Government Agency Authority Under Pressure After West Virginia V. EPA Ruling

    EPA And SEC Face An Uphill Battle Regulating Climate Change And Imposing ESG Reporting And Disclosure Standards

    On June 30, 2022, the Supreme Court Of The United States (SCOTUS) decided the outcome of West Virginia Et Al. V. Environmental Protection Agency Et Al. (West Virginia V. EPA). In its 89-page report, SCOTUS determined that the EPA has limited authority to enforce emissions regulations and requirements. SCOTUS also questioned the EPA’s authority to decide the best course of action for lowering the nation’s carbon emissions, citing Congress should have authority to set climate standards instead of the EPA. The decision is a win for the fossil fuel industry and coal producing states like West Virginia, which have long questioned the federal agency’s ability to determine emissions requirements. Joining West Virginia in suing the EPA was Alabama, Alaska, Arkansas, Georgia, Indiana, Kansas, Louisiana, Missouri, Montana, Nebraska, Ohio, Oklahoma, South Carolina, South Dakota, Texas, Utah, and Wyoming, and Mississippi Governor Tate Reeves (not the state itself).

    Details Of The Supreme Court Ruling

    In the majority opinion, which was passed by a vote of 6-3, SCOTUS cited Section 111 of the EPA’s Clean Power Act of 2015, which addressed carbon dioxide (CO2) emissions from existing coal- and natural gas-fired power plants. “Prior to the Clean Power Plan, EPA had used Section 111(d) only a handful of times since its enactment in 1970,” said the Supreme Court report. Under that provision, although the states set the actual enforceable rules governing existing sources (such as power plants), EPA determines the emissions limit with which they will have to comply. The agency derives that limit by determining the “best system of emissions reductions that has been adequately demonstrated,” or the BSER, for the kind of existing source at issue. The limit then reflects the amount of pollution reductions “achievable through the application of” that system.

    EPA determined three “building blocks” for achieving emissions reductions. The first was improving heat rates at coal-fired power plants so that these plants can burn coal more cleanly. The second building block was transitioning from higher-emitting forms of electricity production to lower-emitting forms of electricity production (namely by shifting from coal to natural gas). The third building block was transitioning from both coal- and natural gas-fired power plants to wind and solar electricity generation. “The Agency explained that, to implement the needed shift in generation to cleaner sources, an operator could reduce the regulated plant’s own production of electricity, build or invest in a new or existing natural gas plant, wind farm, or solar installation, or purchase emission allowances or credits as part of a cap-and-trade regime,” said the Supreme Court report. “Taking any of these steps would implement a sector-wide shift in electricity production from coal to natural gas and renewables.”

    SCOTUS didn’t have a problem with the EPA’s intention, but rather, with its execution of authority and procedure for implementing lower-carbon forms of electricity generation. “It [the EPA] settled on what it regarded as a ‘reasonable’ amount of shift, which it based on modeling how much more electricity both natural gas and renewable sources could supply without causing undue cost increases or reducing the overall power supply,” said the Supreme Court report. “The Agency ultimately projected, for instance, that it would be feasible to have coal provide 27% of national electricity generation by 2030, down from 38% in 2014. From these projected changes, EPA determined the applicable emissions performance rates, which were so strict that no existing coal plant would have been able to achieve them without engaging in one of the three means of generation shifting. The Government projected that the rule would impose billions in compliance costs, raise retail electricity prices, require the retirement of dozens of coal plants, and eliminate tens of thousands of jobs.”

    In 2019, the EPA found flaws in the Clean Power Plan. “EPA explained that the Clean Power Plan, rather than setting the standard ‘based on the application of equipment and practices at the level of an individual facility,’ had instead based it on ‘a shift in the energy generation mix at the grid level,’” said the Supreme Court report. Ultimately, the SCOTUS decision didn’t dismiss the EPA’s authority, but rather, checked its authority by determining the EPA has limits in its regulation and enforcement of its own carbon reduction strategies. “The only question before the Court is more narrow: whether the ‘best system of emissions reductions’ identified by EPA in the Clean Power Plan was within the authority granted to the Agency in Section 111(d) of the Clean Air Act. For the reasons given, the answer is no,” concluded the Supreme Court report.

    “Capping CO2 emissions at a level that will force a nationwide transition away from the use of coal to generate electricity may be a sensible ‘solution to the crisis of the day,’” wrote Chief Justice John G. Roberts Jr. “But it is not plausible that Congress gave EPA the authority to adopt on its own such a regulatory scheme in Section 111(d). A decision of such magnitude and consequence rests with Congress itself, or an agency acting pursuant to a clear delegation from that representative body.”

    In sum, the ruling questioned the EPA’s authority to regulate power plant emissions without congressional guidance. Put another way, the EPA doesn’t have the power to implement its own climate change agenda.

    Consequences Of The Ruling

    The SCOTUS decision sets a precedent for government agency authority when it comes to regulating climate issues, whether that’s the EPA, the Securities and Exchange Commission (SEC), or a different government agency. The ruling could have a major impact on the SEC’s push to regulate ESG reporting.

    In late March, the SEC announced a proposal to standardize ESG disclosures by companies and other registrants. The SEC, in this vein, would serve as a regulator of ESG disclosures, which would be a lot different from, say, Congress being in charge of ESG reporting. But the SEC believes that some sort of order is needed in the metrics that companies report and the way in which they circulate those numbers.

    Standardizing ESG Reporting

    In a statement, the SEC said that is proposing “rule changes that would require registrants to include certain climate-related disclosures in their registration statements and periodic reports, including information about climate-related risks that are reasonably likely to have a material impact on their business, results of operations, or financial condition, and certain climate-related financial statement metrics in a note to their audited financial statements. The required information about climate-related risks also would include disclosure of a registrant’s greenhouse gas (GHG) emissions, which have become a commonly used metric to assess a registrant’s exposure to such risks.”

    In other words, the SEC wants investors to be able to better understand a company’s climate-related risks and how it manages those risks relative to its peers. Another major point from the proposal would require companies to quantify the financial impact of these risks on its short-, medium-, or long-term performance. To follow up on that point, the SEC wants companies to then release a strategy of how they expect to get past the financial hurdles of their climate-based impacts. It should be noted that the SEC isn’t just talking about GHG emissions, but also, severe weather problems, natural disasters, etc. These types of risks would relate more to, say, an insurance company or a data center in Texas that operates on wind power but is at risk to hurricanes.

    Details On SEC ESG Regulation

    In late May, while West Virginia V. EPA was being debated by SCOTUS, Gensler released a statement updating the SEC’s ESG disclosures proposal. In addition to emphasizing his support of the proposal, Gensler pointed out the inconsistency when it comes to what information is reported, in terms of reporting too much, reporting misleading information, or not reporting enough. “It is important that investors have consistent and comparable disclosures about asset managers’ ESG strategies so they can understand what data underlies funds’ claims and choose the right investments for them,” said Gensler. “When I think about this topic, I’m reminded of walking down the aisle of a grocery store and seeing a product like fat-free milk. What does ‘fat-free’ mean? Well, in that case, you can see objective figures, like grams of fat, which are detailed on the nutrition label. Funds often disclose objective metrics as well. When doing so, investors get a window into the criteria used by the asset managers for the fund and the data that underlies the claim. When it comes to ESG investing, though, there’s currently a huge range of what asset managers might disclose or mean by their claims.”

    The SEC often gets criticized for regulating industries once they become sizeable instead of leading regulation before new asset categories emerge. For example, the SEC began cracking down on cryptocurrency regulation once crypto became a multi-trillion industry. The crypto industry is now a major asset class. However, the cumulative size of ESG funds are magnitudes larger than the entire value of all 20,000-plus cryptos in existence. The SEC clearly recognizes that ESG investment has outpaced its ability to regulate the industry and is now scrambling to crack down on disclosure best practices before the industry balloons to larger proportions. “As investor interest in ESG investments has grown, so too have ESG investment products and services,” said Gensler. “For example, we’ve seen an increasing number of funds market themselves as ‘green,’ ‘sustainable,’ ‘low-carbon,’ and so on. While the estimated size of this sector varies, one estimate says that the ‘US sustainable investment universe’ has grown to US$17.1 trillion. Suffice it to say there are hundreds of funds and potentially trillions of dollars under management in this space. ESG also encompasses a wide variety of investments and strategies. Some funds screen out certain industries. Others specifically include certain industries. Others may claim to have a particular impact on an issue. Some may track board votes or make assertions about the GHG emissions, labor practices, or water sustainability of their underlying assets. Some funds involve human judgments. Others might track an outside index. Needless to say, there’s a wide range here. When an investor reads current disclosures, though, it can be very difficult to understand what some funds mean when they say they’re an ESG fund. There also is a risk that funds and investment advisers mislead investors by overstating their ESG focus.”

    Critics of SEC regulation often argue that a government agency should not prevent investors from making choices about how they want to invest their hard earned savings. And while that may be true when it comes to the SEC’s handling of certain asset classes, the agency’s intention with regulating ESG disclosures is something the industry desperately needs to improve its transparency so that investors and policymakers can better track climate improvements and set accurate targets. “People are making investment decisions based upon these disclosures, so it’s important that they be presented in a meaningful way to investors,” said Gensler. “What information stands behind funds’ claims? Which data and criteria are funds using to ensure they’re meeting investors’ targets? I think investors should be able to drill down to see what’s under the hood of these funds. This gets to the heart of the SEC’s mission to protect investors, allowing them to allocate their capital efficiently and meet their needs.”

    The SEC’s proposal would allow the agency to regulate registered investment funds in three major ways:

    • First, it would require funds that say they consider ESG factors to provide investors with information in the prospectus about what ESG factors they consider, along with the strategies they use. This could include, for example, whether a fund tracks an index, excludes or includes certain types of assets, uses proxy voting or engagement to achieve certain objectives, or aims to have a specific impact.
    • Second, a subset of those funds — ESG-focused funds, as defined in the proposal — also would need to disclose details about the criteria and data they use to achieve their investment goals, as well as more specific information about their strategies. These disclosures would enable investors to dig into the details of a fund’s strategy.
    • Third, the proposal would require particular types of ESG-focused funds to disclose relevant metrics. For example, certain funds would be required to report the GHG emissions metrics of their portfolios, and an impact fund would be required to disclose metrics about and annual progress toward its ESG goals.

    A Dangerous Precedent

    Despite your personal opinion on the EPA’s power to impose climate regulation, or your thoughts on whether the SEC should regulate ESG reporting or not, chances are that if you’re a reader of ESG Review, you probably agree that emissions requirements and ESG reporting are important issues. These issues require clarification so that companies and organizations can conduct their operations in a way that lowers their environmental impact without ruining their financial health. In a perfect world, companies would simply set and hit their own climate reduction targets. However, there exists a large disparity between what companies are saying they will do and what is actually being done to fight climate change. Based on whichever administration is in charge at the time, company-specific climate reduction goals can drastically exceed or fall short of government expectations or regulations. Given the inconsistency of government standards and the uncertainty as to the future of government agency authority, the simplest solution is for stakeholders — from shareholders, employees, customers, impacted communities, etc. — to hold companies accountable for setting and hitting meaningful ESG targets.

    The existing framework for ESG reporting is challenging because two companies in the same industry can calculate figures in different ways or flat out omit categories and metrics. Similar to accounting regulations that make it easy to better gauge industry standards and averages, regulating ESG reports would give each report greater credibility, allow for better ESG ratings, improve the ability for investors to accurately construct an ESG portfolio, and make it easier to track a company’s ESG journey over time in a similar way that investors track revenue and earnings growth.