Landmark Rules Ask Companies to Grapple With Climate Risk Very Publicly

The SEC’s recent climate disclosure rule marked a watershed for investors and companies in the US. It showed that the Securities and Exchange Commission now believes climate “is appropriately a factor for company decision-makers,” as my colleague Gabriel Presler, global head of enterprise sustainability for Morningstar, puts it. I couldn’t agree more. The rule now joins an array of climate regulations—in Europe, California, and elsewhere—and the widely followed guidelines set by entitles like the Task Force for Climate-Related Financial Disclosures. All this gives companies principles about how to evaluate and express climate risks and opportunities in the financial documents that investors rely on. Indeed, in an era of increasing partisanship, the rule is “fairly centrist,” according to Aron Szapiro, Morningstar’s head of retirement studies and public policy.

In my role of heading Morningstar Indexes and Morningstar Sustainalytics, I speak to global investors all the time. They look to us for insight on how companies are addressing climate change across various markets and navigating increasingly complex regulations. In fact, in our annual Voice of the Asset Owner Survey, our clients expressed their frustration with navigating regulations across multiple markets. Would this new rule be confusing? What could they expect?

For myself, I had other questions. Did it go far enough? Some believe that in neglecting to require companies to report scope 3 emissions, which are all the emissions from its supply chain and use of its products, the SEC would encourage more greenwashing.

I also wondered about the impact on companies. Complexity and costs are just two unintended consequences that often come from regulation. What did this mean for the smaller companies that provide innovation?

Thus, a week before Earth Day, I sat down with Aron and Gabe to discuss what the new SEC rule and other climate laws and regulations mean for Morningstar, investors, and companies big and small. I hope you’ll find the conversation fascinating—I certainly did. Please read the following condensed, edited excerpts for more.

Ron Bundy: The recent climate disclosure rule from the SEC has generated a lot of questions from our clients, both retail and institutional investors. Aron, help us understand what the SEC just did with this rule.

Aron Szapiro: The SEC adopted a fairly centrist proposal. It increases reporting after fiscal years beginning in 2025 and standardizes disclosures in some areas. Today, this reporting is mostly voluntary. The SEC falls short of the EU’s Corporate Sustainability Reporting Directive, which sets a much higher standard for climate reporting, encompasses a much broader range of companies, and requires much more detail and holistic disclosures than does the SEC. That said, it’s a significant rulemaking and more than a glass half full for investors.

Bundy: I understand this rule has been challenged. Will it actually become reality?

Szapiro: I’ve had a 20-year career watching the day-to-day federal rulemaking process. Over the last 15 years, as Congress has become more and more gridlocked, agencies have used statutory authority often from decades ago to solve modern problems. Recently, the courts have become much less deferential to agencies. We face questions about litigation with every major rulemaking that I cover as head of government affairs. I’m not a lawyer, but I’ve been talking to smart lawyers. This litigation was absolutely expected. It’s a little unusual that it started before the rule was even published in the Federal Register. Could it delay the timeline? Maybe, and maybe not, because the first disclosures for most companies aren’t due until 2026. And so, there’s a chance this is wrapped up by then.

I used the word “centrist” earlier. We have suits filed from both the right and left here. That may help the SEC in saying that it didn’t go too far. They did scale the proposal back considerably, particularly on scope 3 emissions. That gives them ammunition to explain why they made those judgments and why they believe this fits squarely into the legal tradition of the SEC proposing material disclosures. None of this is surprising. That doesn’t make the outcome anymore easy to predict.

I’m using centrist as not kind of a Republican-Democratic thing, although it may line up that way, but just as a spectrum of how specific and expansive the disclosures could have been. They landed in the middle of what we have now, which is mostly voluntary and nonstandardized, and the much more expansive regime that they proposed two years ago.

Bundy: There’s not a lot of centrist thinking coming out of Washington as of late. Do you think the upcoming US election and politics will play a role in the final version of this rule?

Szapiro: Very likely. I think it’s fair to say that if Donald Trump were to win the election, there will be a number of avenues for dismantling this rule. This is not a certainty, and it would take some time. The SEC is an independent agency, and Chair Gensler’s term runs until 2026. But one could expect new Trump appointees to the SEC to try to dismantle the rulemaking. Still, that is a hard thing to do once something is final and effective. And this is inside baseball, but the SEC finalized this ahead of what’s called the Congressional Review Act deadline. The bottom line is this cannot be undone by a simple vote in January 2025 when a new president might take over. We do expect an upcoming vote in Congress to undo this rule will likely pass the House and the Senate. But it’s mostly posturing because such a bill will be vetoed by Biden. By January, too much time will have elapsed since the SEC adopted the rule to use the Congressional Review Act mechanism.

Bundy: How a company’s management team addresses climate change can make a big difference in that company’s performance. Gabe, how will this new ruling change Morningstar’s current climate reporting, in terms of reporting requirements and expectations from our investors?

Gabriel Presler: We’re finding that companies that emphasized readiness ahead of these requirements, and the data show that there are many, are already well-positioned to manage this reporting requirement. Multinationals and any company with global aspirations are already trying to get their hands around this kind of data, because it allows them to comply with regulation well beyond the SEC disclosure proposal, such as Europe’s Corporate Sustainability Reporting Directive [CSRD], and in California. It helps in other markets like Japan, where TCFD reporting [referring to the Task Force on Climate-related Financial Disclosures] is becoming standard. A high-level understanding of how management is thinking about climate is just becoming the cost of entry in many global markets.

The other thing that’s probably worth mentioning is that standards providers have come together in the last several years to provide a lot of consistency. For example, the SEC is following some of the standardized emerging frameworks, like TCFD. The value of articulating a management approach to governance, to risk, to strategy, and to basic metrics and targets around scope 1 and 2 emissions is now shared across the SEC proposal, across TCFD, across CSRD, and a range of other reporting frameworks.

As Aron says, we’re not done yet. But that emerging alignment provides companies with an understanding of how the SEC is going to track over time. Many of us have already set up the systems, like a workflow alignment with our finance and operations partners to meet this reporting requirement in 2026.

Bundy: Gabe, I have a two-part question. One, what points of the rule should investors focus on? Two, does it go far enough to protect investors?

Presler: This might be basic, but I think it’s worth emphasizing: The SEC discussion is an acknowledgement that climate is appropriately a factor for company decision-makers. The SEC is asking companies to stick this information in the 10-K, in the risks section or in the MD&A (management discussion and analysis) section of the company’s filings, or, alternatively, in the 10-Q for newer filers. That’s meaningful: These filings have always been seen as a reliable way for investors to get inside-management thinking. Asking executive leadership to grapple with that very publicly is a meaningful move.

To your second question: Does it go far enough? We think it’s the right next step for where we are. First, the project is looking to guarantee reliable, searchable access to data. Sure, it’s unstructured and qualitative in its first iteration, but the direction of the travel looks explicit. We think holding management to account on new information emerging about risk is something investors can celebrate.

Bundy: Let’s talk about the impact on companies. Sometimes when governments get involved, there are unintended consequences to regulation, such as added complexity and costs. Do you worry about this?

Presler: It’s such a great question. Of course, additional reporting requirements add all sorts of costs, like the cost of new platforms, and of changing the nature of workflows. The SEC has demanded a level of accountability from US company leaders when it comes to documenting their assessment of climate risk. There are implementation costs, such as keeping the paper trail on why company leaders think how they do.

Ultimately, our hunch is that standardized demands spur technology development, such as the creation of carbon measurement platforms. The SEC has adopted a phased-in approach, with big filers first. This gives us some time as an industry and as a market to use technology and the experience of large, accelerated filers to help smaller players when it comes to cost and complexity.

Szapiro: We see federal agencies do that all the time—start with the most sophisticated private-sector players and then expand it. We’ve seen that with XBRL filing, with retirement plan reporting. It’s a sensible way to do things. It really means the absurdly high-cost estimates that some commenters provided really are just that because they assume a static environment. But the environment will be quite dynamic. There will be a small cottage industry of professionals who want to help and that will drive costs down and make the data much more reliable.

Bundy: Big companies can often absorb the added costs and complexity, but small companies are less well suited to do so. In addition, small companies are often the spark plugs of innovation in a dynamic economy, like we have in the US. Could these increased reporting requirements potentially stifle innovation instead of accelerating it?

Presler: A lot of the language from SEC Commissioner Hester Peirce [who opposed the rule] centered around this. But what’s on tap with this disclosure is answering questions around how managers are thinking about climate risk and what basic, measured emissions look like—for some companies. That’s the kind of information that investors, who help companies come to market, are seeking. We’ve seen a distinct uptick in interest in climate tech and sustainability on Morningstar’s private equity data platform, which is called PitchBook.

That kind of information is exactly what firms have to provide in regions where the Sustainable Stock Exchange initiative operates. And that’s a big list! It includes huge players like London Stock Exchange Group. The truth of the matter is that management is generally going to owe this kind of information to the marketplace.

And for certain sectors, this will jump-start a conversation about how to be globally competitive. If a new company aspires to be a supplier in 2025, it could be tough to, say, sell into Target TGT without disclosing emissions to Target. Target is emblematic of lots of other companies, including Walmart WMT and Salesforce CRM. They have big ambitions and commitments when it comes to climate—and that is going to have big implications for their suppliers. The movement is in one direction: more transparency on how management thinks about climate risk. It’s a good exercise for small companies that want to hit the market.

Szapiro: I’m not very sympathetic to the cost and complexity argument. You can make that argument about anything, right? I mean, you could have an AI write a comment letter opposed to this regulation and mention cost and complexity. But it’s overwhelmingly the case that a lot of investors view this as material and want this data anyway.

Bundy: Let’s transition to our last topic. Our clients at Morningstar Indexes and Morningstar Sustainalytics say they’re challenged by navigating regulations across multiple markets. Aron, is it confusing for global investors or global companies to balance them?

Szapiro: There’s certainly the potential for some confusion. The US rules differ significantly from other large jurisdictions, particularly the EU, which is really leading the way. The US approach is much more limited, focused on materiality. The CSRD is more stringent and encompassing. Some companies in the US may only have to disclose scope 1 and scope 2 emissions, but they may need to follow an EU mandate and report scopes 1 through 3, because that covers nearly all companies doing substantive business in the EU. California is another wild card. My colleague Jasmin Sethi just wrote a piece exploring the interaction between the California legislation and the SEC rules, which may help dispel some of that confusion.

Bundy: Given the legal challenges to this rule, what’s next?

Szapiro: The complaints have been consolidated into the Eighth Circuit. My guess is this will get appealed to the Supreme Court either way, particularly if Biden were to win reelection. If you’re a company, you really have to act as though this rule will take effect, even while it’s being litigated. Agencies don’t do this capriciously. They believe they have a strong legal case. They have the authority to promulgate this rule. Likely, there will be some continued uncertainty and then it will be resolved, possibly before the first filings are due.

Bundy: Some believe the SEC rule didn’t go far enough. For example, some people think excluding scope 3 emissions may expand greenwashing.

Presler: I’m torn. Larger, more sophisticated investors have super-sophisticated efforts, like modeling capabilities, and the subject matter expertise to manage, to absorb and digest scope 3 emissions, even though scope 3 emissions are complicated. We think it’s possible that we’ll see scope 3 added to disclosure requirements down the road because for many sectors, scope 3 is the most significant of the emissions categories.

But it’s important to start with what’s comparable and has interoperable datasets right now. And that’s scope 1 and 2. We believe they tell us something about company efficiency and management skill. Do they tell us enough? I don’t think so, but they tell us something. We’re really enthusiastic about the centralization of data because it makes it easier for distributors to get their hands on it. And with AI, they can sort it and can frame it up for investors.

We’re so early in scope 3 emissions reporting that it’s not clear to me that people investing for retirement or their kids’ college are really in the position to engage super meaningfully with scope 3. That said, in some sectors, scope 3 is likely up to 60%, or even 80% of emissions. This is the case for financial services. That’s where Morningstar sits. So, it’s important for us to move to a place where scope 3 is disclosed.

Szapiro: Our position is that scope 3 disclosures are important. We continue to advocate for that around the world. We are putting together a comment letter in Canada right now. So, we do think scope 3 disclosures are important. It wasn’t a surprise that they pulled it back. I do think it would probably require 60 votes in the Senate to change the framework. But we do have all these other jurisdictions that are moving ahead. And so, this data, hopefully will be available to investors.

Bundy: Thank you both very much for sharing your time, insights, and expertise for today’s conversation.