Debate over whether the US Securities and Exchange Commission has the authority to ask companies to provide data on their carbon footprints is poised to intensify after the agency unveiled its long-awaited climate disclosure proposal in late-March.
At the core of criticisms over the proposal is whether such rules are financially material for investors. However, proponents are likely to raise a new way of looking at the issue, called double materiality, a concept introduced recently by European regulators in assessing disclosure information on environmental, social and governance issues.
Last month, the SEC announced plans to require companies to disclose their direct greenhouse gas emissions, known as scope 1, as well as emissions derived from their electricity needs, or scope 2, in their annual SEC filings. The most controversial of the new disclosure rules includes emissions that arise from a company’s value chain, or so-called scope 3. This group of emissions is considered the biggest and broadest component of a company’s pollution — and the most difficult to measure.
Large industry groups were quick to voice their concerns. The U.S. Chamber of the Commerce, the largest corporate lobby group, said the SEC’s plans were not material to investors, and hinted that the proposal could see legal challenges. Indeed, the question of materiality is at the heart of the debate, which has drawn in some SEC commissioners. Hester Peirce, the sole commissioner to dissent from the March proposal, said: “The Commission proposes to mandate a set of climate disclosures that will be mandatory for all companies without regard for materiality.”
What is materiality?
The word material was first introduced in the U.S. Securities Act of 1933. Since the 1940s, the SEC has defined material information in the context of financial statements as “those matters as to which an average prudent investor ought reasonably to be informed before purchasing the security registered.”
Former US Supreme Court Justice Thurgood Marshall, in a landmark case in 1976, wrote that an item is material if there is “a substantial likelihood that a reasonable investor would consider the information important in deciding how to vote or make an investment decision.”
Critics of the SEC’s current proposal argue that the existing materiality principle is sufficient to incorporate climate or other environmental, social, and corporate governance (ESG) issues into company reporting. Companies should determine for themselves, as they currently do, whether such issues are material or immaterial. There is no need for new disclosure rules to address such issues, they say.
“Institutional investors in the United States are increasingly focused on stakeholder governance and ESG issues, and corporate disclosure on these topics can and should be addressed within the American framework of materiality,” said legal experts at Wachtell, Lipton, Rosen & Katz in a report last year. “If disclosure of immaterial information is required for non-financial reasons, it should be acknowledged as such and not swept into the concept of materiality.”
However, the SEC and proponents of the new rules say that while many US companies are disclosing a lot of data about their climate activities, the information is inconsistent and non-standardized, which makes comparison for investors difficult. New disclosure rules are needed to bridge the information gaps. And when it comes to materiality serving as the determinant for what companies should and should not disclosure, there is a significant uncertainty about what is actually material.
“The definition of materiality is and always has been slippery,” says Azish Filabi, executive director at The American College Maguire Center for Ethics in Financial Services. “Current law appears to require, at a minimum, that companies shall disclose all matters, including ESG matters, that are material to a reasonable investor. What constitutes ‘material,’ ‘reasonable,’ and even at times ‘investor’ isn’t always clear.”
“Double materiality”: The European approach
European regulators, which have been ahead of their US counterparts in formulating disclosure requirements on climate change, have come up with an attempt at reconciling the need for investors to have greater information on ESG issues and the question of whether such factors are deemed financially material.
The concept of double materiality describes how corporate information can be important both for its implications about a firm’s financial value, and about a firm’s impact on the world at large, particularly with regard to climate change and other environmental impacts. The idea of double materiality comes from a recognition that a company’s impact on the world beyond finance can be material, and therefore worth disclosing, for reasons other than the effect on a firm’s bottom line.
Some experts argue that the meaning of double materiality is still up for debate and requires further analysis. “Yes, in principle the impacts of a company or a portfolio on the climate or the wider environment can be material — but how do we know what exactly is a material impact?” asks Matthias Tager, a PhD candidate in Environmental Policy and Development at the London School of Economics.
The answer, says Tager, fundamentally depends on one’s view of why information on environmental impacts should be material in the first place. In his view there are two probable reasons:
- Environmental impacts could translate into financial risks, for example, through legal liabilities or harms to a company’s reputation.
- A reasonable person might consider the information material for reasons other than direct financial repercussions.
“The question of what double materiality means thus turns into a question of who the ‘reasonable person’ is, and what their interests are, which in turn define what counts as material — in other words, [what’s] important to them,” Tager explains.
Double materiality in US regulation
Whether the SEC will borrow a page from EU regulators and introduce the concept of double materiality to bolster its case for climate disclosure rules is anyone’s guess. As the agency works through future disclosure rules on social or human capital issues, however, a broader vision of materiality may come into play.
“Though there are indications that most major institutional investors still prefer to maintain the traditional definition [of materiality], there is growing interest in the new European formulations, and the SEC will face increasing pressure to take some form of action in this direction,” said the law firm Wachtell.
Indeed, arguments against such an approach are already in hand, as made by SEC Commissioner Peirce last year in a statement on ESG metrics. “The European concept of ‘double materiality’ has no analogue in our regulatory scheme, and the addition of specific ESG metrics, responsive to the wide-ranging interests of a broad set of ‘stakeholders,’ would mark a departure from these fundamental aspects of our disclosure framework,” Peirce said at the time.