The Current State of ESG Investing: Towards a More Unified ESG Disclosure Regime?

Moliang Jiang

 

In 2020, impact and Environmental, Social, and Governance (“ESG”) investments became increasingly mainstream, with focus on issues like climate change, workplace diversity, employee welfare, human capital management, and supply chain sustainability and resilience.[1] Against the backdrop of changing political and social environment globally, investments that focus on ESG principles could expand further in the coming years. PwC forecasts that “ESG funds will experience a more than threefold jump in assets by 2025, increasing their share of the European fund sector from 15% to 57%.”[2]

ESG-focused funds invest in companies or other funds, with the goal of generating both financial return and measurable and beneficial social, environmental, and governance impact.[3] The underlying principle is that ESG-negative behaviors hurt investment returns.[4] In the US, the majority of ESG financial products are bonds, with ESG loans accounting for a smaller portion of ESG asset class.[5] Most ESG bonds are “use of proceeds” or asset-linked bonds, the proceeds of which fund projects with positive environmental or climate impacts or which are backed by green assets (e.g., residential solar systems, loans for energy-efficient homes, etc.).[6]

ESG reporting by companies and asset managers is critical for investors to make informed investment decisions. Up to now, information provided by companies has largely taken the form of voluntary disclosures.[7] While most ESG disclosure is made on a voluntary basis, regulators have started to take on a more proactive role, particularly in Europe.[8]Compliance with the EU regulation on sustainability-related disclosures will be required after March 10, 2021 for certain EU and non-EU investment managers.[9] The new EU ESG disclosure regulation (the EU Taxonomy Regulation) seeks to prevent sponsors and firms from providing deceiving information about the ESG impacts of their financial products by establishing an EU-wide disclosure standard for funds marketed in EU.[10] In the US, the SEC Investor Advisory Committee has held three sessions on ESG Disclosures  in 2016, 2018, and 2019.[11] On the other side of the Pacific, in 2020, Securities and Futures Commission (SFC) in Hong Kong published a paper on management and disclosure of climate risks by investment managers, including proposed amendments to their code of conduct requiring consideration of climate risks in investment and risk-management processes.[12] Besides government initiatives, NGOs have launched a number of global non-governmental ESG frameworks for ESG reporting.[13]

Partly due to lack of well-defined disclosure requirements in and outside of the US, third party ESG data providers have sprung up to offer ratings and scorings that investors seek but companies do not disclose publicly.[14] Data providers conduct their own analysis and generate reports by collecting data from different information sources and sending out questionnaires to the companies.[15] The myriad of data providers has led to lack of consistency and comparability of different metrics, placing a significant burden on issuers and posing a significant challenge to investors and asset managers.[16] BlackRock has pushed for a global ESG standard, calling for the “‘alphabet soup’ of standards used by companies to showcase their sustainability efforts to be replaced by a globally recognized framework.”[17]

The SEC has declined to mandate ESG-specific disclosures, opting instead to use traditional materiality formulations as the benchmark for disclosures.[18] Former SEC Chairman Jay Clayton has expressed his caution against ESG-specific disclosures, stressing that “environmental and climate-related matters are complex, forward-looking and uncertain, likely involve estimates and assumptions, and are difficult to verify.”[19] Under current SEC rules and guidance, issuers are required to make ESG-related disclosures only if they are “material,” meaning that “information regarding an ESG issue is required to be disclosed only if it would be viewed as significantly altering the ‘total mix’ of information available for investors.”[20] However, the SEC faces increasing pressure from the growing investor interests in “a regulated, uniform approach by Issuers to ESG disclosure.”[21] In May 2020, the SEC Investor Advisory Committee recommended that the SEC begin an “earnest” effort to update reporting requirements to include “material, decision-useful, ESG factors.”[22] It remains to be seen how SEC will respond to increasing demand from investors and this recommendation.

The SEC should play a more prominent role in oversight of ESG disclosures to curb the inconsistency of disclosure standards and reduce the confusion surrounding the growing space of ESG investing. Inconsistent ESG disclosure leads to risks such as “potential liability under state and federal securities and consumer protection laws, books and records requests, agency investigations, and even breach of fiduciary claims against control persons for failure to exercise adequate oversight.”[23] More uniform ESG disclosure requirements will meet the rising expectations from investors and stakeholders and give companies a framework to disclose their ESG-related information, easing the burden now placed on companies to navigate different standards put forth by third party providers.

The standardization of ESG disclosure requirements would have several implications for companies and investors. Boards of directors might face heightened oversight responsibilities if stakeholders and investors can play a more active role in holding companies accountable in the event of an environment incident under their watch.[24] As more companies include ESG-related information in their SEC filings, they could face liability under federal securities laws if the information they provide is false or misleading. Against the backdrop of heightening investor and consumer interest in ESG, the courts are also increasingly likely to find statements regarding ESG issues material to investors in securities litigation. Given the Biden administration’s agenda to advance more progressive climate policies and the new SEC Chairman Gary Gensler taking office in 2021, we could potentially see more regulatory guidance as well as novel legal challenges for ESG investing in the next couple of years.

 

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[1] David M. Silk, Sabastian V. Niles & Carmen X. W. Lu, ESG and Sustainability: Key Considerations for 2021, Harvard Law School Forum on Corporate Governance (Jan. 30, 2021), https://corpgov.law.harvard.edu/2021/01/30/esg-and-sustainability-key-considerations-for-2021/.

[2] Siobhan Riding, ESG funds forecast to outnumber conventional funds by 2025, FT (Oct. 17, 2020), https://www.ft.com/content/5cd6e923-81e0-4557-8cff-a02fb5e01d42.

[3] Todd N. Bundrant, Ann Richardson Knox, Gabriela Sakamoto & Monica J. Steinberg, The Growth of ESG in Fund Finance and Other Financial Products in the United States, Mayer Brown (Jan. 27, 2021), https://www.mayerbrown.com/en/perspectives-events/publications/2021/01/the-growth-of-esg-in-fund-finance-and-other-financial-products-in-the-united-states.

[4] Id.

[5] Id.

[6] Id.

[7] Holly J. Gregory, Heather Palmer & Leonard Wood, Emerging ESG Disclosure Trends Highlighted in GAO Report, Harvard Law School Forum on Corporate Governance (Aug. 15, 2020), https://corpgov.law.harvard.edu/2020/08/15/emerging-esg-disclosure-trends-highlighted-in-gao-report/.

[8] ESG Disclosures: Frameworks and Standards Developed by Intergovernmental and Non-Governmental Organizations, Paul, Weiss (Sep. 4, 2020), https://www.paulweiss.com/insights/esg-thought-leadership/publications/esg-disclosures-frameworks-and-standards-developed-by-intergovernmental-and-non-governmental-organizations?id=37914.

[9] ESG Developments in the European Union—Sustainability Related

Disclosures for AIFMs and AIFs, Simpson Thacher & Bartlett LLP (Oct. 28, 2020), http://www.stblaw.com/docs/default-source/memos/firmmemo_10_28_20.pdf.

[10] Kirsten Lapham, John Verwey, Amar Unadkat & Michael Singh, European ESG Disclosure Requirements for Asset Managers, The National Law Review (Sep. 18, 2020), https://www.natlawreview.com/article/european-esg-disclosure-requirements-asset-managers.

[11] Recommendation of the SEC Investor Advisory Committee Relating to ESG Disclosure, SEC (May. 21, 2020), https://www.sec.gov/spotlight/investor-advisory-committee-2012/esg-disclosure.pdf.

[12] Tim Baines & Paul Forrester, Oil And Gas Cos. Must Ensure They Can Back Up ESG Claims, Law 360 (Jan. 26, 2021), https://www.law360.com/articles/1347704/oil-and-gas-cos-must-ensure-they-can-back-up-esg-claims?copied=1.

[13] ESG Disclosures: Frameworks and Standards Developed by Intergovernmental and Non-Governmental Organizations, supra note 8.

[14] Recommendation of the SEC Investor Advisory Committee Relating to ESG Disclosure, supra note 11.

[15] Id.

[16] Bundrant et. al, supra note 3.

[17] Attracta Mooney, BlackRock pushes for global ESG standards, FT (Oct. 29, 2020), https://www.ft.com/content/2a8d7fac-5ab6-43e5-9e04-8e9b3adfd195.

[18] David M. Silk, Sabastian V. Niles & Carmen X. W. Lu, ESG Disclosures: SEC Appoints Climate and ESG Policy Advisor; U.K. and EU Regulators Ramp Up Reporting Requirements, Wachtell, Lipton, Rosen & Katz LLP (Feb. 4, 2021),  https://www.wlrk.com/webdocs/wlrknew/WLRKMemos/WLRK/WLRK.27354.21.pdf.

[19] Donna Mussio, Mary Beth Houlihan & Taylor Souter, To Lead or Not to Lead: Contrasting Recent Statements by SEC and ESMA Chairs on ESG Disclosure, Harvard Law School Forum on Corporate Governance (Mar. 16, 2020), https://corpgov.law.harvard.edu/2020/03/16/to-lead-or-not-to-lead-contrasting-recent-statements-by-sec-and-esma-chairs-on-esg-disclosure/.

[20] SEC Again Urged to Regulate ESG Disclosures, Jones Day (June 2020), https://www.jonesday.com/en/insights/2020/06/sec-again-urged-to-regulate-esg-disclosures#:~:text=Under%20current%20SEC%20regulations%20and,investors%E2%80%95which%20offers%20flexibility%20to.

[21] Recommendation of the SEC Investor Advisory Committee Relating to ESG Disclosure, supra note 11.

[22] Id.

[23] SEC Again Urged to Regulate ESG Disclosures, supra note 18.

[24] What Corporate Governance and ESG Professionals Need to Know, Gibson Dunn (June, 2020), https://www.gibsondunn.com/wp-content/uploads/2020/10/Ising-Meltzer-McPhee-Percopo-Assaf-Holmes-ESG-Legal-Update-What-Corporate-Governance-and-ESG-Professionals-Need-to-Know-Society-for-Corporate-Governance-06-2020.pdf.