Our views on changing dynamics in energy, ESG, finance, globalization and US policy.
While ESG issues have been a "hot topic" for several years, in recent weeks, the SEC has significantly increased its focus on the topic, paying particular attention to climate:
- Corp Fin to Focus on Climate Disclosure: On February 24, 2021, Acting SEC Chair Allison Herren Lee issued a statement directing the Division of Corporation Finance ("Corp Fin") "to enhance its focus on climate-related disclosure in public company filings" and update the SEC's 2010 climate change disclosure guidance.1 Lee noted that it is the SEC's "responsibility to ensure that [investors] have access to material information when planning for their financial future."
- ESG Task Force: On March 4, 2021, the SEC announced the creation of an enforcement task force focused on climate and ESG issues.2
- SEC's Role in Developing an ESG Reporting Framework: On March 11, 2021, Acting Director of Corp Fin John Coates made a statement that, among other things, touched on the SEC's possible role in developing a universal ESG reporting framework3 and on March 15, 2021, acting Chair Lee confirmed that the SEC has "begun to take critical steps toward a comprehensive ESG disclosure framework."4
Taken together, these developments reflect the increasing attention investors and others are paying to ESG issues, make clear that "climate and ESG are front and center for the SEC"5 and indicate the role that the SEC may be looking to play in shaping disclosure around these issues going forward.
Corp Fin to Enhance Focus on Climate Disclosures under Current Rules; Provide Updated Guidance in the Future
Lee's February statement articulates that as part of its enhanced focus on climate disclosure, the SEC staff (the "Staff") will:
- "review the extent to which public companies address the topics identified in the SEC's 2010 [climate change disclosure] guidance to public companies regarding existing disclosure requirements as they apply to climate change matters;
- assess compliance with disclosure obligations under the federal securities laws;
- engage with public companies on these issues; and
- absorb critical lessons on how the market is currently managing climate-related risks."
The Staff will use insights from this work to begin updating the SEC's 2010 climate change disclosure guidance, which provided guidance on how existing disclosure requirements apply to climate change matters.6 The guidance directs companies to consider how various provisions of existing rules have the potential to require climate-related disclosure—such as the Regulation S-K requirements for business narratives, legal proceedings, risk factors and MD&A—and addresses in some detail how those disclosure obligations could apply to climate change. For example, it highlights a number of climate-related topics that could have an impact on a company's climate disclosure, such as regulatory, legislative, business and market changes that "could have a significant effect on operating and financial decisions, including those involving capital expenditures to reduce emissions" and the potential material impact climate change could have on a company's business and operations.7 However, the existing disclosure regime continues to be criticized for not eliciting the information investors seek with respect to climate change.8
Noting the "critically important role" the Staff plays "in ensuring compliance with disclosure obligations, including those that implicate climate risk," Lee's statement emphasizes that the Staff will be enforcing "rules on the books" and updating its existing guidance as part of its "path to developing a more comprehensive framework that produces consistent, comparable, and reliable climate-related disclosures," as further discussed below.
Climate and ESG Enforcement Task Force
With the announcement of the Division of Enforcement's task force, the SEC also made clear that the climate and ESG focus will not be limited to Corp Fin. The task force's initial focus will be to identify any material gaps or misstatements in issuers' disclosure of climate risks under existing rules. In addition, the task force will "bolster the efforts of the Commission as a whole" in addressing "climate risks and sustainability," which are "critical issues for the investing public and our capital markets" by:
- "develop[ing] initiatives to proactively identify ESG-related misconduct";
- "coordinat[ing] the effective use of Division resources, including through the use of sophisticated data analysis to mine and assess information across registrants, to identify potential violations";
- "analyz[ing] disclosure and compliance issues relating to investment advisers' and funds' ESG strategies";9 and
- "evaluat[ing] and pursu[ing] tips, referrals and whistleblower complaints on ESG-related issues, and provid[ing] expertise and insight to teams working on ESG-related matters across the Division."
Even before any ESG disclosure regulations are promulgated or updated climate change disclosure guidance is issued, the SEC's increased focus on existing ESG and climate disclosure requirements could result in enforcement. The task force will be led by Kelly L. Gibson, the Acting Deputy Director of Enforcement, with 22 members drawn from the SEC's headquarters, regional offices and Enforcement specialized units.
SEC Role in Shaping Future ESG Disclosure Framework
In his March statement, Coates acknowledged that while "[t]here remains substantial debate over the precise contents and details of what ESG disclosures might or should encompass" and "there is no one set of metrics that properly covers all ESG issues for all companies," he believes that the SEC should "continue to adapt existing rules and standards to the realities of climate risk" as well as "be open to and supportive of innovation—in both institutions and policies on the content, format and process for developing ESG disclosures."
In particular, Coates expressed that the "SEC should help lead the creation of an effective ESG disclosure system so companies can provide investors with information they need in a cost effective manner," noting that "the process to create such standards is not likely to be simple, quick or easy" and the SEC should be a "key part" of this process, a sentiment that Lee echoed and emphasized as she noted the SEC was already working towards crafting an ESG disclosure framework. Considerations in this process include:
Costs of No ESG Disclosure Requirements
According to Coates, there is often a lack of "consistent, comparable, and reliable ESG information available upon which to make informed investment and voting decisions," which results in investments being held back in the absence of that information. In addition, "[c]ompanies face higher costs in responding to investor demand for ESG information because there is no consensus ESG disclosure system," which leaves them "faced with numerous, conflicting and frequently redundant requests for different information about the same topics," which can be "particularly burdensome for smaller and more capital constrained companies, and yet if these companies do not provide ESG disclosures, they risk higher costs of capital."
Mandatory vs. Voluntary
Coates points out that, while people "often think of mandatory disclosure in a way that suggests that there is nothing more than an on/off switch between mandatory and voluntary disclosure," the existing disclosure regime is "more nuanced than that" and the "SEC is well equipped to lead and facilitate a discussion on when and how ESG risks and data must be disclosed, and how to create and maintain an effective ESG-disclosure system that would promote the disclosure of decision-useful, reliable and, where appropriate, globally comparable ESG information." Coates noted that the existing disclosure regime already requires certain mandatory ESG disclosure (e.g., disclosure of how a company's board considers diversity in identifying director nominees) and permits significant differences in how companies respond to mandatory requirements (e.g., in determining what is material to a company, allowing for "comply or explain" disclosures).
Lee also pointed out that "not all companies do or will disclose without a mandatory framework" and that for those companies that provide voluntary disclosures, "there are real questions about reliability and level of assurance for [those] disclosures" and thus the SEC needs to set standards in order to balance principles and metrics and add reliability.
The Virtues of Achieving a Single Global ESG Reporting Framework and the SEC's Role in Achieving this Goal
Coates emphasizes that "ESG issues are global issues. ESG problems are global problems that need global solutions for our global markets" and it "would be unhelpful for multiple standards to apply to the same risks faced by the same companies that happen to raise capital or operate in multiple markets." However, establishing a global framework "is complex and raises a number of considerations" including "funding, governance and public accountability" and the SEC "can and should play a leading role in the development of a baseline global framework that each jurisdiction can build upon to address its individual needs."
Taking it a step further, acting Chair Lee stated in her March speech that "no single issue has been more pressing for [her] than ensuring that the SEC is fully engaged in confronting the risks and opportunities that climate and ESG pose for investors, our financial system, and our economy." She noted the "tremendous shift in capital towards ESG and sustainable investment strategies" and that "ESG risks and metrics now underpin many traditional investment analyses on investments of all types." While investors "have embraced sustainability factors and metrics as significant drivers in decision-making, capital allocation, and pricing," in order to get them the decision-useful information, the SEC has "begun to take critical steps toward a comprehensive ESG disclosure framework aimed at producing the consistent, comparable, and reliable data that investors need."
Lee also issued a separate statement requesting "public input… from investors, registrants, and other market participants on climate change disclosure," which poses a series of questions designed to "facilitate the staff's assessment" of the SEC's disclosure rules, including "whether and how they should be modified…, potential new Commission disclosure requirements, and potential new disclosure frameworks that the Commission might adopt or incorporate in its disclosure rules."10
With increased focus on ESG disclosure, public companies should:
- Evaluate their Climate Disclosures: Companies should begin or continue to assess their climate-related disclosures in light of existing SEC disclosure requirements, including the 2010 climate disclosure guidance, to ensure that they are providing disclosure that is accurate and provides the material impacts of climate change on its business. Companies should re-visit the 2010 guidance and consider disclosure rules related to a company's risk factors, business description, legal proceedings, and management discussion and analysis when crafting and evaluating their climate disclosures.
Consider Institutional Investor Positions: The SEC's increased scrutiny comes on the heels of continued institutional investor focus on climate disclosures. For example, in his 2021 letter to CEOs, BlackRock CEO Laurence Fink asked companies to disclose a "plan for how their business model will be compatible with a net zero economy…[which] emits no more carbon dioxide than it removes from the atmosphere by 2050." BlackRock Investment Stewardship has further cautioned that, "where corporate disclosures are insufficient to make a thorough assessment, or a company has not provided a credible plan to transition its business model to a low-carbon economy…[it] may vote against the directors we consider responsible for climate risk oversight." BlackRock is also looking for disclosure regarding how climate risks and risk mitigation affect a company's business, including things such as sea level rise and extreme weather events, national emissions goals, carbon taxes, regulations and investment in alternative energy. In addition, BlackRock repeated its call on companies to disclose in line with SASB and TCFD.
Regardless of potential SEC-mandated ESG disclosure, investor mandates and expectations related to ESG disclosure are expected to increase.11 Companies should carefully consider their institutional investors' positions on climate disclosure, including their preferred disclosure frameworks, and how best to meet those demands for information.
- Consider the Placement of Climate Disclosure: While climate disclosure per se is not specifically mandated under the SEC's existing disclosure regime, any material information related to how climate change might impact a company's business must be included in SEC filings. In recent years, ESG reporting has mainly been addressed through the standalone sustainability reports posted on corporate websites12, and the number of companies with sustainability reports on their websites has continued to increase. Meanwhile, many companies have also enhanced their ESG disclosures in SEC filings13, and the SEC has recently encouraged the move towards integrating more ESG disclosures into SEC filings, specifically with the new requirement to include human capital disclosures in Form 10-Ks. Moreover, the SEC's recent statements and directives related to climate disclosure look to further reduce the divide between ESG disclosure provided on corporate websites versus in SEC filings. With the SEC's focus on both changing disclosure requirements and enhanced enforcement of existing rules, pressure to improve and expand ESG disclosure in SEC filings is likely to continue to grow and, over time, companies will have to further consider including additional ESG disclosure in their Form 10-Ks and 10-Qs.
- Ensure Consistency of Disclosures: Wherever disclosures are made, companies should ensure that these disclosures are subject to disclosure controls and consistent throughout all of their communications, as Acting Chair Lee reiterated that the SEC may compare the consistency of the voluntary reporting and disclosures in SEC filings.
- Beyond Climate: Consider other ESG Disclosures: In addition to climate disclosures, companies should consider their other ESG disclosures, such as human capital management disclosure, as these are likely to be part of the SEC's comprehensive ESG focus. Lee points out that the SEC should "consider the broader array of ESG disclosure issues" as it works to "make progress on standardized ESG disclosure more broadly." Lee's speech advocates that, in the near term, the SEC should address ESG issues individually, such as by "offering guidance on human capital disclosure to encourage the reporting of specific metrics like workforce diversity, and considering more specific guidance or rulemaking on board diversity." Lee also emphasizes that political spending disclosure is "inextricably linked to ESG issues" and "is key to any discussion of sustainability," signifying another potential area of SEC focus going forward.
1 The statement is available here.
2 The SEC's press release is available here.
3 The statement is available here.
4 The speech is available here.
6 The 2010 climate change disclosure guidance is available here.
7 For example, developments in legislation and regulation (including potentially, international accords) regarding climate change could trigger disclosure obligations under Items 101, 103, 503(c) and 303 of Regulation S-K.
8 For example, a recent evaluation of public company disclosures made for fiscal years 2010 to 2013 found that disclosures were “very brief, provide[d] little discussion of material issues, and [did] not quantify impacts or risk.” Further, some companies continue to either eschew climate risk disclosures or provide only generic, boiler-plate disclosures that do not provide any meaningful information to investors. See report from the Institute for Policy Integrity at NYU and the Environmental Defense Fund, available here.
9 In addition, on March 3, 2021, the SEC Division of Examinations issued a press release stating that this year the Division is "enhancing its focus on climate and ESG-related risks by examining proxy voting policies and practices to ensure voting aligns with investors' best interests and expectations, as well as firms' business continuity plans in light of intensifying physical risks associated with climate change," said Acting Chair Lee. The Division will continue to review the compliance programs of registered investment advisors, including with respect to the offering of ESG-related investment strategies. The press release is available here. Further in her March speech, Lee highlighted the fact that "most shareholder voting is done through the proxy process...[h]owever, [investment] funds may not always reflect [shareholders' ESG] preferences in their voting." To address this discrepancy, Lee has asked the Staff to consider: (i) recommendations for enhancing, supplementing, or replacing the Commission’s 2019 Guidance on Proxy Voting Responsibilities of Investment Advisers "to ensure that advisers understand how to weigh competing concerns of all types in deciding whether and how to cast votes on behalf of their clients"; (ii) updates to disclosures of fund voting decisions to maximize transparency around fund proxy voting; and (iii) whether to recommend that the Commission "re-open the comment file on the 2016 universal proxy rule proposal to take into account market developments since then and move towards finalization."
10 The March 15, 2021 statement is available here. The comment period will be open for 90 days.
11 See our related client alert here.
12 See our prior alert, "A Survey and In-Depth Review of Sustainability Disclosures by Small- and Mid-Cap Companies."
13 See our prior alert, "ESG Disclosure Trends in SEC Filings."
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