Over the past year, three converging trends have put environmental, social, and governance (“ESG”) topics at the center of yet another polarizing national debate.
- ESG Mainstreaming. The first is that investments that integrate ESG factors in some way have gone mainstream over the past decade. ESG is no longer limited to “sustainable, responsible, and impact” (SRI) investing (or to use an older term, “socially responsible investment”), and demand is projected to soar.
- ESG Regulation. With a Wild West of self-proclaimed ESG funds and self-defined “green” corporate practices, the second trend — related to the first — is the SEC’s push to adopt higher disclosure standards for both asset managers and portfolio companies themselves. Next month, the SEC is expected to release its final version of new corporate reporting requirements for climate-related financial risk and separate reporting requirements for ESG-oriented investment products and services. The SEC is also expected to propose new rulemaking on “human capital management” or workforce-related disclosures later this year.
- Anti-ESG Backlash. The third trend is the anti-ESG backlash from some lawmakers and state governments. In 2022, Texas and West Virginia blacklisted asset managers who have committed not to invest in the fossil fuel sector. They lead a growing number of states who have banned or may soon ban their pension funds from considering ESG factors in investment (while California, New York, Illinois and others mandate or encourage it). The controversy led to a recent showdown at the federal level over a bill that, if not vetoed by the President, would have blocked the Department of Labor (DOL) from implementing a rule that allows pension funds governed by the Employee Retirement Income Security Act (ERISA) to consider ESG factors in investment decisions. The DOL rule still faces legal challenge in federal court.
Three ESG Fears
Three main fears drive the current opposition to mandatory climate disclosure and to the use of ESG factors in investment analysis and voting:
- Pandora’s Box. One fear is that the lack of clear definition around ESG makes it potentially unbounded, like the proverbial Pandora’s Box. This could leave federal regulators (like the SEC and the DOL) free to justify broader regulation to reach an ever-expanding list of “environmental and social (read “workforce”)”-related issues. Asset managers might, it is argued, use ESG to drive client funds toward their own investment agendas, even though such behavior would violate their existing obligations as investment fiduciaries.
- The Trojan Horse. Another dominant anti-ESG argument is that ESG is not really about financial risk but is instead a kind of modern Trojan Horse. Not only could ESG include an undefined array of issues, but asset managers (and pro-ESG regulators) could, under the guise of risk-adjusted returns and financial analysis, foist their own social and political values on investors and the capital markets.
- The Costs of ESG Regulation. The prospect of any kind of regulation around ESG also fuels more pragmatic objections about the potential compliance costs. In the case of the SEC’s climate disclosure, for instance, if you’re inclined to doubt that the proposed rules are necessary to protect investors and let markets do what they do best – price risk – or you tend to discount the other benefits of mandatory disclosure, then this worry follows fairly quickly from the other two.
Boundary Setting & The SEC’s Corporate Climate Disclosure Rules
In a recent article, I respond to these concerns as they relate to the SEC’s draft climate risk disclosures. The article explains the “line-drawing” choices the SEC has made, how “climate risk” relates to other ESG concepts, and how the SEC’s forthcoming rules are both more bounded and more flexible than the approach international standard setters are taking.
As my article explains, the SEC’s climate disclosure rulemaking is limited to disclosure of material climate-related financial risks to the company; how the company’s operations affect the environment or contribute to climate change are not covered. Companies will have to report on direct and indirect greenhouse gas (GHG) emissions, but here too, emissions are a measure of both how climate-induced market or regulatory uncertainty may affect the company’s performance and also the company’s own impact on climate. Even the more prescriptive disclosures on matters like the company’s climate transition plan and targets, only ask companies to tell investors what they are already doing. The new rules will also ask companies to tell investors how they decide what climate risks, if any, are material, but companies are not required to mitigate those risks or indeed to reduce their climate impacts.
As I explain, the rules fall well within the bounds of the SEC’s long-standing statutory authority, and their scope is far more limited than the sustainability disclosure mandates being adopted outside the U.S.1 Since the SEC’s proposed disclosure rules define climate risk, they may actually help set a clear baseline for companies and protect investors by reducing ESG “greenwashing.” Limiting the scope to climate also responds, in part, to worries about an SEC-driven Pandora’s box.
Second, fears of an ESG Trojan Horse are not really relevant to the SEC’s climate disclosure rules. The SEC was already offering guidance on climate risk materiality ten years ago before the topic had attracted much public attention. The US is also late to the game in proposing ESG disclosure rules compared to capital markets nearly everywhere else, lagging behind the UK, Asia, and Europe. To state the obvious, financial regulators abroad are not requiring climate disclosure to align with “blue” or “red” issues. Instead, they are focused on protecting investors and on market stability, and depending on their own national priorities, on helping their economies respond to the climate crisis without making it worse. To those for whom this last point raises new worries that the real Trojan horse may be a foreign or globalist agenda rather than a domestic, liberal one, I note that the SEC’s forthcoming rules build on an established framework that was developed by the G20’s Task Force on Climate-Related Financial Disclosures (TCFD) with broad public input, including from US investors and companies. The TCFD is also based on a wide range of voluntary standards, many designed by US organizations. Indeed, the US has been a leader in private standard-setting that is now a foundation not only for the SEC’s climate disclosure rules but for the emerging international reporting standards as well.
Finally, on the question of compliance costs that new mandatory climate disclosure may impose, my article suggests several factors that should not be overlooked. First, the SEC has sought to cut companies’ compliance costs — and avoid the unnecessary rulemaking costs of reinventing the wheel — by basing its approach on climate reporting standards that companies are already using. Using the same baseline standards that the European Union and the International Sustainability Standards Board (ISSB) are using for the reporting standards they will adopt later this year also promises to cut compliance costs for companies who operate or list internationally. The more important cost has to do with the threat of private litigation, which is higher for US companies than for their counterparts abroad. As explained below, I therefore argue that the SEC (or Congress) should consider temporarily shielding companies from private litigation while the new rules come online.
Lessons for Both Sides in the Climate Disclosure Debate
Looking at the SEC’s line-drawing choices, I believe, should lead both sides of the climate disclosure debate to be more honest about where their opponents’ concerns have merit :
- Cautions for Opponents.
- The Costs of the Status Quo. Opponents of the rules tend to focus on the spectre of rising compliance costs for companies if the new rules come into force. Generally ignored are the costs of the current system, which requires investors to pay higher fees, undertake costly shareholder engagement campaigns, or foot the bill for research to find information that could be readily provided or compiled far more cheaply by companies themselves.
- Including the Costs to Capital Markets. Opposing mandatory climate disclosure (no matter how flexible) also comes at the cost of the reputation and stability of the U.S. capital markets if the U.S. becomes the only market in the world where investors do not have reliable and comparable climate risk information as a matter of course. The main purpose for a system of securities disclosure is to make companies provide comparable, reliable information about risk to investors that they would rather not disclose.
- The Costs of Flexibility. The flexibility and relatively narrow scope of the SEC’s proposal is understandable in view of the legal challenges that will inevitably confront any new disclosure rules. But the more flexible the final rules, the less successful they will be in standardizing climate disclosure and putting the U.S. in synch with other global markets.
- Cautions for Supporters.
- Bounding Climate & ESG. Supporters of the new rules, on the other hand, should admit that scope and boundary limits around ESG and climate matter. They should also admit that narrowing disclosure to “climate risk” still requires companies to take account of other environmental or sustainability matters, such as resource consumption or even biodiversity loss, that could have a financial impact on the company. Reporting on climate is also not unrelated to whether the company’s impact on the environment is an indirect source of financial risk. Also, as climate change begins to have ever more visible impacts on vulnerable populations, the dividing lines between climate risk and workforce health and safety risks (the “S” in ESG) are already blurring. The new SEC rules are necessary precisely to define the boundaries for the benefit of both companies and investors.
- Bounding Litigation Risk. Finally, a limitation of the proposed rules is that the current safe harbors that shield companies from securities litigation based on projections and other forward-looking statements (and the proposed safe harbor for third-party, Scope 3, emissions information) do not go far enough. This is because companies will be required under the proposed rules to report more consistently and more precisely on climate risk and on what, if anything, they are doing about it. A temporary moratorium on private securities fraud litigation during the first few years after the rules take effect would give companies more breathing room to report climate risk information to investors while they adapt quickly to more demanding reporting expectations.
Regardless of the future of the new rules, companies and investors will have to grapple with these issues as climate change and climate risk disclosure become part of the corporate compliance and investment landscape internationally.
Virginia Harper Ho is a Professor of Law at City University of Hong Kong School of Law
This post is based on Professor Virginia Harper Ho’s recent article, “Climate Disclosure Line-Drawing & Securities Regulation” available on SSRN.