The inconsistency in ESG disclosure is apparent when we compare the reporting requirements in markets across different jurisdictions, from the Asian markets, to the European and the US markets. There is great progress being made in the attempt to standardize ESG regulations in the US market, but are we any closer to achieving a standardized framework globally? One question to bear in mind is, should governments mandate mandatory ESG reporting? And why is there a demand for standardizing ESG disclosures. Many stock exchanges across the world have introduced a framework of "if not, why not" and a "please explain" clause to mandate listed companies to report on ESG risks that are deemed material to their business.
For example, in Hong Kong, all listed companies on the HKEX must explain why certain ESG risks were not reported, as we discussed in our recent article here. Again, a similar approach in the European markets gives companies the flexibility to report and disclose material ESG risks. However, how far are we really, from mandatory ESG disclosures, as mandated from government, under laws and regulations. We explore cases in the US to give examples of instances whereby federal government regulation continues to lag behind state authorities in the passing of bills to standardize ESG and sustainable investment related disclosures.
One step closer to standardization in ESG disclosure
With growing demand from investors for improved disclosure, ESG is described as "one of the most important topics in the markets right now, according to Representative Carolyn Maloney (D-New York), chair of the Subcommittee on Investor Protection, Entrepreneurship and Capital Markets in the US.
The first hearing on ESG disclosure was held in July, 2019 in the US House Committee on Financial Services, titled "Building a Sustainable and Competitive Economy: An Examination of Proposals to Improve Environmental, Social and Governance Disclosures"
The U.S. congressional committee debated drafts on five possible bills, all of which would require public
companies to reveal more information on topics including climate policies, political expenditures and human rights. The proposed bills discussed were:
ESG Disclosure Simplification Act of 2019 (California)
Shareholder Protection Act of 2019
Corporate Human Rights Risk Assessment, Prevention and Mitigation Act of 2019
Climate Risk Disclosure Act of 2019
Country by Country Tax Payment Disclosure
In the hearing, sustainability experts argued that the lack of a legal framework was creating inconsistency in disclosure across companies.
Voluntary disclosure is becoming the norm for listed companies in many countries across the world. Its fair to say, the terms ESG and sustainable investing are increasingly trendy terms, with some arguing that it should not be done under the penalty of the law. But for the most part, the standardization and regulation of ESG disclosure will ensure a leveled playing field for companies and investors alike.
Naming and shaming corporate villains is indeed not the outcome of ESG regulation, as many companies have followed voluntary self disclosure of ESG and climate risks, and various voluntary frameworks already in place to provide such guidance; the two most frequently discussed at the hearing; the Global Reporting Initiative and the Climate Disclosure Project.
ESG disclosure relies on international standards and does not increase the reporting burden for companies because the vast majority of companies are already voluntarily reporting to the GRI.
Standardising ESG disclosures will therefore create essential, clear and comparable data.
Timothy Mohin, CEO of Global Reporting Initiative (GRI), said: "Just like financial disclosure, it’s essential that this committee and policymakers around the world focus on a single global standard, because we need a common global language if we are going to unlock free trade and capital flows that increasingly depend on this information."
Can we expect to see standardized ESG reporting in the US?
ESG regulation is building momentum in the US. The movement seems to be inexorably toward mandatory reporting and is a sign of progress. Large, mainstream investors believe these are financially relevant issues and that is not going to change.
A New ESG Regulatory Environment
While the US federal government remains silent on ESG disclosure and integration requirements, US states and the EU have not. Emerging regulatory developments around ESG disclosure and integration requirements are indicative of a movement towards standardized definitions of material ESG factors and a desire to promote responsible investment by regulators. As such, public and private market investors alike (including the underlying businesses in which they invest) should proactively prepare for applicable ESG disclosure and integration requirements (aligning their practices with those of their investors) in lieu of waiting for regulations to pass and retroactively adapting to new ESG investment norms.
While pressure from institutional investors has increased, federal disclosure requirements remain unlikely in the near future because of the SEC’s materiality requirements for disclosures in conjunction with the current US political climate. The SEC defines material information as any fact that a reasonable shareholder would consider important. Although the petition’s argument highlights how ESG risks meet the SEC’s definition of materiality in various ways, the federal government is unlikely to prioritize ESG disclosure regulations under the Trump administration, which historically has not prioritized sustainability initiatives, but let's steer away from the politics and stick to the progress being made in this area.
As ESG reporting and integration regulations stall at the federal level in the US, state regulators have begun to develop their own requirements designed to promote responsible investment. California historically served as a trailblazer for ESG integration in the management of its pension systems, developing frameworks such as the CalSTRS 21 Risk Factors, which have served as a guide for other state pension funds for incorporating ESG considerations into investment decisions.
Even if the federal government is standing still on ESG, US states are not. California and the State of Illinois are two states in the US that have paved the way for standardizing ESG disclosure and regulation for companies and pension funds.
Case Study: California
The best known state signaling has been by California’s leading pension systems: the California Public Employees’ Retirement System (CalPERS) and California State Teachers’ Retirement System (CalSTRS).
For over a decade, California has been integrating ESG factors into the way it has managed these funds, and, in more recent years, has become growingly specific about how it considers ESG. This approach has shaped not only the funds in which California invests (e.g., through demands on investor agreements and in side letters) but also the broader market. For example, CalSTRS “21 Risk Factors—which form the core of its ESG policy and have existed for over a decade (undergoing the last significant revision in 2018)—have come to serve as a benchmark for a number of asset managers who are incorporating CalSTRS’ leadership into their approach to ESG integration.
But California is not alone in leveraging regulation of its pension systems to advance sustainable investment. The trend has manifested in other states, including Connecticut, Illinois, New Jersey, New York, Oregon, and Washington. In fact, certain city-managed pension systems have also taken up this approach, including Boston, Chicago, New York, and Seattle.
As reported by Bloomberg Law, in September 2019, Illinois signed the Sustainable Investing Act into law, signaling the next step in state ESG integration requirements. Relative to California and other states’ ESG integration requirements, Illinois’ new law, effective January 2020, requires all public or government agencies that manage public funds to implement responsible investment policies covering all public funds under their control. Bloomberg Law notes that the law gives agencies significant freedom in crafting their policies but also offers guidance around potential material ESG factors, including corporate governance and leadership factors, environmental factors, social capital factors, human capital factors, and business model and innovation factors.
The Future of ESG Regulation
As we have seen from the above examples, the lack of widespread public disclosures across the board, a lack of standardized metrics, and a lack of enforceable goals makes it difficult for standardized ESG metrics to be considered in the U.S. Although much progress has been made, with California and the State of Illinois already paving the way with the passing of bills relating to sustainable investing, there is still a long way to go from a global standard in ESG disclosure. As exemplified in the hosting of the first U.S. congressional committee on the debated drafts of the five possible bills relating to ESG and climate policies, traction is already being made in this area, and the acceleration of ESG regulation will only increase over time.
(Written by Lena Chen)