FOCUS IN ACTION
Trends in ESG Regulation
"A corporation ignores environmental and social challenges at its own peril."
- Martin Lipton and William Savitt
The 'Wild' West of ESG
Over the past decade, there’s been a tremendous flow of capital into investment strategies and funds that consider environmental, social, and governance (ESG) factors. According to The Forum for Sustainable and Responsible Investment’s (US SIF) 2020 Trends report, the total U.S.-based assets under management utilizing sustainable strategies grew to over $17 trillion at the start of 2020- an increase of 42 percent from 2018. This means that one in every three dollars of the total U.S. assets under professional management now has a sustainability focus. Global growth figures are even more astonishing. There is no arguing that ESG is here to stay.
As the ESG market share continues to grow, so does its scrutiny. You don’t have to look hard to find ESG-related controversies in the news. “Greenwashing”, an organization making false claims that a product or service is more environmentally friendly than it truly is, often makes the headlines. The growing ESG ratings industry has also gotten flack for being inconsistent and, at times, opaque. Corporations and investors alike are demanding standardization of sustainability definitions and disclosures. Regulators are taking note but, so far, the policy response has been slow and muddled.
There are several- perhaps, too many- voluntary sustainability frameworks already in place. The Global Reporting Initiative (GRI), the Task Force on Climate-related Financial Disclosures (TCFD), the Sustainability Accounting Standards Board (SASB), and CDP are some of the most widely accepted frameworks. Although well-intentioned, they have many shortfalls. Some of these frameworks are more tailored to investors, while some prioritize companies. Some only focus on environmental issues, while some include social and governance issues as well. The discrepancies between different standards often lead to confusion, inconsistencies, and inefficiencies of reporting. It’s onerous and costly for companies to report in alignment with multiple standards. It’s impossible for investors to compare disclosures across different frameworks.
All of these issues present an argument for some level of governmental regulation of sustainability disclosures, and the EU has taken the clear lead. With the goal of assisting all stakeholders in evaluating the non-financial performance of large companies, the EU launched the Non-Financial Reporting Directive (NFRD) in 2014. This law, which applies to public companies with more than 500 employees, requires that certain ESG information be disclosed in a statement, as part of a company’s annual public reporting obligations. In April 2021, the Commission adopted a proposal for a Corporate Sustainability Reporting Directive (CSRD), which would build upon the NFRD. Some proposed changes include requiring an audit of the reported information, extending the directive to all large companies (not just public), and aligning the report with EU sustainability reporting standards.
The EU has implemented several additional initiatives in recent years, including the Sustainable Finance Action Plan (SFAP) and the EU Taxonomy. These complex, multi-stage directives lay the blueprint for regulatory changes in line with the European Green Deal and the region’s goal of achieving a climate neutral economy by 2050. The SFAP gave way to the Sustainable Finance Disclosure Regulation (SFDR). Effective as of March 2021, the SFDR requires sustainability-related disclosures for financial market participants, as well as the obligation to disclose adverse impacts on sustainability factors at both the entity and product level. The EU Taxonomy is a classification system that seeks to define which economic activities are ‘sustainable’. Under this regulation, both financial firms and non-financial firms will be mandated to disclose alignment with the taxonomy, with some starting in 2022. The hope is that both of these initiatives will help promote sustainable investment, help companies become more sustainability-focused, and protect investors from greenwashing.
In the U.S., federally mandated sustainability disclosure requirements are lagging. However, this is expected to soon change. The Biden administration has made it clear that climate and ESG-related risk disclosure is a top priority. The SEC is undergoing a review and intends to release updated guidance on mandatory climate and ESG disclosures later this year, building on its 2010 climate disclosure guidance. Although the 2010 guidance led to a dramatic increase of companies mentioning climate change and/or emissions in their 10-Ks in the year following the issuance, the enforcement and oversight has subsequently dwindled. In September 2021, the Division of Corporation Finance released a sample letter it may send to companies asking for specific climate information to be included in future annual filings. Some asks include:
- Disclose the material effects of transition risks related to climate change that may affect your business, financial condition, and results of operations, such as policy and regulatory changes.
- Please revise your disclosure to identify material pending or existing climate change-related legislation, regulations, and international accords and describe any material effect on your business, financial condition, and results of operations.
- If material, provide disclosure about your purchase or sale of carbon credits or offsets and any material effects on your business, financial condition, and results of operations.
The letter sends a clear message: companies must begin disclosing more comprehensive and financially material climate-related information in annual filings. It’s important for companies to take this seriously, and as preparation for the impending SEC rule making on corporate disclosures.
Other countries around the world are also implementing or strengthening ESG regulations. According to a late 2021 study conducted by the European Corporate Governance Institute, nearly 30 countries have mandated ESG disclosures. In Australia’s 2003 Corporate Governance Principles and Recommendations, listed entities are recommended to “disclose whether it has any material exposure to environmental or social risks, and if it does, how it manages or intends to manage those risks.” Expanding its 2013 regulation for listed companies to detail emissions, diversity and human rights, the UK recently announced new Sustainability Disclosure Requirements. The UK has also committed to implementing mandatory reporting aligned with the TCFD. In China, new laws will strengthen its Environmental Information Disclosure Act of 2008. Effective 2022, entities will be required to annually report on carbon emissions, pollutant generation, environmental management, and contingency planning for environmental emergencies.
The Future of Sustainability Standards
As more regions move towards ESG mandates and oversight, it will be important for regulations to be based on standardized frameworks and definitions. Is a global framework too optimistic? The IFRS Foundation believes it’s a necessity. This public interest organization is the governing body of the International Accounting Standards Board, which sets the accounting rules for financial statements of public companies used by most countries. At the end of 2021, the IFRS Foundation announced the creation of the International Sustainability Standards Board (ISSB). The intention of the ISSB is to “deliver a comprehensive global baseline of sustainability-related disclosure standards that provide investors and other capital market participants with information about companies’ sustainability-related risks and opportunities to help them make informed decisions”. It’s hard to imagine an organization more equipped and well-positioned to develop a global sustainability standard than IFRS. The board is soliciting feedback from TCFD and other frameworks in order to inform the building blocks of its standards. As is the case with the IFRS accounting standards, it will be up to countries to decide whether to require companies in their jurisdictions to actually adopt these standards, once developed.
Where ESG Ratings and Indices Fit
While governments struggle to implement coherent policies, the market has developed its own response to the demand for defining and measuring sustainability. ESG Rating companies such as MSCI and Sustainalytics have developed proprietary methodologies to objectively score companies based on E, S, and G characteristics. There are thousands of underlying data points contributing to these scores, which often take into account industry-specific risks. The goal of MSCI’s ratings, for example, is “to measure a company’s resilience to financially material environmental, societal and governance risk”. Although imperfect, ESG ratings are a valuable tool for investors to compare ESG risks within peer groups and measure relative performance. Indices built on ESG ratings have become more prevalent in recent years and can help serve as a benchmark. A company’s inclusion in the MSCI KLD 400 Social Index, for example, can be used as a measure of success. Inclusion in ESG indices may also help companies attract capital from ESG investors as it becomes more common practice to utilize these indices for benchmarking purposes. It’s important for companies to be aware of their ESG ratings, understand the various methodologies, and respond with transparent disclosures in sustainability reports or filings.
Measurable Outcomes at Focus Impact
In addition to the ESG framework of measuring sustainability, Focus Impact takes it a step further by overlaying an emphasis on measurable “S” outcomes. We seek to invest in companies that are aligned with one or more of four SDGs which impact people outcomes:
We developed the “Social Forward” concept as our own response to stakeholders’ demands for companies to deliver double-bottom line results. At Focus Impact, we believe companies focused on the “S” have more engaged employees, satisfied and loyal customers, a growing and dedicated investor base, and superior risk-adjusted returns.