ESG backlash fails to halt SEC's push for climate risk rules

From candy makers to missile manufacturers, chief financial officers at companies have for years tried to attract equity capital by adopting environmental, social and governance (ESG) best practices. Global investment in so-called sustainable mutual funds and exchange-traded funds has more than tripled since 2018 to $2.47 trillion, according to Morningstar data, indicating their efforts are beginning to pay off.

However, ESG is now facing a hostile redefinition. Critics call it "woke capitalism," viewing it as a "climate cartel" of shareholder activists, asset managers and politicians imposing it on American businesses.

"ESG is a harmful strategy because it allows the left to achieve goals it could never accomplish at the ballot box or in free-market competition," former Vice President Mike Pence said in May. He joined critics including Berkshire Hathaway Vice Chairman Charlie Munger and Tesla CEO Elon Musk.

CFOs should not expect the backlash to stop a proposed Securities and Exchange Commission (SEC) rule that would align securities law more closely with climate activism and corporate ESG disclosure trends, according to lawyers and former regulators. Currently, 92% of S&P 500 companies already publish ESG reports, the Governance and Accountability Institute says. Facing investor pressure, thousands of companies globally have committed to reporting greenhouse gas (GHG) emissions.

"The largest institutions have made commitments, and they are not going to back away," said Elizabeth Saunders, a partner at Clermont Partners. "That ship has sailed."

The SEC could issue a rule by January requiring public companies to provide detailed disclosures on carbon emissions and climate risks, lawyers and former regulators say. The SEC is reviewing more than 14,000 public comments on the proposed rule, but any revisions to its 490-page draft are likely to retain the most stringent and costly climate risk measurement and reporting requirements.

"If I were a CFO of a public company, I would fully expect these rules to take effect," said Kai Liekefett, a partner at Sidley Austin and co-chair of its shareholder activism practice. "You need to be prepared — you cannot expect Santa Claus to bring you gifts."

Currently, the SEC does not require companies to report climate risks or describe how they report them. Instead, the agency relies on "interpretive guidance" issued in 2010, advising companies on how to disclose climate change impacts based on existing or new legislation, regulations and global agreements. Under the new climate risk rule, the SEC aims to require companies to describe in their 10-K filings their strategies for addressing climate risks, including plans to meet targets they set to curb such risks. Companies would also need to disclose their greenhouse gas emissions data (whether from their own facilities or through energy purchases) and obtain independent attestation of their data.

SEC Chair Gary Gensler says clear, uniform disclosure of climate change costs would benefit both companies and investors. Companies would gain detailed insight into potential costs and opportunities, while investors would be better able to assess risks at specific companies and compare risk levels across industries. "If information is consistent and comparable, it helps both issuers and investors and can lower the cost of risk premiums, which are part of the cost of capital," Gensler said at a Harvard University forum on September 15.

Measurement chaos

The current patchwork of methods for measuring corporate ESG compliance is causing confusion among investors and some CFOs and their executive colleagues, lawyers and former regulators say. "It is a complete mess," Liekefett said in an interview, adding that ESG rating firms still need several years to reach consensus on uniform measurement. More than 100 firms globally specializing in ESG ratings often give the same company different rankings, researchers at MIT Sloan School of Management noted in a study titled "Aggregation Confusion."

Moreover, when measuring and reporting carbon emissions and other ESG factors, CFOs currently must choose from dozens of inconsistent frameworks. The chaos in measurement systems also creates confusion and enables some companies to "greenwash," or exaggerate their progress in following ESG principles. "In my view, these metrics and measurement systems are still in their infancy in some respects," said Brad Smith, president of Microsoft, adding they are insufficient to assess whether 3,470 companies worldwide are fulfilling commitments to improve their environmental impact. "Unless there is accountability, the public — whether shareholders, customers or community members — has no reason to have fundamental confidence in what companies say," Smith said at the Harvard forum.

Gensler said at the Harvard forum that global regulators are gradually reaching consensus on common standards for climate risk reporting. The SEC's disclosure rule, like mandates adopted in Europe and elsewhere, draws on guidelines from the Task Force on Climate-related Financial Disclosures (TCFD), he said in a recorded interview. "We are all trying to build on that." TCFD describes 11 types of disclosures across four areas: governance, strategy, risk management, and metrics and targets. It does not delve into how to measure climate risk. The SEC also encourages use of the Greenhouse Gas Protocol, an accounting and reporting standard for greenhouse gas emissions.

SEC critics say the costs of the upcoming rule far outweigh its benefits. The regulation would accelerate the growth of the "climate industrial complex," SEC Commissioner Hester Peirce said before casting the sole dissenting vote in the 3-1 commission decision. "We are laying the foundation here for a new disclosure framework that will eventually rival our existing securities disclosure framework in scale and cost, and may surpass it in complexity," she said. "We are not the Securities and Environment Commission — at least not yet."

Broad backlash

Criticism of the SEC's draft rule echoes many points in the broader ESG backlash and highlights the rule's vulnerability to delay, lawyers and former regulators say. "Everyone is preparing for the 'additional wars' after the SEC issues the final rule," said David Brown, a partner at Alston & Bird. The SEC estimates small companies would need to spend an additional $420,000 annually and large companies an additional $530,000 to comply with greenhouse gas emissions disclosure requirements. "The SEC has vastly underestimated the funds needed to comply with this rule," Brown said in an interview. He predicts judges will eventually tell the agency, "'Your economic analysis is flawed — go back and redesign it.'" CFOs will need to hire accountants, data analysts and other sustainability experts, and pay external auditors and consultants for independent reviews of SEC filings, Brown said. Additionally, measuring Scope 3 greenhouse gas emissions from upstream and downstream contractors will be challenging and costly. "The Big Four accounting firms are hiring tens of thousands of people to get ahead, and because talent is scarce, costs naturally rise," Brown said. "The Sarbanes-Oxley Act was called the 'Auditor Full Employment Act,'" he said. "This is the 'ESG Consultant Full Employment Act.'"

While imposing heavy compliance costs on companies, the SEC is also exceeding its congressionally mandated authority, Pennsylvania Senator Pat Toomey, the senior Republican on the Senate Banking Committee, told Gensler at a September 15 committee hearing. "The SEC is wading into controversial public policy debates beyond its mission and expertise, and doing so without legal authorization," Toomey said. "Compliance costs are more substantial to investors than the (climate risk) information itself." He added that the SEC ultimately aims to shut off investment in fossil fuel producers by "providing data to climate activists to launch political pressure campaigns against companies, often to the detriment of shareholders." "The SEC will have to explain itself to the courts." Congressional reaction to the proposed rule has largely split along party lines. "The SEC's work on climate risk disclosure is an important example of improving market risk understanding, providing transparency and comparability — clarity and uniformity are key," Ohio Senator Sherrod Brown, the Democratic chair of the Banking Committee, said at the hearing. "If only some companies provide disclosures, and in a haphazard manner, that helps no one."

Supreme Court ammunition

Opponents of the SEC rule found ammunition in a June Supreme Court ruling that limited the Environmental Protection Agency's (EPA) authority to regulate power plant emissions under the Clean Air Act. In the 6-3 ruling in West Virginia v. EPA, the Court invoked the "major questions doctrine," holding that federal agencies need congressional direction before issuing regulations with significant economic or political impact. That doctrine "will be the threshold question determining whether the SEC can survive challenges," Saunders predicted in an interview. "Everything else becomes secondary."

Critics also say the information the SEC rule requires disclosing is not material to investors' decision-making and risk management efforts. Gensler defended the proposed regulation, noting investors with $130 trillion in assets globally are urgently demanding uniform, consistent climate risk disclosures. "I do not think any court today would rule that climate risk is not material for some companies," Saunders said.

Nevertheless, several states, including Florida, Oklahoma, Texas and West Virginia, say asset managers such as BlackRock are pushing an ESG agenda at the expense of investor returns. They call ESG principles irrelevant to investment decisions and have barred some asset managers using ESG benchmarks from managing state pension funds. Louisiana Treasurer John Schroder notified BlackRock CEO Larry Fink in an October 5 letter that the state would withdraw $794 billion in pension fund assets from BlackRock funds due to the asset manager's use of ESG criteria. "Your blatant anti-fossil fuel policies will destroy Louisiana's economy," Schroder said. "In my view, your support for ESG investing is inconsistent with Louisiana's best economic interests and values." BlackRock has pushed back against assertions that it dictates to companies how to handle carbon emissions, saying such decisions should rest with company management teams and boards.