While the investor community continues to call for more useful ESG disclosures, some regulators try to put on the brakes.

By Paul A. Davies, Paul M. Dudek, and Kristina S. Wyatt

Calls for Improved ESG Disclosures

Many in the investor community have spoken out about their desire for more comparable, decision-useful environmental, social and governance (ESG) information to help inform investment decisions. The year 2020 rang in with Larry Fink’s now famous letter to CEOs in which he declared “we are making sustainability integral to the way BlackRock manages risk, constructs portfolios, designs products, and engages with companies. We believe that sustainability should be our new standard for investing.” At roughly the same time, State Street Global Advisors issued its annual CEO’s letter in which it emphasized that “addressing material ESG issues is good business practice and essential to a company’s long-term financial performance — a matter of value, not values.” Also in January 2020, the International Business Council of the World Economic Forum issued a consultation draft calling for the development of common, consistent ESG reporting metrics to bring order and consistency to the ESG reporting landscape. The consultation draft was intended to address the “lack of consistency by which companies measure and report to investors and other stakeholders the shared and sustainable value they create.”

In May 2020, the US Securities and Exchange Commission’s (SEC’s) Investor-As-Owner Subcommittee of the SEC Investor Advisory Committee issued a statement declaring that the time has come for the SEC to address ESG disclosure requirements (see Drumbeat Grows Louder for SEC to Take Action on ESG Disclosures). In so doing, the SEC Investor Advisory Committee observed that “the use of ESG-related disclosures has gone from a fringe concept to a mainstream, global investment and geopolitical priority.” Subsequently, the SEC’s Asset Management Advisory Committee formed an ESG subcommittee to address ESG issues in asset management. At its initial meeting, the subcommittee emphasized the need for a consistent framework for asset managers’ integration of ESG factors into their investment processes. In July 2020, the US General Accountability Office issued a report, Public Companies: Disclosure of Environmental, Social, and Governance Factors and Options to Enhance Them, which found that investors are increasingly asking companies to disclose information related to ESG factors to help them incorporate material ESG concerns into their investment analyses. The report noted that, despite the SEC’s principles-based disclosure rules and its 2010 interpretive release designed to help companies apply the SEC’s disclosure provisions to climate change impacts, and despite third party reporting frameworks, investors still are not receiving the information they need. According to the report, “Some investors and market observers have continued to express dissatisfaction with the quality and consistency of public companies’ ESG disclosures.”

Regulatory Reticence on ESG

While the investor community appears unified in the position that enhanced ESG disclosures would help them factor ESG considerations into their investment decisions, the US Department of Labor (DOL) and some members of the SEC have expressed significant skepticism. In June 2020, the DOL proposed a new rule to “provide clear regulatory guideposts for plan fiduciaries in light of recent trends involving environmental, social and governance (ESG) investing.” In announcing the proposed rules, Secretary of Labor Eugene Scalia made clear his disfavor of plan fiduciaries’ inclusion of ESG factors in their investment processes: “Private employer-sponsored retirement plans are not vehicles for furthering social goals or policy objectives that are not in the financial interest of the plan.” The new proposed rule has drawn a mixed response, including a call by 13 Senate Democrats for the withdrawal of the proposal.

The SEC reflects a similar divergence of thought. While Commissioner Allison Herren Lee has championed SEC rulemaking to address investors’ calls for enhanced ESG disclosures, Chairman Jay Clayton, Commissioner Hester Peirce, and Commissioner Elad Roisman have all spoken against the need for enhanced ESG reporting rules. Most recently, Commissioner Roisman, in a speech to the Society for Corporate Governance’s National Conference, pushed back against calls for greater regulation of ESG disclosures: “Increasingly, there has been a desire from some quarters to conflate greater societal debates about environmental regulation and social policies with public company disclosure requirements.” Like Secretary of Labor Scalia, Commissioner Roisman expressed concern that funds focused on environmental and social issues do so at the expense of investment returns rather than for their benefit.

The Road Ahead

The regulation of ESG disclosures is difficult because ESG factors cover a wide swath, touching all companies in some way and yet no two companies in precisely the same way. Devising prescriptive disclosure rules presents difficulties because the issues that are material to one company are not necessarily material to another, hence the appeal of the current “principles based” disclosure rules. By expressing disclosure principles, and leaving it to the reporting companies to determine what information to disclose, principles-based rules allow companies to address the issues that are material to their specific circumstances.

In theory, this is a sound approach. But in practice, this system has left investors and issuers dissatisfied. Investors complain that they are not receiving the comparable, decision-useful information they need on ESG factors. Companies express concern over the proliferation of voluntary reporting standards and the lack of guidance as to which standards to follow. In the absence of a harmonized disclosure framework, companies find themselves inundated with informational requests from third-party ESG ratings firms that seek to fill the void. Unfortunately, these ratings firms are not always consistent with each other, and so increase costs for companies without satisfying investors’ informational demands. Further, ratings firms seem compelled to reduce their assessments to a single letter or number grade, sweeping in disparate elements, which reduces the usefulness of a company’s response.

The DOL’s rule proposal and Commissioner Roisman’s statement illustrate a consequence of the breadth of the ESG disclosure landscape and the lack of consensus on the multitude of ESG data points that might be the subject of regulatory disclosure requirements. The DOL proposal and Commissioner Roisman’s statement assume that companies face a binary choice between focusing on ESG factors on the one hand, and pursuing financial returns and reduced risk on the other. That is, a pursuit of environmental and social goals is presumed to reduce investment returns. Investors, meanwhile, maintain that they need improved information on companies’ management of their ESG risks in order to properly value their investments. BlackRock and State Street have clearly drawn a positive correlation between good environmental and social performance and good investment performance.

The difficulty is to bridge that divide, so that companies’ ESG disclosures clearly articulate the material risks and opportunities posed by ESG factors in a manner that enables investors to properly incorporate those factors into their investment decisions and compare companies. At the same time, companies should not be asked to disclose information that is immaterial. If the SEC were to develop more prescriptive ESG disclosure standards, the challenge would be to craft disclosure rules that elicit disclosure of material ESG factors in a manner that is clear and comparable across companies, without requiring disclosure of immaterial information. Ideally, this would be done in a manner that minimizes the burden to reporting companies and maximizes the utility to investors.

Given the current regulatory divide, this might be a tall order. Perhaps the first step should be an earnest discussion among investors, reporting companies, and regulators.