Statements by the SEC’s Investor Advisory Committee and Asset Management Advisory Committee point to the growing need for action on ESG.
Recommendations of the Investor Advisory Committee
“The use of ESG-related disclosures has gone from a fringe concept to a mainstream, global investment and geopolitical priority.”
The Investor Advisory Committee was established under the Dodd-Frank Act to advise the SEC on its regulatory priorities, the effectiveness of disclosure, investor protection, and other interests. It reflects a cross section of market participants, including investor groups, academics, think tanks, former regulators, and investment managers. The committee has engaged with a variety of market participants that have consistently reinforced the message that ESG factors are material to investors, regardless of the issuer’s sector or geography. Yet, it reported, “despite a plethora of data, there is a lack of material, comparable, consistent information available upon which to base some of these decisions.” According to the committee, a “patchwork” approach has created fertile ground for third-party rating systems that seek to fill the informational voids left by companies’ inconsistent and sometimes inadequate disclosures. The proliferation of ratings providers, each using different standards and criteria and asking companies for different information, has resulted in companies being inundated with questionnaires and requests for information. The ratings that yield from this process frequently lack transparency and consistency as to their methodologies. The committee concluded, “Despite a great deal of information being in the mix, there is a lack of consistent, comparable, material information in the marketplace and everyone is frustrated — issuers, investors, and regulators.”
The committee recommended that the SEC engage in the process of updating its reporting requirements to incorporate material, decision-useful ESG considerations, emphasizing five purposes:
- Investors require reliable and material ESG information on which to base their investment and voting decisions.
- Issuers should be the source of the material information on which investors make their investment decisions, not the third-party data sources that currently fill the void.
- Requiring disclosure of material ESG information will level the playing field among larger and smaller issuers, as smaller issuers frequently are unable to satisfy the many third-party requests for ESG information.
- Requiring the disclosure of ESG information will facilitate the flow of capital to US markets and to US issuers (and prevent investors from withdrawing their money from US markets).
- If the US does not take action, other jurisdictions are likely to impose standards to which US issuers will be bound to adhere, and thus if the US wants to take a leadership role, it must step up.
ESG Subcommittee of the Asset Management Advisory Committee
The newly minted Asset Management Advisory Committee put ESG at the top of its agenda for its May 27 meeting, even as it tabled other topics due to the COVID-19 crisis. The ESG subcommittee was formed to give the SEC a range of perspectives on issues of significance in the asset management world. Its members include investor groups, investment advisors, regulators, academics, and funds. Its ESG subcommittee is focused on five issues:
- Whether ESG is about “values” or “value” and, therefore, whether the regulatory focus should be on consumer choice or financial metrics
- Assessment of whether the current methods for assessing ESG focused funds accurately reflect the impact of ESG strategies on fund performance
- Proxy voting in ESG strategies
- Issuer disclosure of ESG data
- The role that ESG rating systems and benchmarks should play
As with the Investor Advisory Committee, the ESG subcommittee focused on the need for consistency, comparability, and quality of data. It emphasized the need to create a consistent framework for asset managers’ integration of ESG factors in their investment processes. Currently, the lack of well-defined, systemic steps for the application of ESG factors in the investment process hampers efforts to understand the role of ESG in fund performance. The ESG subcommittee noted that currently there is “no industry standard as to what ESG integration means and expected outcomes of integration.”
In order to achieve comparable ESG attribution, the ESG subcommittee noted that there is a need for greater transparency, consistency, and data quality related to ESG factors. Specifically, it noted the need for clear disclosure of ESG score data, disclosure on the expected non-financial effects as they relate to the fund’s objectives, and disclosure and independent validation of the degree of ESG compliance, with mapping to specific ESG criteria. These criteria focus on director independence, supply chains, human rights, employee protection, diversity, and climate change.
The ESG subcommittee is studying enhancements to issuer disclosures that could improve investors’ ability to invest according to their ESG preferences. Specifically, it is focused on disclosure quality and opportunities to improve the comprehensiveness, meaningfulness, materiality, and comparability of issuer ESG disclosures. The ESG subcommittee will continue to evaluate relevant issues, including the current gaps in disclosures and the role that regulation might play in filling them, the proliferation of reporting standards and varying interests of different stakeholders, and the overabundance of metrics that can make information difficult for investors and asset managers to consume. The quality and consistency of disclosures offered by companies is also a key area of concern. The ESG subcommittee reported that “comparability and consistency are sometimes lacking; fewer than 30% of public companies disclose ESG risks, and the percent is smaller for private issuance; fixed income disclosure is often threadbare and focused only on the issuer, or use of proceeds. Disclosure is often backward looking rather than forward looking.”
A particular area of focus for the ESG subcommittee is the role of ESG rating systems and benchmarks. Like the Investor Advisory Committee, the ESG subcommittee noted the role of third-party rating systems in filling the informational gaps left by fragmented disclosure standards and inconsistent issuer disclosures. Specifically, the ESG subcommittee is investigating the comparability of ESG rating systems, recognizing that rating systems can differ philosophically in key ways, including whether they rate companies on an absolute basis or relative to their peers, how they define peer groups, whether their focus is on stakeholder sentiment or financial factors, and whether their focus is on company policies or performance. All of these factors can impact the comparability and consistency of the conclusions reached.
As highlighted above, Chairman Clayton raised concerns about the comparability and reliability of ESG rating providers’ findings. Specifically, he expressed skepticism that a combined, aggregate ESG score is likely to be useful to investors, since it can muddy the importance of the component parts. “While I believe that in many cases one or more ‘E’ issues, ‘S’ issues, or ‘G’ issues are material to an investment decision, I have not seen circumstances where combining an analysis of E, S, and G together, across a broad range of companies, for example, with a ‘rating’ or ‘score,’ particularly a single rating or score, would facilitate meaningful investment analysis that was not significantly over-inclusive and imprecise.”
Key Themes and Takeaways
Consistency Is King. A resounding theme of both advisory committees is the need for reporting frameworks that drive consistency across companies as they report ESG data and associated ESG risks and opportunities. Further, there is a demand for consistency in how funds disclose ESG factors. Without these levels of consistency, investors are not getting the information they need. Third-party rating providers are filling the gaps and overwhelming companies with questionnaires and forms. Worse, third-party rating providers are not themselves consistent in their evaluation of companies. As a result, investors and companies are frustrated with the status quo.
Understand the “Why” of ESG Data. The ESG data that companies report will not be useful if it isn’t put into context by the companies themselves. The same holds true for ESG-focused funds. The fund managers will need to explain how they integrate ESG factors into their fund construction and why they do so. Regarding the ESG subcommittee’s question as to whether ESG funds are about “value” or “values,” in many cases the answer will be both, simultaneously. Understanding and explaining how ESG factors build value and resilience and how they comport with the company’s or the fund’s purpose is critical to demystifying the broad and frequently confusing ESG investment landscape. This clarity is also a key defense against greenwashing, the practice of providing misleading information concerning a company’s “green” or sustainability performance. Some commenters say the time has come for a discussion and analysis of key ESG data that provides management’s perspective on the relevance of the data — similar to the analysis provided in MD&A that provides shape and context for financial statement disclosures.
Make It Safe to Speak. If companies are going to provide more robust information about their ESG risks and opportunities, which appears to be the direction of travel, the SEC might consider establishing a safe space within which to do so. Given the uncertainties associated with ESG effects generally, and climate change specifically, companies are concerned about litigation risk for disclosures that ultimately could turn out to be inaccurate. The establishment of a tailored safe harbor that would be available to companies that make good-faith ESG disclosures in accordance with the SEC’s disclosure guidance might encourage companies to engage more fully in the ESG disclosure process. This engagement, in turn, is likely to provide a critical step forward in promoting decision-useful, robust, and thoughtful ESG disclosures.
 “Recommendation from the Investor-As-Owner Subcommittee of the SEC Investor Advisory Committee Relating to ESG Disclosure” (as of May 14, 2020).
 “ESG Subcommittee Update Report to the SEC Asset Management Advisory Committee” (May 27, 2020).
 This concern over ESG ratings is not unique to US markets. For a discussion of a recent dispute in Germany over an ESG rating issued by Institutional Shareholder Services, see Paul A. Davies, Michael D. Green, Joachim Grittmann, and Alexander Wilhelm, “ESG Ratings on Trial in Germany” (April 7, 2020), available at https://www.globalelr.com/2020/04/esg-rating-on-trial-in-germany/.