Institutional investors are regularly calling for more disclosure from companies on environmental, social, and governance (ESG) matters.
The Investor Advisory Committee of the Securities and Exchange Commission, in calling for Commission action, stated that “the time has come” for the SEC to act on mandatory ESG disclosure requirements. Two current SEC commissioners have also called on the agency to address the matter. As Commissioner Allison Herren Lee called it, the lack of required disclosure on climate change risks in amendments to Regulation S-K was “the elephant in the room,” while Commissioner Caroline Crenshaw said the agency’s failure to address disclosure issues such as climate change and human capital management was “quite simply, a failure to modernize.”
Two key stumbling blocks have stood in the way of Commission action on ESG disclosures. The first comes from the current regulatory structure and a Commission majority that has opposed a prescriptive ESG disclosure requirement, while the second comes the nature of ESG data itself.
The Current Commission Approach
The SEC relies on a materiality standard for any required ESG disclosures, rather than any particular line-item disclosures. Regulation S-K provides in Item 101, as amended effective Nov. 9, 2020, that companies must describe any “material effects” that compliance with environmental regulations might have upon their “capital expenditures, earnings and competitive position.”
In addition, those amendments require a description of an issuer’s human capital resources, including any “measures or objectives that the registrant focuses on in managing the business.” The rule change does not define “human capital” or require the use of any particular metrics. Plus, companies need only discuss this information “to the extent such disclosure is material to an understanding of the registrant’s business taken as a whole.”
The SEC noted in its 2010 climate change guidance that companies must disclose material environmental matters under Item 103 of Regulation S-K. The 2010 guidance also noted that companies should include climate change in their management discussion and analysis (MD&A) coverage of material trends, events or uncertainties. A January SEC interpretive release, addressing the disclosure of key performance indicators and metrics in MD&A, stated in a footnote that the climate change guidance does apply to ESG metrics such as the employee turnover rate, workforce factors, total energy consumed, and data security measures.
With regard to board diversity, Item 407(c)(2)(vi) of Regulation S-K requires companies to reveal how the nominating committee or the board considers diversity when reviewing candidates for board membership. In addition, if the nominating committee or the board has a diversity policy for board membership, the company must show how it implements this policy.
The current SEC has, however, regularly declined to add specific ESG disclosure requirements to this existing framework. Materiality is a sufficient disclosure threshold for ESG disclosure issues, in the majority view. As Commissioner Hester Peirce stated, “there is reason to question the materiality of ESG and sustainability disclosure.” She cautioned that the agency “ought not step outside our lane and take on the role of environmental regulator or social engineer.”
The Investor Push for More ESG Disclosures
In its 2020 letter to CEOs on its proxy voting agenda, State Street Global Advisors indicated that it would vote against directors of companies that underperform in “identifying material ESG issues and incorporating the implications into their long-term strategy.” State Street said that an ESG focus is essential to a company’s long-term financial performance, and is “a matter of value, not values.”
Similarly, BlackRock stated that “we believe that all investors, along with regulators, insurers, and the public, need a clearer picture of how companies are managing sustainability-related questions.” The data should extend beyond climate concerns to various questions concerning workforce diversity, supply chain sustainability, and privacy and data security. The firm stated that it would “be increasingly disposed to vote against management and board directors when companies are not making sufficient progress on sustainability-related disclosures and the business practices and plans underlying them.”
The Problem With ESG Data
The markets are awash in ESG data. Companies voluntarily release ESG data in their sustainability reports, various non-governmental organizations compile and release sustainability statistics, and ESG information services sell data to their customers.
The problem with the abundance of information is that it is not transparent, consistent, or readily comparable. A 2019 Harvard Business School study noted issues with “the sheer variety, and inconsistency, of the data and measures, and of how companies report them,” as well as inconsistencies and lack of transparency in benchmarking, or the definition of company peer groups by data providers and ratings services.
The SEC’s Investor Advisory Committee recommendation concluded that mandatory standardized reporting by issuers would significantly mitigate problems with data inconsistency. According to the committee majority, investors and third-party data providers would both benefit from access to accurate, comparable, and material issuer-sourced information based in consistent standards and oversight. Market forces have so far been inadequate for compelling the production of information leading to comparable, actionable data sets. Regulation, the committee said, could effectively promote standardization in these disclosures that investors have been seeking.
What Will 2021 Bring?
A change in SEC leadership will likely prompt action on prescriptive line-item ESG disclosures. Commissioner Lee has called the Commission’s failure to act on ESG disclosures an “unsustainable silence,” and asserted that “we are long past the point at which it can be credibly asserted that climate risk is not material.”
Similarly, Commissioner Crenshaw stated that “the question of whether climate change and human capital are material concerns of investors is no longer academic.” She urged the Commission majority to “facilitate the efficient comparison of long-term sustainability in the face of present-day risks to issuers.” A third vote supportive of ESG disclosure would likely result in the consideration of ESG proposals in 2021. The Biden Administration will name new SEC leadership, which will likely also constitute a third vote for expanded ESG disclosure requirements.
The Commission is likely to act in three main ways.
Initially, the staff will likely prepare a proposal on expanding the disclosures required concerning board consideration of diversity matters.
The staff will also likely draft initial climate change proposals, reflecting the recommendations of the Investor Advisory Committee. The committee urged the Commission to establish a principles-based framework providing issuer-specific, material, decision-useful information reflecting the same data that companies use to make their own business decisions.
Finally, the staff will likely recommend a proposal to expand required human capital disclosures to cover metrics on workforce diversity, part- and full-time workforce makeup and turnover, and tenure. An SEC under new leadership appointed by President-elect Biden will likely look favorably on such recommendations in 2021.
Access additional analyses from our Bloomberg Law 2021 series here, including pieces covering trends in Litigation, Transactions & Markets, the Future of the Legal Industry, and ESG.
Bloomberg Law subscribers can find related content on our In Focus: ESG resource.
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