The Time Has Come to Mandate ESG Disclosures: Where Should the SEC Start?

Sustainability-focused funds have seen an incredible boost in popularity since the proliferation of ESG roughly a decade ago. ESG—short for environmental, social, and governance—is a company-wide ethos aimed at implementing responsible policies based on these three factors. Sustainable (or ESG) funds select their constituent investments based on a firm-level analysis of these factors. At the end of 2020, assets under management in sustainable funds surpassed $1.7 trillion. A forecast by Bloomberg suggests that total ESG assets under management may exceed $53 trillion by 2025.

At this point in 2021, it is old news that many sustainable funds financially outperformed their non-sustainable counterparts in the midst of the financial downturn caused by the onset of the COVID-19 pandemic. Interestingly, though, sustainable funds also have a track record of outperformance when markets are stable. 

Unfortunately, the Securities and Exchange Commission (SEC) is playing catch up when it comes to mandating disclosures of material ESG factors. Firm-level ESG policies could provide investors with useful insights on operational efficiency and stabilityespecially in times of financial stress. Thus, a gap in the market exists for reliable, regulated, and audited ESG information. Seeing as how “accessible and usable disclosures are central to the SEC’s mission,” this market failure seems to fall squarely within the purview of the SEC to address. This raises three related questions: (1) How, if at all, would investors use this information? (2) What is currently being done to address this market failure? (3) What should be done to address this market failure? 

How, if at all, would investors use this information?

Investors and asset owners consistently utilize voluntary sustainability disclosures and actively adjust their investment strategies to comport with nonfinancial ESG information. However, investors are beginning to question the prevailing sustainability disclosure practices used by public companies. With greenwashing—the practice of making one’s company appear more environmentally friendly than it actually is—rampant in voluntary sustainability reports, this presents a difficult dilemma to investors: use the potentially jaded, unregulated, and unaudited voluntarily reported ESG information or risk falling behind the rest of the investment community in reaping the superior returns of ESG funds. Again, this signals the need for regulatory oversight, allowing for investors to use this information freely without fear of being misled.

But what is it that makes accurate and reliable ESG information so useful to investors? Some argue that a robust firm-level ESG policy leads to operational superiority, which necessarily generates value for the firm. This theory begins with the idea that risk management is at the heart of ESG policies. In turn, this provides leadership within the company that is more adept at overcoming environmental and social disruptions (e.g., a climate crisis, a racial crisis, or even a global pandemic).

Generating value through ESG policies is recognized through a multitude of initiatives. For example, companies with robust ESG policies can create long-term value by solving sustainability-related issues throughout their operations. Managing resources efficiently—such as developing renewable energy initiatives and reducing wasteful use of fossil fuels or electricity—establishes a cost-effective and sustainable operational plan. In doing so, companies that employ such a policy can reduce their costs and better insulate themselves from the uncertain business risks associated with those resources in times of crisis.

Given the troubling backdrop of 2020 as it relates to race relations in the United States, diversity and inclusion is front and center for every organization right now. While diversity is important in and of itself, within the scope of ESG and drivers of financial performance, strong diversity practices can also be emblematic of superior operations. Specifically, research suggests that 75 percent of organizations with “frontline decision-making teams reflecting a diverse and inclusive culture will exceed their financial targets,” and that gender-diverse teams will outperform gender-homogenous teams by 50 percent.

ESG policies can also generally impact the workforce at a company. Such policies can assist in attracting and retaining quality employees, while enhancing motivation by providing a righteous and sustainable purpose for which its employees can rally behind. This contributes to more productive and higher-performing employees. Importantly, employee satisfaction and shareholder returns are positively correlated.

Firm-level ESG policies are drivers of value and can signal operational superiority within a company. While resource efficiency and diversity and inclusion are important in their own right, robust policies of this sort have material impacts on companies’ day-to-day efficiency and improve operations. With investors consistently utilizing nonfinancial ESG information in their investment decision-making, and with these specified ESG factors having a material impact on companies’ financial performance, the SEC should think critically about how it can promote consistent and comparable ESG disclosures.

What is currently being done to address this market failure?

The SEC favors a principles-based materiality disclosure regime, as opposed to a strict rules-based nonfinancial disclosure regime. Current ESG disclosure rules follow two frameworks: (1) broad topics focused on materiality, or (2) incredibly narrow topics, highlighting discrete issues. In the first framework, ESG factors could potentially be disclosed, among other non-ESG factors. Specifically, Regulation S-K mandates disclosures of certain environmental compliance costs, ESG risks that are material risk factors to the company, and Management’s Discussion and Analysis of “any known future trends or uncertainties” that could materially impact the firm’s financial performance. The second framework deals with much more specialized disclosures, such as Dodd-Frank’s mandate of the disclosure of mine safety policies or business activities in Iran.

Despite receiving thousands of comment letters signaling the public’s desire for disclosures of workforce development, diversity, and climate risk in response to a call for comments on Proposed Rule: Modernization of Regulation S-K Items 101, 103, and 105, the SEC promulgated a final rule on August 26, 2020 that was silent on both diversity and climate risk

Developments Regarding Mandated ESG Disclosures in 2021

The legislative and executive branches have made various efforts in 2021 to work towards providing investors with accurate and reliable SEC-mandated ESG information. The charge began with California Democrat Juan Vargas introducing H.R. 1187, or the ESG Disclosure Simplification Act, to Congress on February 18, 2021. This bill requires an issuer of securities to disclose certain ESG factors and their connection to the long-term business strategy of the company. Further, H.R. 1187 would establish the Sustainable Finance Advisory Committee that would recommend to the SEC ESG metrics that issuers should be required to disclose. This bill has passed the House and is currently in the Senate.

In response to investor demand, SEC Commissioner Allison Herren Lee released a public statement in March, calling for public input on potential climate change disclosures. Commissioner Lee stated that she is “asking the staff to evaluate [the SEC’s] disclosure rules with an eye toward facilitating the disclosure of consistent, comparable, and reliable information on climate change.” 

In late May, President Biden issued an executive order systematizing the executive branch’s efforts in identifying the financial risks climate change poses to government and private assets. In doing so, President Biden instructed the Financial Stability Oversight Council to develop a plan to improve disclosures regarding climate risks and related ESG factors. While this is an important development, it is also important to note that the White House lacks direct authority over the SEC and its policy-making ability. 

SEC Chair Gary Gensler brought attention to potentially mandating ESG disclosures in his September 14th testimonybefore the Senate Committee on Banking, Housing, and Urban Affairs. Chair Gensler’s testimony referenced the increasing number of funds labeling themselves as “green” or “sustainable.” In response to this point, Chair Gensler has asked SEC staff to inquire into the information supporting these labels and to determine how the SEC can ensure the public has the information they need to understand their investment choices regarding these funds.

Contrastingly, Republicans have largely ignored investor demand for climate risk information and have consistently disparaged the notion of mandating climate and ESG-related disclosures, deriding their efficacy in investment decisions and parading the idea as a radical liberal agenda. Representative Doug LaMalfa of California said, in response to H.R. 1187, that “[i]nvestors don’t need a ‘wokeness’ report card on a company’s long-term business strategy. Through this bill, Democrats will use bureaucrats to forcibly collect information that progressive interest groups will use to publicly harass American companies.” In response to Chair Gensler’s Senate testimony, Senator Pat Toomey of Pennsylvania claimed that regulating and mandating “these political and social issues” is not within the SEC’s role or expertise.

Much of the political back and forth presents mandatory ESG disclosures as a partisan issue. However, it is increasingly apparent that mandating disclosure of ESG factors that have a material operational impact on a company falls within the mission of the SEC. The SEC has a mission to “protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation.” To achieve this mission, the SEC requires public companies to regularly disclose “significant financial and other information so investors have the timely, accurate, and complete information they need to make confident and informed decisions” (italics added). It is clear that ESG factors represent “other,” non-financial information that investors need to make “informed decisions.”

What should be done to address this market failure?

The SEC should further explore the ESG factors that materially impact a company’s operations. Since the SEC’s current nonfinancial disclosure regime focuses on materiality, this is a logical starting point. Contextualizing ESG disclosures in this manner may also bridge the political gap as it falls within the current remit of SEC-mandated nonfinancial disclosures.

In a recent speech, Chair Gensler mentioned how many commenters to the request for information on climate disclosuresreferenced the Task Force on Climate-related Financial Disclosures (TCFD) framework, among others. Chair Gensler noted that he has asked SEC staff “to learn from and be inspired by these external standard-setters.” While the TCFD framework is globally lauded, it draws from the Global Reporting Initiative’s (GRI) framework. The GRI framework is much more expansive than the TCFD framework and provides for more specified disclosures on a wider array of issues. Thus, the SEC should begin their inquiry into ESG disclosures with the GRI framework.

The GRI framework is best suited for the SEC’s current model of nonfinancial disclosures. Particularly, GRI encourages the use of the GRI Standards in piecemeal fashion, suggesting that this may be the best method of reporting information to specific users, such as investors. Therefore, once a company identifies such factors that are material, it can look to the Standards and disclose information as recommended by the accompanying Standard. This aligns with the SEC’s current nonfinancial disclosure model and my recommendation that the SEC only mandate disclosure of those ESG factors that have a material impact on company operations. 

The GRI framework also boasts widespread adoption among the world’s largest companies. Specifically, 73 percent of the world’s largest 250 companies and 67 percent of the world’s largest 100 firms (comprising 5,200 companies) now use the GRI framework.

The GRI framework also enables the SEC to choose from the expansive list of Standards for what it deems material. As already referenced in this post, resource efficiency and diversity practices can have a material impact on company operations. If the SEC chooses to mandate disclosures of this type, the GRI has Standards to facilitate that.

GRI 302, GRI 305, and GRI 307 lay out disclosures for Energy (mostly in terms of usage and efficiency), Emissions, and Environmental Compliance, respectively. GRI 302 focuses on energy and fuel consumption inside and outside of the company and the reduction and conservation of energy, paired with the company’s initiatives aimed at such reductions. GRI 305 suggests disclosures on greenhouse gas emissions and other ozone-depleting substances, while also focusing on the company’s initiatives to reduce such emissions. GRI 307 recommends disclosing any significant monetary and non-monetary sanctions for non-compliance with environmental laws and regulations.

GRI 405 lays out suggested disclosures for diversity and equal opportunity at the company. Specifically, it recommends disclosing the percentage of individuals within the company’s governance bodies—such as the board of directors and board committees—and the percentage of employees in each seniority level and job function within the context of gender, age group, and minority and vulnerable groups. This Standard also recommends disclosing the ratio of basic salary and remuneration of women to men.

Conclusion

While ESG disclosures may be costly to individual companies, mandating this information benefits the market as a whole because investors would have additional, accurate, and regulated information at their disposal. Regulated ESG disclosures would also diminish greenwashing practices, thereby leading to less misinformation in the market and more company accountability.

ESG factors are not merely a façade for a company’s social responsibility. Instead, they can signal value-driven operations for which investors—who already rely on this type of information—need trustworthy and relevant disclosures for.

Nicholas P. Mack is a J.D. Candidate at Vanderbilt University Law School.

This post is adapted from his article, “The COVID-19 Pandemic Highlighted the Need for Mandated ESG Disclosures: Now What?” available on SSRN and forthcoming in Volume 30 of the University of Miami Business Law Review.

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