPA as a precedent, arguing that Congress has not given the SEC the authority to act on climate change.

What's it mean for corporate America?

If a scaled-back proposal is approved, publicly traded companies will face more regulation and an increase in paperwork.

The challenges for Corporate America will include: 1) rising expenses, 2) heightened activism, and 3) greater litigation risks. As with cybersecurity, a new consulting industry will emerge to provide guidance on climate change.

What are the reasons for increased litigation risk? One industry observer, who requested anonymity to speak freely, stated that if the disclosure is incorrect, the SEC can sue them. Even if the disclosures are accurate, they may be used by activists to argue that corporate America is not doing enough on climate change.

The ETF community is watching carefully

The ETF community is closely monitoring the vote on the proposal, as it will offer more data on climate issues that can be integrated into ESG ETFs.

DWS's Arne Noack, head of systemic investment solutions for the Americas, stated that many companies in America already report their emissions data.

"Noack informed me that the emissions data we have on S&P 500 companies is already quite comprehensive, as it is either self-reported or obtained from external sources."

Still, Noack is supportive of the new rule.

"Improving data quality leads to better ESG strategies and more effective portfolios," he stated. "In a world where emissions are high, the goal is to lower them. To achieve this, specific actions must be taken, but the crucial element is data. Without accurate data, we must rely on estimates."

Recently, there has been a significant decrease in the popularity of ESG ETFs, which were previously highly sought after.

Several ESG funds have shuttered due to: 1) investor uncertainty over ESG definition and measurement, 2) high fees, and 3) political controversy.

The fuzziness of ESG has attracted the interest of the SEC.

The SEC modified its "Name Rule" last year to mandate that 80% of a fund's portfolio consist of assets that correspond to the fund's name. This change was prompted by concerns that ESG funds were charging higher fees for what seemed like specialized stock selection but in reality merely mirrored index funds.

The proposed SEC rule may cause companies to be reclassified as "green" or "not so green" based on the disclosures required.

If companies in green funds are not meeting ESG standards, the funds will face criticism for charging high fees for funds that do not align with ESG principles.

""ESG investing will become more politicized if many of the holdings in ESG products are found to be unfit for the portfolio, as disclosed," Todd Sohn, ETF and technical strategist at Strategas, stated."

Arne Noack, the manager of the Xtrackers S&P 500 ESG ETF and DWS Head of Systemic Investment Solutions for the Americas, will be the guest on ETF Edge at 1:10 p.m. ET Monday. He will be joined by Dave Nadig, who was previously a financial futurist at Vettafi. ETFedge.bizfocushub.com.