Environmental, Social and Governance (ESG) issues have been a growing focus for regulators, investors and consumers for the past several years. There has been a trend toward greater efforts to address such issues from a variety of perspectives both within and outside the United States. For example, investors and stakeholders are seeking out companies that have fully integrated their ESG risks and opportunities into their corporate strategy. Chief executive officers are redefining the corporation’s fundamental purpose to extend beyond maximizing shareholder value. In addition, regulators around the globe are proposing and implementing regulations aimed at heightened transparency for ESG issues.
Key developments in 2019 reinforce this trend and forecast an even greater focus on ESG issues in 2020 and beyond.
Stay Current on Private Sector
In August 2019, the Business Roundtable released a headline-making statement signed by over 180 CEOs that, in its essence, redefined the purpose of the corporation. The document states a broad commitment to focus on maximizing value for all stakeholders, representing a significant shift away from traditional shareholder primacy. The specific commitments include:
- Delivering value to customers
- Investing in employees through fair compensation and benefits
- Providing training and continuing education and fostering diversity and inclusion
- Dealing fairly and ethically with suppliers
- Supporting communities in which companies work by respecting the people and protecting the environment through sustainable practices
- Generating long-term value for shareholders.
Despite the aspirational nature of this statement, it demonstrates that the private sector is reenvisioning its role in society and highlights a budding consensus among executives that ESG is central to that evolution.
Subsequently, the U.S. Chamber of Commerce released a guide to best practices for voluntary ESG reporting, a fundamental aspect of any company’s ESG program. The guide encourages reporting to focus on:
- Identifying the long-term impact of ESG issues
- Considering the audience
- Coordinating between internal departments for accurate disclosure
- Clarifying the terminology for laymen
- Tailoring reporting to the company explaining utilized metrics and why they were chosen
- Making reports readily available and describing a rigorous review or audit process.
The Chamber framed this guide as encouraging a system of “private ordering” in lieu of further regulation and as a complement to the existing U.S. legal requirement that public companies disclose all material information in Securities and Exchange Commission (SEC) filings.
Other commentators have disagreed with the Chamber’s position and advocated for further required disclosures. Indeed, the SEC itself has proposed rules requiring additional human capital disclosures.
Keep Up with SEC Developments
The SEC has proposed regulatory modernizations that would require enhanced business and risk factor disclosures. It also is undertaking additional steps that may result in required disclosures pertaining to ESG.
For example, on August 8, 2019, the SEC proposed revisions to Regulation S-K, including to Item 101(c), which would require an enhanced narrative description of the business, including the company’s human capital resources. This would address any measures or objectives that management focuses on, to the extent material to an understanding of the business “measures or objectives that address the attraction, development and retention of personnel.”
In response to an earlier concept release, the SEC received multiple comment letters advocating for greater human capital disclosure, with the majority tending to be in favor of the proposal. In many cases, additional disclosure or inclusion of a non-exhaustive list of items that may impact a company were also favored.
Many companies address human capital management in public disclosures outside of those filed with the SEC, such as website disclosures, ESG or sustainability reports. A number of others are addressing items such as board of directors oversight of human capital management in proxy disclosures and general efforts around human capital issues such as:
- Diversity and inclusion
- Health and safety
- Skills and stability.
Investors and market participants advocating for the inclusion of additional disclosure argue that companies with poor management of human capital could face operational, legal and reputational risks, giving companies with strength in the area a competitive advantage. Opponents suggest that retaining human capital disclosures in voluntary publications, rather than requiring specific metrics in SEC filings, provide each company with flexibility. That is, a company’s discussion could evolve as investors’ focus continues to develop and it could include a broad discussion of considerations specific to its business. Those against the measure also argue that the inclusion of human capital disclosures are already required, to the extent they are material to the understanding of a company’s business, with the same threshold required under the proposed rules.
Whether or not the change to S-K Item 101(c) occurs, boards should consider what, if any, additional human capital disclosures would be helpful to their investors and continue to review the scope of their oversight of company human capital management practices.
Having a clear internal view of what management focuses on, in connection with the company’s human capital, is increasingly critical to addressing any new disclosure requirements, as well as engaging with investors. As the SEC noted in its proposed rule, each industry, and each company within a specific industry, has its own evolving human capital considerations, and boards will likely continue to shift in their engagement and oversight of the company practices in this area.
At the same time, the SEC’s Office of Compliance Inspections and Examinations (OCIE), which handles examinations of SEC-registered investment advisers and broker-dealers, appears to be engaged in a broad sweep examination effort of ESG reporting practices and related disclosure in investment-related materials. Specifically, OCIE has requested, among other things, that a number of registered entities provide:
- Information about their ESG-related policies and procedures
- Information regarding how the regulated entity measures its progress against previously made ESG related commitments
- Copies of policies, procedures, compliance/internal audits, and pitch, promotional and advertising materials that discuss ESG.
While these requests for information are being made in the context of examinations, and thus may or may not lead to SEC enforcement action, they highlight the SEC’s overall interest in, and attention to, ESG issues. And, given the fact that many sweep examination efforts lead to public risk alerts from OCIE, the OCIE’s staff may soon issue a pronouncement regarding its views of ESG-related issues in the regulated entity space.
Be Aware of EU Trends
Outside the U.S., the regulatory trend is farther along toward required ESG reporting. For example, a new European Union (EU) regulation, scheduled to come into effect in February 2021, will require higher levels of sustainability-related disclosures in the financial services sector that articulate climate risks and opportunities as part of a company’s fiduciary duties. The new rule intends to harmonize the EU approach to integration of sustainability risks and opportunities into the procedures of institutional investors. A wide range of financial entities regulated by the EU or one of its Member States will be subject to this new regulation when it comes into effect in February 2021.
Transparency provisions on ESG issues are not new to the industry, but the regulation here contains some of the first mandatory provisions relating to transparency around how ESG is considered from a fiduciary perspective. It aims to strengthen reporting obligations by asset managers to their clients and other market participants, enhancing transparency on sustainability risks and green investment strategies.
The EU is, in part, seeking to root out and eliminate so called greenwashing of investments, creating greater transparency on which entities are taking sustainability concerns seriously. Financial actors will ultimately be required to publicly disclose their sustainability policies, as well as the principal adverse impacts affecting their investments (taking into account their size, their nature and the scale of their activities). Pre-contractual disclosures will also be required in order to inform clients of how sustainability risks are integrated in investment decisions and advice.
While some of the details of the regulation are yet to be determined, the basic parameters will apply to EU regulated entities in the near future. The process by which the regulation was developed and issued means that individual Member States will have little ability to vary implementation of the regulation.
The EU’s finance ministers formalized the regulation at their November 2019 meetings, and the regulation is indicated as coming into effect 15 months following its official publication— meaning that the regulation will apply in February 2021.
Follow Best Practices in Coming Year
ESG issues are becoming increasingly important to stakeholders, domestic and abroad. The U.S. and other jurisdictions are taking tangible steps toward heightened ESG accountability and transparency. Overall, the focus on ESG by major U.S. private sector organizations like the Business Roundtable and the Chamber illustrate that ESG issues and reporting are a growing area of scrutiny and reflection, and that domestic policy and practice are in the process of determining a path forward.
U.S. regulators have yet to take as prescriptive an approach. Despite the status of U.S. domestic policy, U.S. entities and investors with a global footprint must remain cognizant of ESG obligations imposed by other jurisdictions currently leading in this space, as well as trends and proposed rules that may signal a forthcoming changing of the tide domestically.
Prudent boards will take proactive steps to align with emerging best practices in the private sector while monitoring whether U.S. legislators will establish further regulatory mandates, as the EU has done and the SEC proposes to do.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.