SEC To Require ESG Disclosure of Data
Government agencies and nonprofit organizations all around the world are moving forward with ESG regulations and requirements. The US Securities Exchange Commission (SEC) has released two proposals this year that would increase government oversight and make information more transparent in matters relating to publicly traded companies and the environment.
In a similar fashion, the European Commission (EC), the executive of the European Union, has created the Corporate Sustainability Reporting Directive (CSRD). Plus the International Financial Reporting Standards (IFRS) has created the International Sustainability Standards Board (ISSB) in order to create rules and regulations surrounding ESG reporting. The development of these standards will have an important impact on the world going forward and will further connect the capital markets to sustainability.
International ESG proposals
The European Union differs from the United States in several ways. First, the SEC’s proposed rule would only require the disclosure of climate-related information, while the CSRD would require sustainability information in addition to climate information. Essentially, the CSRD disclosures are broader, as companies will have to report how their businesses impact people and the environment, a concept known as double materiality.
Second, the CSRD’s proposal involves the creation of European Sustainability Reporting Standards (ESRS), while the SEC has not created a universal set of standards. The CSRD would also apply to large non-listed entities while excluding micro-cap entities, but the SEC’s proposal only affects listed companies.
The role of the IFRS and their ISSB creation is to establish a global set of standards that would serve as a baseline for all countries around the world. The ISSB has released two proposals S1 and S2.
In general, S1 seeks companies to disclose material information about significant sustainability-related risks and opportunities to which it’s exposed, to accurately value a company’s enterprise value. They argue that to gauge enterprise value an investor must have access to information that’s not currently available only through financial reports. S2 focuses more deeply on environmental factors and includes a requirement to release climate-related physical and transition risks.
SEC Proposal for Required Climate Disclosures
In their proposal published on March 21, 2022, the SEC outlined the new requirements for climate disclosures for registered companies.
The goal of these new disclosure requirements is to provide investors with a detailed and consistent source of information on companies’ climate risks so that they can make better-informed decisions when choosing companies to invest in, as well as to provide reporting obligations for issuers. Climate risks pose serious threats to the financial performance of companies and therefore, investors representing tens of trillions of dollars are in support of climate-related disclosures being required of registered companies.
There are currently many issuers seeking to disclose climate-related information, but without concise guidelines, it’s hard for them to effectively convey this data and meet investor demand. SEC Chair Gary Gensler believes that when there is a high demand for regulatory guidelines from both investors and companies alike, the SEC has an important role to play.
Four SEC Disclosure Requirements
The SEC proposal was introduced in two parts. The first part included 4 disclosure requirements:
- Governance of climate-related risks and climate risk management processes.
- Have any climate-related risks, as identified by the registrant, had or are likely to have a material impact on a business and short and long-term financial statements?
- Have any identified climate-related risks affected or are likely to affect the registrant’s strategy, business model, and outlook?
- The impact of climate-related events (severe weather events and other natural conditions) on the items of a registrant’s consolidated financial statements, as well as on the financial estimates and assumptions used in the financial statements.
GHG Disclosure Requirements
The second part of the disclosure requirements focused on greenhouse gas emissions. Registrants would be required to disclose direct greenhouse emissions, which are known as scope 1, as well as indirect emissions from purchased energy, which are known as scope 2. A company would be required to report scope 3 emissions, which are GHG emissions from upstream and downstream activities if they have a set target or goal which includes these.
SEC Disclosures Will Provide Data Needed By ESG Rating Companies
ESG rating companies have been an important development when it comes to investors understanding the climate risks that threaten certain publicly traded companies.
Companies like MSCI, S&P Global and FTSE Russel provide a valuable service by analyzing climate disclosures and creating a simple-to-understand rating for investors to use as a guideline. ESG ratings function similarly to credit ratings which can be used to understand the risks of buying corporate bonds. Credit rating agencies have a plethora of information from SEC filings made by publicly traded companies, while ESG rating companies lack the same type of transparency.
According to FTSE Russel, they only make ESG ratings based on public information, which about two-thirds of companies do not share, making it difficult to rate them. The new SEC proposal will only make this information more accessible to investors and rating agencies, which will allow for more accurate ESG scores and better investment decisions.
SEC Requirements for ESG Funds
The Name Rule
In Addition to the enhanced pro-climate disclosure proposal, the SEC is also proposing a change to the Name Rule which addresses mutual and exchange-traded fund names that are misleading to investors.
The amendment to the rule would require US-listed funds to have 80 percent of their investments aligned with the strategy in their name. The language of the current rule applies to the type of investment, the industry, and the geographic region, but does not include the strategy. The new structure of the rule would prevent investment firms from greenwashing to achieve higher assets under management and better returns. An example of this is the recent charges brought against the Bank of New York Mellon, in which the SEC claims an investment advisor implied that funds had undergone ESG reviews when this was not the case.
Defining types of ESG funds
The SEC is also proposing to enhance disclosures by certain investment advisors as it relates to ESG. The SEC argues that there are many different types of strategies when it comes to an ESG fund, and the SEC is trying to increase transparency for investors so they can better understand where their capital is going.
According to commissioner Allison Herren Lee, the first goal of the proposal would be to create two categories of ESG funds, known as Integration Funds and ESG-Focused Funds. A third category would be a subset of ESG Focused Funds known as Impact Funds. An Integrated Fund combines both ESG factors with non-ESG factors to create superior returns while taking less risk. An ESG Focused Fund would rely on several ESG factors for investment decisions, and would not pay as much attention to other factors. An Impact fund would be focused on one specific ESG issue and its only goal would be to impact this ESG goal.
In addition to categorizing ESG funds, the proposal looks to outline certain disclosure requirements for each fund type. Integration Funds would be the least scrutinized, while ESG Focused funds would be more highly regulated, due to their claims of being more committed to ESG. The last part of the proposal states that ESG Focused Funds with environmental goals must report on GHG emission data, while integration funds only need to describe how they consider GHG emissions in their investments.
What To Do Now if You’re A Public Corporation
Public companies must prepare for the new SEC rules by setting some cash aside. The SEC’s proposal for increased regulations related to climate disclosures may take some time to come to fruition as lawmakers still need to hammer out certain aspects of the proposal to make sure it is legal and in compliance with the SEC’s mandate.
However, companies must be prepared to deal with the costs associated with these new regulations, which the SEC estimates to be around $640,000 for the first year and $530,000 per year in perpetuity. Some companies have come out saying these estimates vastly underestimate the potential costs, especially companies that have no existing disclosure practices currently in place. For comparison, The Sarbanes-Oxley Act of 2002, created in the wake of the .com bust, cost companies approximately $2.3 million per year.
To prepare for the SEC rules before they are finalized, companies should look to comply with the ISSB, as this organization’s standards are less scrutinous and should provide a solid baseline. Ultimately, companies must plan on being required to comply with the SEC, and they must prepare for the possibility that they see tighter access to capital if their disclosures do not meet the standards of investors and lending institutions.
What to Do now if You’re An Investment Firm
The next steps for investment firms or fund managers are quite easy and straightforward. Much of the burden on disclosing ESG information falls into the hands of the companies themselves and not on the investors or investment firms. Those who manage ESG funds must simply avoid greenwashing by having fund names that comply with the new Name Rule and have a clear-cut strategic purpose for their fund that can be defined as Integration or ESG Focused. It is the mandate of these firms to make it as clear as possible to investors where their money is going when they buy these funds.
SEC Regulations Are Coming: Now Is A Good Time To Get Ahead of Them
Depending on one’s personal views, some may believe that the SEC needs to go further to drive real change and enhance ESG’s impact on the world. Others might believe that the SEC is overreaching with their authority.
It’s important to be cognizant of the SEC’s mission, which is to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation.
The SEC argues that their proposals fall in line with their mission, but going beyond that would be doing something beyond the scope of its mandate. Instead, the responsibility falls into the hands of the Environmental Protection Agency (EPA), whose mission is to protect human health and the environment.
Beyond government, it’s the responsibility of the American citizen to demand environmental disclosures and sustainability by directing their investments and consumption to companies that align with their beliefs.