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Sustainability Matters

Will the U.S. Supreme Court Deny Investors the Climate-Risk Information They Need?

A novel legal theory could provide the basis for invalidating the SEC’s climate-disclosure rule.

In March, the U.S. Securities and Exchange Commission proposed a rule that would require public companies to report on climate-related risks. The comment period is now complete, and the SEC is in the process of finalizing the rule, which has widespread support among investors.

Morningstar supports the rule as “timely and necessary,” in the words of Aron Szapiro, our head of public policy, because “Climate and carbon risks have increasingly become material for many companies within various industries, and as such, disclosures in this area are financially material and key aspects of investor decision-making.”

But in its final ruling of the term last week, the Supreme Court cast doubt on whether a climate-risk disclosure rule can withstand a legal challenge.

Amid the flurry of landmark decisions ending the right to abortion, expanding gun rights, and weakening the separation of church and state, the court also dealt a serious blow to the U.S. Environmental Protection Agency’s ability to regulate global warming.

In West Virginia v. EPA, the court declared that the legislation authorizing the EPA, the Clean Air Act, does not clearly authorize the agency to create a plan that would transform the electricity generation system in the United States by requiring a shift away from higher-carbon-emitting power plants to those that rely on lower-emitting fuels or renewables.

While the decision leaves room for the EPA to regulate greenhouse gas emissions from individual power plants, it limits the agency’s ability to implement more-systemic changes, as proposed in the Obama Administration’s Clean Power Plan. Because that plan is no longer even being considered for implementation by the current EPA, the case should have been dismissed.

But the court forged ahead anyway, ruling that the Obama plan went beyond the scope of Congress’ initial grant of authority to the EPA. The rationale cooked up by the court is something that has never been used before: the so-called “major questions” doctrine.

The idea is that anytime a federal agency proposes a rule on a “major” public policy question, it must have a much more specific grant of authority from Congress than has been required in the past. Yet the court provides little guidance on what constitutes a “major question” or on what a sufficient grant of authority would look like. It’s a “we’ll know it when we see it” approach that undermines the capacity of the federal government to address pressing issues and invites endless litigation over federal regulations.

The decision threatens the long-standing practice of Congress delegating broad authority to federal agencies, allowing them to use their expertise to address urgent issues without having to return to Congress for more-specific authorization. The administrative rulemaking process, which requires significant public input, assures that agencies act rationally and within the reasonable scope of their authority. It’s not hyperbole to say that the smooth functioning of government depends on this process.

Under the best of circumstances, Congress struggles to enact major legislation and to base it on expertise rather than purely political considerations. Suffice it to say, Congress is not operating under the best of circumstances today. Thus, the court’s ruling makes an already chaotic federal policymaking process even more chaotic.

So, What Does West Virginia v. EPA Have to Do With the SEC’s Proposed Rule on Climate-Risk Disclosure?

You guessed it. Opponents of the rule—generally not investors but conservatives and fossil fuel interestsare arguing that requiring public companies to disclose their climate risks constitutes a “major question” that was not contemplated by Congress when it granted the SEC the authority to protect investors from financial risks through disclosures in the Securities Act of 1933 and the Securities Exchange Act of 1934. Further, critics claim the SEC proposal is not about disclosing climate risks at all, but an attempt to regulate carbon emissions and therefore completely outside the scope of the SEC’s authority.

To be sure, Congress authorized the SEC to require disclosures about risks to protect investors a long time ago, prior to knowledge of global warming and its cause. But the Securities Acts gave a clear grant of authority for the SEC to go beyond risks that were apparent at the time, expecting the commission to use its expert judgment to update disclosure as newly identified risks emerged.

By the 1970s, Congress explicitly added environmental protection to the SEC’s disclosure mandate in the National Environmental Policy Act, and courts subsequently ruled that the commission was authorized to adopt environmental disclosures.

This presents an open-and-shut case for the proposed rule, according to Harvard Law Professor John C. Coates:

“1. Congress created and in plain words authorized the Commission to protect investors by specifying public company disclosures of information about financial risks and

2. The rule proposes disclosures of information about financial risks and opportunities that are reasonably understood as appropriate for the protection of investors.”

While critics want to argue that the proposed rule is a back-door approach to a major policy question (regulating carbon emissions), there is nothing in the proposal requiring companies to reduce emissions. It only requires disclosure of climate risks and includes reporting of scope 1 and scope 2 emissions (companies that have committed to scope 3 reductions would have to report on them) so that investors can compare the level of risk across companies.

In the end, the SEC has the unambiguous authority to protect investors from material risks by requiring disclosures, including environmental-related disclosures. The proposal protects investors from material climate-related risks by requiring disclosures; it does not require carbon emissions reductions.

It all seems clear, but based on last week’s ruling in West Virginia v. EPA, who’s to say what will happen when opponents take it to court, as they inevitably will? The court has left the door open to a challenge of a final rule based on the newly articulated “major questions” doctrine. Perhaps it will find that because the final rule is simply “related to” a major question that Congress has not yet addressed definitively, it is therefore invalid. I want to believe that even this court would not go there, but by opening the door to this kind of challenge, the court, at minimum, has delivered to investors ongoing uncertainty and a likely delay in getting the information they need to make better decisions.

Jon Hale (jon.hale@morningstar.com) has been researching the fund industry since 1995. He is Morningstar’s director of ESG research for the Americas and a member of Morningstar's investment research department. While Morningstar typically agrees with the views Jon expresses on ESG matters, they represent his own views.