The COVID-19 crisis and its economic impact have reinforced arguments by some investors and commentators promoting the implementation of standards for ESG disclosures. In general, the EU and the UK have been ahead of the US in adopting ESG-focused regulatory standards and disclosure requirements. In the US, most ESG disclosures are made on a voluntary basis, driven primarily by investor demand. However, some recent activity at the SEC points toward an increased possibility of ESG-related regulations. These developments in the EU, UK and the US affect many US public companies, asset managers and financial intermediaries.
Recent US Developments
In the US, the most prominent standard for ESG reporting has been the United Nations-supported Principles for Responsible Investments (“UNPRI”), which were launched in 2006 and provide six principles and a menu of possible actions to incorporate ESG standards into investment practices across asset classes.
In addition, two entities have developed frameworks in recent years for public companies to report ESG-related information. First, the Sustainability Accounting Standards Board (“SASB”) has crafted reporting standards for 77 industries concerning what SASB views as financially material sustainability topics, with corresponding industry-specific quantitative and qualitative reporting items. Separately, the Task Force on Climate-related Financial Disclosure (“TCFD”) has developed recommendations for climate-related metrics, risk management and targets for reporting companies to disclose. In response to growing investor demand, an increasing number of companies have incorporated some or all of these metrics in various reports to the public.
While ESG-related disclosures remain largely voluntary in the US, the SEC has become active in regulating the space in recent years. The SEC’s Office of Compliance Inspections and Examinations (“OCIE”) conducted a sweep in 2018 in which it asked firms with ESG product offerings about their criteria for defining “ESG,” whether firms were following established principles like the UNPRI, and to what degree firms were engaging on ESG matters with issuers in which they invest. OCIE also asked about firms’ marketing of ESG products and the degree to which the products were advertised as sustainable or “green.” More recently, in its report on examination priorities in 2020, OCIE referred to ESG investment offerings as an area concerning which examiners would pay particular attention.
In March 2020, the SEC issued a request for comment on potential updates to its 2001 Names Rule, which is designed to ensure that the name of mutual funds and other registered investment products reflects the types of assets in which it invests. The SEC recognizes that a fund’s name is a tool for communicating with investors and can have a significant impact on their investment decision. The Names Rule is designed to protect investors from names that are materially deceptive or misleading. In considering revisions to the Names Rule, the SEC highlighted the growth in sustainable investing since 2001, given the often subjective and amorphous standards for what constitutes an “ESG” fund.
Separately, the SEC’s Investment Advisory Committee (“IAC”), which is meant to represent the interests of investors before the Commissioners of the SEC, voted recently to recommend that the SEC should take steps to update issuer reporting requirements to include ESG factors. The IAC expressed a concern that the US will fall behind other countries in regulating ESG standards. The IAC was not unanimous in its views on the need for ESG disclosure requirements, with several committee members arguing that not all ESG factors are material and that the cost to public companies to report detailed ESG data could be overly burdensome.
More recently, at its second meeting, the SEC’s Asset Management Advisory Committee heard a report by its ESG subcommittee, which is studying and evaluating potential areas for rulemaking or further action regarding ESG disclosures and standards. Finally, on June 22, the Department of Labor proposed amendments to the “Investment duties” regulation under the Employee Retirement Income Security Act, which would require retirement plan fiduciaries to select investments based only on “pecuniary factors.” The proposal recognizes that ESG factors may well qualify as economic considerations, “but only if they present economic risks or opportunities that qualified investment professionals would treat as material economic considerations under generally accepted investment theories.”
Recent EU and UK Developments
ESG disclosure standards are already in place in the EU, which the European Commission has sought to develop further in recent years. As part of its Action Plan for Sustainable Finance, the EU has passed an ESG-related Disclosure Regulation and the European Parliament has adopted the text of a Taxonomy Regulation, both of which are designed to form central pillars of the new sustainability framework. The Disclosure Regulation, combined with a number of other developments (such as revisions to the MiFID II product governance regime) has the potential to impact US financial institutions in a number of ways, e.g. where they have EU regulated affiliates and in some cases where they market financial products to EU investors. There may also be an impact on US commercial companies as the EU investor community seeks to gather the data required for compliance with this new disclosure framework.
The “Taxonomy Regulation”, which is intended to underpin the regulatory reform effort, is set to establish an EU-wide taxonomy on environmental sustainability, and will in theory give both corporates and financial institutions a common language to identify which activities and financial instruments may be considered environmentally sustainable. Pursuant to the Taxonomy Regulation, firms will need to apply “technical screening criteria” (i.e., performance thresholds) to assess whether specific activities undertaken by investee companies contribute to climate change adaptation or to an increase in climate resilience.
Separately, the European Commission is consulting on a set of revisions to the AIFMD, MiFID II and the UCITS Directive, which would require EU asset managers and investment firms to embed a consideration of sustainability risk within their businesses, and to consider the interaction between potential conflicts of interest and sustainability (e.g. relating to the potential for greenwashing and misrepresentation to damage the interests of their clients and investors).
While the UK Government initially stated that it intended to match the ambition of the EU reforms, we have more recently seen a softening in that position, with suggestions from HM Treasury that the UK will take a “wait and see” approach to implementation of the reforms. This seems likely to be the case in relation to the new EU disclosure requirements in particular, which the UK has previously indicated may simply be too prescriptive.
Nonetheless, the UK has been working on its own set of reforms in the ESG space. For example, the FCA has proposed new standards requiring all commercial companies with a premium listing to either make climate related disclosures consistent with the approach set out by the Taskforce on Climate-related Financial Disclosures (TCFD) or explain why not. In addition, UK pension trustees are currently ramping up to comply with revisions to the UK Occupational Pension Schemes (Investment) Regulations 2005, which will require pension trustees to disclose how they have considered ESG, stewardship and engagement in their investment approach. These reforms to requirements affecting UK institutional investors could be the beginning of a divergence with the US institutional community (particularly given the DOL’s approach to ERISA plan fiduciaries). As a result, it could well become increasingly challenging for asset managers to manage the competing approaches and interests of both sets of investors.
Conclusion: Increased Enforcement Risks Will Spur Demand for Accurate and Thorough ESG-related Data throughout Supply Chain
As a result of financial regulatory activities in the US, EU and the UK, asset managers and financial intermediaries will likely increase the pressure on the companies in which they invest to disclose ESG data. For many companies with substantial supply chains around the globe, supply chain relationships contribute significantly to ESG impact, goals, and public claims. As a result, these companies will likely demand ESG data from vendors and others throughout their supply chain.
The focus on ESG data also will lead to greater enforcement risks as the SEC and other regulators increase scrutiny of the accuracy of ESG disclosures. All of the above regulatory changes will continue to elevate the importance of effective supply chain ESG-related assessments and robust responsible sourcing programs. Given that statements regarding ESG often take the form of public relations and marketing pieces, companies should be mindful not to oversell or overstate the facts regarding their ESG-related conduct, or fail to disclose any meaningful deterioration of ESG metrics they have previously chosen to adopt. Appropriate processes to vet and ensure the validity of ESG claims, as well as legal review of claims and public statements, are critical to mitigate regulatory risk.
The Baker & McKenzie Financial Regulation and Enforcement team recently addressed ESG-related financial regulatory and enforcement developments in a webinar (the video recording is available here; and transcript here). Baker McKenzie attorneys from the firm’s US and UK offices, Amy Greer, Caitlin McErlane, Jennifer Klass, Peter Chan, Julian Hui and Jonathan Hoffman, discussed the state of play in the US, EU and UK.
Baker McKenzie Partner Caitlin McErlane recently wrote an article, published in the Capco Institute’s Journal of Financial Transformation, on the EU’s ESG reform project.