Economy and Society: SEC set to impose environmental disclosure rules

Economy and Society is Ballotpedia’s weekly review of the developments in corporate activism; corporate political engagement; and the Environmental, Social, and Corporate Governance (ESG) trends and events that characterize the growing intersection between business and politics.

ESG Developments This Week

In Washington, D.C.

The SEC is finally set to impose environmental disclosure rules

After nearly a year of waiting on what the SEC planned concerning disclosure rules, the Securities and Exchange Commission released its 510-page proposal called “The Enhancement and Standardization of Climate-Related Disclosures for Investors.” The new disclosure standards will have to be approved by a majority vote of Commissioners, but given that the panel is currently composed of three Democrats and one Republican (due to the retirement in January of Commissioner Elad Roisman), observers expect that passage is virtually guaranteed. The following summary from the Wall Street Journal details what investors should expect from the new rules:

“The proposal would force publicly traded companies to report greenhouse-gas emissions from their own operations as well as from the energy they consume, and to obtain independent certification of their estimates. In some cases, firms also would be required to report greenhouse-gas output of both their supply chains and consumers, known as Scope 3 emissions. Companies would have to include the information in SEC filings such as annual reports….

SEC commissioners, staff and advisers have spent months negotiating the contours of the proposal. Their challenge is to reconcile two conflicting goals: To make public as much information about climate change and associated risks as they can feasibly demand from companies, and to craft rules that withstand legal scrutiny in federal courts that have grown increasingly conservative. The Biden administration has deemed climate change a major risk to the financial system.

A sticking point in the deliberations were the circumstances in which the SEC would mandate disclosure of Scope 3 emissions, which is typically much larger than a company’s direct greenhouse-gas output. But companies struggle to accurately estimate the emissions from their suppliers, who may not offer their own calculations of greenhouse-gas output, or from customers who use their products and services.

The rules proposed Monday would allow firms a degree of flexibility. Disclosure of Scope 3 emissions would be mandatory only if output of those greenhouse gasses is material, or significant to investors, or if companies outline specific targets for them.

For instance, if a firm announces plans to reach “net-zero” emissions by a certain date, it would have to specify whether that goal includes all scopes of greenhouse-gas output. If so, disclosure of its Scope 3 emissions would have to be included in its SEC filings starting in 2025 for large firms. Companies wouldn’t, however, be required to obtain independent assurance that their Scope 3 estimates are accurate and wouldn’t be held liable for the estimates if they were provided in good faith.

An SEC official said most companies in the S&P 500 would likely have to report Scope 3 emissions.

Many regulators say the threats to companies from global warming fall into two buckets: First are the so-called physical risks posed to a company’s facilities and operations by the increased frequency of extreme weather events—droughts, floods, wildfires and hurricanes—in regions where such occurrences used to be rare. Second are “transition risks” resulting from efforts to both wean the economy off fossil fuels and prepare for the effects of climate change.

The SEC’s proposal would require publicly traded companies to include in their financial statements estimates of the impact of both sets of risks. Firms also would have to provide broader explanations about their long-term vulnerabilities to climate change and their processes for addressing those concerns.”

SEC Commissioner Peirce argues against new rules

The lone Republican on the Commission, Hester Peirce, delivered a critical response statement decrying both the real fiscal costs of compliance with the new rules and risks associated with expanding the SEC’s mandate so determinedly and, in her opinion, without a legal right to do so:

“Contrary to the hopes of the eager anticipators, the proposal will not bring consistency, comparability, and reliability to company climate disclosures.  The proposal, however, will undermine the existing regulatory framework that for many decades has undergirded consistent, comparable, and reliable company disclosures….

The proposal turns the disclosure regime on its head.  Current SEC disclosure mandates are intended to provide investors with an accurate picture of the company’s present and prospective performance through managers’ own eyes.  How are they thinking about the company?  What opportunities and risks do the board and managers see?  What are the material determinants of the company’s financial value?  The proposal, by contrast, tells corporate managers how regulators, doing the bidding of an array of non-investor stakeholders, expect them to run their companies.  It identifies a set of risks and opportunities—some perhaps real, others clearly theoretical—that managers should be considering and even suggests specific ways to mitigate those risks.  It forces investors to view companies through the eyes of a vocal set of stakeholders, for whom a company’s climate reputation is of equal or greater importance than a company’s financial performance.

As you have already heard, the proposal covers a lot of territory.  It establishes a disclosure framework based, in large part, on the Task Force on Climate-Related Financial Disclosures (“TCFD”) Framework and the Greenhouse Gas Protocol.  It requires disclosure of: climate-related risks; climate-related effects on strategy, business model, and outlook; board and management oversight of climate-related issues; processes for identifying, assessing, and managing climate risks; plans for transition; financial statement metrics related to climate; greenhouse gas (“GHG”) emissions; and climate targets and goals.  It establishes a safe harbor for Scope 3 disclosures and an attestation requirement for large companies’ Scope 1 and 2 disclosures. 

Some elements are missing, however, from this action-packed 534 pages:

–          A credible rationale for such a prescriptive framework when our existing disclosure requirements already capture material risks relating to climate change;

–          A materiality limitation;

–          A compelling explanation of how the proposal will generate comparable, consistent, and reliable disclosures;

–          An adequate statutory basis for the proposal;

–          A reasonable estimate of costs to companies; and

–          An honest reckoning with the consequences to investors, the economy, and this agency….

We are here laying the cornerstone of a new disclosure framework that will eventually rival our existing securities disclosure framework in magnitude and cost and probably outpace it in complexity.  The building project upon which we are embarking will consume our attention and enrich many, as any massive building project does.  The placard at the door of this hulking green structure will trumpet our revised mission: “protection of stakeholders, facilitating the growth of the climate-industrial complex, and fostering unfair, disorderly, and inefficient markets.”  This new edifice will cast a long shadow on investors, the economy, and this agency.”

On Wall Street and in the private sector

Does ESG distort markets?

In the past few days, the Financial Times has published several stories on ESG and what its writers argue is its distorting impact on all sorts of markets, from capital markets to business markets to talent markets.

First, the paper takes on ESG and what is argued is its propensity to “misprice dangers for investors” in credit markets:

“Last year, environmental, social and governance-linked (ESG) bond funds netted roughly $102bn, a record level of net inflows, according to data from research group EPFR. Searches for “ESG” in Google reached an all-time high in February 2022. And investors around the world advertised the sophisticated ESG standards that they apply across asset classes.

However, ESG products are still often treated separately from the core investment business and ratings are still not always a primary or decisive part of the credit risk assessment process. And, even when they are, there is no universal standard for what constitutes an ESG risk.

For example, in 2021, there were still upgrades in the credit ratings of coal companies, mortgage booms in flood zones, and schools embroiled in sexual assault cases that successfully raised money in the municipal bond market.

“It’s obvious to me that there are ESG risks that are not priced into fixed income markets,” warns Tom Graff, head of fixed income at Brown Advisory, the investment manager….

ESG risk is similarly underpriced in the municipal bond market, argues Erin Bigley, head of fixed income responsible investing at AllianceBernstein. Issuers that are providing educational or healthcare services, for example, may be assumed to embody ESG principles, even when they do not.

“We have found that there are issuers where our ESG scores have indicated risks that are not priced into the market,” says Bigley. “Even on the very high-quality side.””

Next, FT addresses the distortions being caused by “the boom in ESG ratings” and the confusion that it’s argued they often sow:

“There is a new gold rush under way in finance. It is not Wall Street bankers rushing for the latest big takeover deal or to list speculative acquisition vehicles.

It is the race to carve out market share in the very lucrative business of providing advice to investors on environmental, social and governance issues — particularly in the form of rating and ranking how companies fare on such factors.

It is being driven by the sheer weight of money flooding into ESG funds as issues such as climate change and sustainability move up the investor agenda. About $2.7tn of assets are now managed in more than 2,900 ESG funds, according to Morningstar. In the fourth quarter of last year alone, there were about $142.5bn of inflows into the sector.

A flourishing industry of ESG rating consultants has sprung up to assist these investors. Mike Zehetmayr, a specialist for EY on financial service risk and compliance technology, says his firm identified about 100 providers in October, double what it had found the year before….

However, there is an emerging problem in the diversity of approaches and methods used by providers, all of which have their own theoretical biases. With so many consultants and methods around, it can distract some investors and make it harder to draw meaning from aggregate ratings and rankings….

Meanwhile, the companies themselves are overwhelmed with data access requests not only from ESG data providers and shareholders but also from other stakeholders such as suppliers and customers, says EY’s Zehetmayr. And corporates are wary lest they release any inappropriate data, miring them in controversies.”

Finally, the paper takes on what it argues are the distortions introduced into talent markets by ESG:

““Competition to secure experts in sustainable investing has led to a battle for talent that is driving bidding contests by fund managers and pushing salaries up by half for top hires.

Head hunters and executives say competition is so intense that people are fielding multiple job offers, on top of concerted efforts by current employers to retain them.

“We have a big ESG team and we haven’t lost too many of them, but I think they are the stars of the asset management world right now. Once upon a time, it was the star equity manager; now it’s the star ESG professional,” said Mark Versey, chief executive of Aviva Investors.

Efforts to align investments with climate goals and social good have been building for a decade, but have taken off in the past few years. According to data from Morningstar, assets in sustainable funds grew 53 per cent year-on-year to $2.74tn in 2021.

Demand for people to manage these investments has exploded as a result, but the pool of qualified candidates is small. In a CFA Institute analysis of 10,000 investment jobs advertised on LinkedIn, 6 per cent required sustainability skills, yet less than 1 per cent of the 1m investment professional profiles included in the study listed these skills on their profiles.

In response, fund managers are not only poaching staff from rivals, they are also taking the unusual step of hiring from outside the industry as they struggle to fill vacancies.”

In the spotlight

Who is driving ESG?

In a piece published March 21, Institutional Investor magazine confirmedalbeit unwittinglythat one of the biggest arguments about ESG investing is potentially true. Many ESG opponentsincluding SEC Commissioner Hester Peircehave argued that ESG and sustainability investments and policies are being driven not by actual investors but by the investment professionals whose interests may or may not align perfectly with those of their clients. Institutional Investor cites research that suggests this may, indeed, be the case:

“For better or worse, institutional investors tend to rely on asset managers when it comes to environmental, social, and governance practices. Some managers are jumping on the opportunity to grow their businesses.

In a study from Chestnut Advisory Group, a boutique growth strategy consultant with a focus on asset managers and outsourced chief investment officers (OCIOs), CEO Amanda Tepper wrote that while ESG is a hot-button issue in the investment world, managers and asset owners are left to their own devices when it comes to crafting and implementing specific philosophies….

Sixty-three percent of institutional investor respondents say they’re “just getting started” in their overall ESG efforts, while only 13 percent of asset managers said the same. “That means [that institutional investors] are relying on whatever it is the asset managers are doing to address ESG. They’re not doing it themselves,” Tepper told Institutional Investor….”

The magazine goes on to note that this distinction is inevitable and also potentially provides certain benefits.