Last week, the SEC's Investor Advisory Committee held a meeting focused in part on the use of environmental, social and governance information in the capital allocation process—how do investors use ESG information in making investment decisions? The panelists—an academic and several representatives of asset managers—all viewed ESG data as important to decision-making, particularly in relation to potential financial impact, even for investment portfolios that were not dedicated to sustainability.

To open the meeting, Commissioner Allison Lee, after acknowledging how much emphasis investors are now putting on ESG issues, observed that the SEC "last issued guidance on climate-related disclosure in 2010. A lot has changed since then in terms of what we know about the significance of climate risk from a scientific standpoint, as well as what we know about the risks companies face as a result. A lot has also changed in terms of the kinds of disclosure that investors need to accurately assess and price that risk, on everything from board oversight of the risk to estimates related to stranded assets."


In August, Lee and fellow Commissioner Robert Jackson published a joint statement to encourage public comment about, among other things, the absence of climate risk as a topic for discussion under the Description of Business in the proposal to modernize Reg S-K (see this PubCo post), released on August 8. According to Lee and Jackson, while estimates of the scale of climate risk vary, "what is clear is that investors of all kinds view the risk as an important factor in their decision-making process. Yet it remains tough for investors to obtain useful climate-related disclosure. One argument against mandating such disclosure is that climate risk is too difficult to quantify with acceptable accuracy. Whatever one thinks about disclosure of climate risk, research shows that we are long past the point of being unable to meaningfully measure a company's sustainability profile." (See this PubCo post.)

Chair Jay Clayton, who was not in attendance at the meeting, but nevertheless provided a statement, expressed interest in understanding what data companies and investors use to make decisions, recognizing that the answers could be complex: "1) not all companies in the same sector use the same or comparable data in their decision making and (2) investor analysis also varies widely. In the areas of 'E' and 'S' and 'G,' in particular, the approach to investment analysis appears to vary widely, in some cases incorporating objectives other than investment performance over a particular time frame or frames." To generate "decision-useful" (Clayton translation: material) information, these complexities must be taken into account. Clayton also noted that "E," "S" and "G" are very different in terms of disclosure:

"For example, 'G' is significantly rooted in and bounded by law, regulation and governance agreements, lending itself to a fair degree of precision. 'G' also generally is more historical than forward-looking and is substantially under the control of the registrant. 'E' has some similarities to 'G'—for example, 'E' disclosure is often based on law and regulation or at least the effects of law and regulation. However, 'E' disclosure can be significantly forward-looking, including estimating or otherwise discussing the effects of current law and regulation as well as pending or potential regulation. We have long recognized there can be a substantial difference between historical information and forward-looking information. As I have previously discussed with this Committee, due to this complexity, I have concerns that imposing a uniform, mandatory disclosure framework for many areas [of] 'E,' 'S' and 'G' disclosures runs the risks of sacrificing what may be the more relevant, company-specific disclosure for the potential for greater comparability across companies."

As he has historically, Clayton continued to promote the SEC's longstanding disclosure framework as the right approach to ESG.


Clayton has consistently been far from enthusiastic about marketwide ESG regulation: in the face of rulemaking petitions and other mounting calls for rulemaking that standardized ESG disclosure, Clayton's view was "that in many areas we should not attempt to impose rigid standards or metrics for ESG disclosures on all public companies. Such a step would be inconsistent with our mandate, would be a departure from our long-standing commitment to a materiality-based disclosure regime, and could effectively substitute the SEC's judgment for the company's judgment on operational matters." (See this PubCo post.) Instead, Clayton has favored application of "the 'materiality' based approach to disclosure regulation. This has been the commission's perspective for 84 years and it has served our investors and markets very well. Keeping that perspective in mind is critical to our mission." What that meant to Clayton was that if a matter was "going to affect the company's bottom line or presents a significant risk to the business, I would expect them to do something about it. If the matter is material, I also would expect the company to disclose the matter and what they are doing about it. This is consistent with general fiduciary obligations of directors and officers, as well as our disclosure rules." (See this PubCo post.)

In that regard, he has previously recommended a speech by Corp Fin Director Bill Hinman, which addressed the application of principles-based disclosure requirements to complex and evolving disclosure questions. In his speech, Hinman described "principles-based disclosure" as a framework where "requirements articulate an objective and look to management to exercise judgment in satisfying that objective by providing appropriate disclosure when necessary." One benefit of principles-based disclosure was that its inherent flexibility allowed disclosure to evolve with emerging issues.

In the speech, Hinman viewed the issue of ESG disclosure as "complicated," largely because of the tension between the desire of some for specific sustainability disclosure requirements—along with the debate about which set of reporting standards should apply—and the concern of others that specific sustainability disclosure requirements would elicit information that was not really material to a reasonable investor. (See, for example, this PubCo post and this PubCo post.) These issues had not yet settled out in the marketplace, and the SEC was continuing to monitor the evolution of market-driven solutions, comparing information in SEC filings with information provided voluntarily outside of SEC filings. In particular, the SEC was wary of imposing specific bright-line disclosure requirements that could increase the costs of being a public company without delivering relevant and material information to investors and others, thus potentially decreasing the attractiveness of public-company status.

In preparing principles-based disclosure regarding sustainability, Hinman advised that companies apply the MD&A standard of allowing investors to see the company "through the eyes of management," including describing plans to mitigate material risks and the material impact of these decisions on the business. He suggested evaluating the disclosure relative to the disclosure that management provides to the board.

With regard to climate-related disclosures specifically, Hinman referred to the SEC's 2010 interpretive release, which discussed the application of existing disclosure requirements to climate change issues. The approach taken there was consistent with the approach to cybersecurity—looking to the current disclosure obligations under existing laws and regulations for direction. Hinman cited as examples the discussions in the guidance of how "businesses that may be vulnerable to severe weather or climate-related events should consider disclosing material risks of, or consequences from, these events," as well as the nature of the disclosure that a company should provide, if material, if the company "determines that its physical plants and facilities are exposed to extreme weather risks and it is making significant business decisions about relocation or insurance."

Hinman noted that the guidance did not address the board's risk management role in this area, but that board risk oversight, including the relationship between the board and senior management in managing material risks, was a disclosure requirement under Item 407(h) of Reg S-K and Item 7 of Schedule 14A. Accordingly, Hinman advised, "[t]o the extent a matter presents a material risk to a company's business, the company's disclosure should discuss the nature of the board's role in overseeing the management of that risk." Hinman suggested that the SEC's cybersecurity guidance may provide useful parallels to sustainability and other emerging risks. (See this PubCo post.)

[Based on my notes, so standard caveats apply.]

At the Committee meeting, a Columbia professor specializing in sustainable finance discussed the "robust correlation" between measures of sustainability and financial performance, which has been demonstrated in thousands of studies. In particular, he cited a 2018 study of studies showing that sustainability measures were highly correlated with financial operating performance, but less so with market performance (suggesting that the market takes quite a while to catch up and recognize the benefit). He also observed that the largest asset managers have made clear that they do incorporate ESG information into their analyses. Many analysts tend to research outside of the financial statements for information that, although public, is not necessarily widely known, asking various stakeholders, employees, customers, regulators and others for ESG information.

A representative of AllianceBernstein, an investment manager, said that while they maintain one portfolio with an ESG mandate and one without, they incorporate ESG information in all of their actively managed portfolios because they believe that it drives better outcomes. Further, their analysts look at ESG issues for each company. For example, if a company is a significant carbon emitter, they might look into the potential for regulations or carbon taxes and consider what the impact might be on shareholder value. She also noted that, while they may use third-party ratings systems to a limited extent, for the most part, they consider them to be overly simplistic and backward-looking, taking into account only what can be measured, not what should be measured. The firm's engagement process drives home the point that ESG matters. She also lamented the lack of quality standardized data, which makes it more difficult not only for their own analysts, but also for companies, which end up spending substantial time responding to multiple requests for different types of ESG data (referred to by a committee member as "survey fatigue"). In her view, ESG information was becoming increasingly material, and the SEC could take the lead in driving more complete and accurate standardized data.

A representative of Neuberger Berman, an asset manager, observed that there has been increased industry acceptance of the importance of ESG in influencing risk and return; over one-third of their clients now ask how ESG issues are considered, and, in North America, there was a 94% increase this year in inquiries about ESG. He favored a disclosure standard that was more holistic than a normative critique of a company—with more standardized information and dialogue, they would be better able to perform analyses and reach more qualitative conclusions. He agreed that third-party ratings providers were limited in scope and too backward-looking; they are useful primarily as a starting point. Therefore, multiple sources were important. He also observed that different managers followed different risk-return strategies, requiring different types of ESG information. Currently, evaluating the information is an imprecise task because of the "patchy" and inconsistent nature of the disclosure among companies. There is insufficient quality, decision-useful data, exacerbated by corporate greenwashing. With some exceptions, companies spend too much on corporate social responsibility reports that are not decision-useful or comparable. For example, a study found that only 25% included quantitative information. He also contended that companies collect much more data for internal purposes than they share publicly. Typically, companies are unwilling to share more information because their competitors are not disclosing it and it's not legally required, which the SEC could address. But regulating is not the only approach; industry groups could do more, he said, citing as an example, the Edison Electric Institute, which has created a framework, informed by SASB (see this PubCo post), for the utilities segment. However, not all participate in these frameworks and their usefulness is constrained by the voluntary and consensus-building requirements of the process. The SEC could play more of a role, perhaps by developing safe harbors for disclosure or comply-or-explain disclosure requirements, focusing on financial materiality. He closed by adding that U.S. disclosure lags international markets in the ESG context.

A representative of State Street Global Advisors, the third largest asset manager, said that they view consideration of ESG as part of their fiduciary duty to clients. However, a recent survey found that availability of high quality information that was financially material, consistently disclosed and comparable across companies was one of the biggest challenges. And companies need guidance on how to measure and disclose ESG information in a standardized way. State Street leveraged SASB and other sources to develop their R-Factor" (responsibility factor) scores for their voting and engagement process. According to State Street, "R-Factor" is an ESG scoring system...that leverages multiple data sources and aligns them to widely accepted, transparent materiality frameworks to generate a unique ESG score for listed companies. R-Factor" measures the performance of a company's business operations and governance as it relates to financially material ESG challenges facing the company's industry. It is designed to provide companies a roadmap to improve ESG practices and disclosure, and to help create sustainable capital markets." They also use ESG information for client reporting and investment solutions. Depending on the type of investment strategy, some investment portfolios may require specialized data, but the information is always viewed through a lens of risk and return.

A representative of Calvert Research and Management, an investment manager, noted that 85% of the S&P 500 issue sustainability reports, but there is wide variation in the contents. They want companies to focus resources on the ESG risks and opportunities that are financially material. To the extent company disclosures are simply boilerplate, they are not particularly useful, but, she cautioned, without regulatory guidance, boilerplate would become more common. Studies have shown that ESG practices have converged, but that more differentiated practices are associated with better returns. How could disclosure of more relevant ESG information be encouraged? They supported the SEC's recent first steps toward human capital disclosure. Overly prescriptive rulemaking can quickly become outdated, but the lack of comparability is also problematic. They supported a framework that combined principles and prescription, such as the SASB framework, which uses standardized industry-focused metrics and a disclose-or-explain approach. For its analysis, they use KPIs focused on peer groups, which differentiate by industry with regard to the environmental and social components, but not on governance.

In the ensuing discussion, a participant floated the idea of the SEC's selecting an outside framework, such as SASB or TCFD, to mandate. Even though there are a number of frameworks, they are not regularly used or, if used, companies may respond selectively or fail to include quantitative data. One panelist observed that there is insufficient transparency into how companies determine which ESG issues are material for their financial performance. SASB was widely commended for its differentiation by industry, consistency of reporting and focus on financial materiality. One panelist said that there was broad consensus in the industry that SASB provides a common framework of decision-useful information that would be helpful to most investors. However, even among those who supported SASB, several considered SASB to be only a floor. One panelist suggested that, under SASB, it was easy for information to appear highly material even if, for that company, it was not.

SASB differs from TCFD in that it focuses on companies' operations and factors the company can control, while TCFD focuses on climate and also has a strategic aspect. One panelist said that SASB looks at materiality from an immediate perspective, while TCFD also considered medium-term materiality. It was also noted that companies might need some assistance in understanding how to comply with the TCFD. One panelist observed that companies do not yet have the kind of infrastructure needed to readily obtain the necessary data for many frameworks, as evidenced by the mad dash at year end to put reports together. One panelist observed that, although many companies provide sustainability reports, less than a third include third-party assurance. How do investors know that the information provided is accurate and comparable across companies? That is the assurance that regulation would provide.

While it was desirable to avoid burdensome regulation, the low level of current requirements was problematic in one panelist's view. But the panelists all seemed to consider it advisable to try to nudge companies toward some kind of framework for purposes of consistency, a process the SEC could do well. One panelist noted the need to recognize the difficulty of building consensus for a framework. One panelist commented that a way to build consensus would be to prioritize the easiest topics, such as energy use, where there seems to be some agreement about the measures, or climate. Another recommendation was to start with human capital management, which the SEC has already begun to tackle. (See this PubCo post.) Several participants lamented the possible adverse effect of the new SEC proposal to modernize the shareholder proposal process on smaller holders, particularly with respect to the potential for limitation of submission of climate-related proposals. Even small holders can be canaries in the coalmine. (See this PubCo post.)

One committee member said that it would have been helpful to have included some panelists with a perspective that was skeptical of ESG. As the lone committee member objecting to a more pronounced role for the SEC—or at least the only one that was vocal about it—he raised the possibility of adverse consequences if the SEC mandated ESG disclosure, including potential disclosure of proprietary information as well as litigation risk. The SEC should limit its role to policing disclosures. In addition, in his view, the empirics related to many ESG issues is more mixed than some might suggest. He also remarked that, according to many ESG skeptics, ESG is used simply as a way for analysts or advisors to follow their own personal political preferences, rather than as indications of performance.


As discussed in this PubCo post, according to this recent study from consulting firm McKinsey, investors want to see a different kind of sustainability reporting. The authors observe that, in light of mounting evidence "that the financial performance of companies corresponds to how well they contend with environmental, social, governance (ESG), and other non-financial matters, more investors are seeking to determine whether executives are running their businesses with such issues in mind." Although there has been an increase in sustainability reporting, McKinsey's survey revealed that investors believe that "they cannot readily use companies' sustainability disclosures to inform investment decisions and advice accurately." Why not? Because, unlike regular SEC-mandated financial disclosures, ESG disclosures don't conform to a common set of standards—in fact, they may well conform to any of a dozen major reporting frameworks and many more standards, selected at the discretion of the company. That leaves investors to try to sort things out before they can make any side-by-side comparisons—if that's even possible. According to McKinsey, investors would really like to see some type of legal mandate around sustainability reporting.

In response to a question from McKinsey about sustainability standards, 14% of investors said there should just be fewer standards, but an overwhelming 75% of investors said there should be only one standard. Executives had a similar perspective: 28% said there should be fewer standards, and 58% said there should be only one standard. In addition, the vast majority of investors agreed or strongly agreed that more standardization would help with effective capital allocation (85%) and with more effective risk management (83%). A similar majority of executives agreed or strongly agreed that more standardization would help their companies benchmark against their peers (80%) and enhance their companies' ability to create value or mitigate risk (68%). What's more, 82% of investors said companies should be legally required to issue sustainability reports and, surprisingly, 66% of executives agreed.

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.

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.