Responsible investment and environmental, social, and governance (ESG) disclosure requirements have historically been driven by investor demands, allowing companies and investors to choose from over a dozen disclosure frameworks to report on their performance. As such, the depth and scope of data disclosed varies, leading various stakeholders – including investors and executives – to call for increased standardization and regulation of sustainability disclosures and methods taken to integrate ESG factors into investment processes. In response to mounting pressure from investors and intergovernmental organizations to require more consistent and widespread disclosures, regulatory bodies in the EU and US recently passed regulations establishing criteria and requirements for ESG disclosures from financial market participants and financial advisors. While the scope and frameworks of these regulations vary, the underlying signal remains the same: regulators are increasingly requiring investors and asset managers to evaluate and disclose ESG risks and opportunities in investment decisions.
EU ESG Disclosure Requirements Lead the Way
The EU continues to lead the charge in responsible investment disclosures, publishing new rules for disclosure requirements for responsible investments. As Latham & Watkins highlights, the new regulation outlines how financial market participants and financial advisors must incorporate ESG risks and opportunities into investment decisions, processes, procedures, and policies and report on their integration of these considerations in a uniform manner, specifically highlighting how ESG risks may impact profitability and initiatives undertaken to implement environmentally friendly operational changes. The regulation focuses on three key areas of disclosure aligned with the EU’s larger Action Plan on Sustainable Finance, which are summarized by Latham & Watkins as follows:
Elimination of greenwashing – The regulation intends to raise awareness within the markets about sustainability and reduce the number of unsubstantiated and misleading claims about sustainable attributes of investments.
Regulatory neutrality – EU governing bodies including the European Banking Authority and the European Securities and Markets Authority will monitor application of the regulation across financial market operators to ensure consistency in disclosures.
Level playing field – The scope of the regulation covers a broad set of financial institutions, including investment funds, insurance-based investment products, private and occupational pensions, individual portfolio management, insurance advice, and investment advice.
Although the EU Member States and EU Parliament approved the regulation, implementation and enforcement will commence upon completion of the required legal and technical reviews, likely in early 2021, according to IPE.
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.
US Federal Disclosure Requirements – Nascent for Now
Relative to the EU, the US has been slow to embrace ESG disclosure requirements at the federal level, even with growing pressure from institutional investors. As Business Law Today reports two law school professors, Cynthia Williams from York University and Jill Fisch from the University of Pennsylvania, and US institutional investors including CalPERS and the Connecticut State Treasury representing over $5 trillion in assets submitted a petition in 2018 urging the SEC to create a standard reporting framework under which all US public companies would be obligated to disclose identified ESG risks in their operations. The petitioners argue that, because ESG issues can have material impacts on the ability of companies to generate capital and operate competitively, the SEC should require consistent disclosure requirements to allow investors to compare and analyze ESG performance across companies and industries. For example, the petitioners highlight findings such as the Sustainability Accounting Standards Board’s (SASB) conclusion that approximately 93% of US capital market value is susceptible to material financial implications from climate change in order to bolster their argument for how ESG issues meet SEC’s materiality thresholds.
Business Law Today notes that 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. While the petition’s scope largely focuses on public markets, private companies may also be expected to follow similar disclosure schedules (if passed), as investors are increasingly demanding standard and consistent ESG reporting across all asset classes.
Emerging State-Level ESG Requirements
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. However, 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.
With Illinois’ new law coming into effect at the beginning of Q1 2020 and additional regulations pending in states such as Massachusetts, Minnesota, New Jersey, and New York aimed at incorporating ESG risks such as climate change into investment decisions, firms should remain cognizant of evolving regulatory requirements affecting their investors and proactively engage with them to align investment practices with state-level legislation.