New and Impending ESG Disclosure Regulations, and Why They Matter
Over the past decade, the number of investment managers creating ESG funds and companies publishing ESG reports has grown exponentially. One in every three dollars of total U.S. assets under management now has a sustainability focus. With this growth has come added scrutiny of the ESG space. “Greenwashing”, the dubious practice of an organization making false claims that a product or service is environmentally friendly, often finds its way into the news. How can consumers and investors differentiate between a green “tall tale” and reliable information? Without standardized definitions, disclosures, reporting and oversight, the answer remains elusive.
The Case for Oversight
Corporations, investors, and consumers are calling for increased regulation of ESG disclosures. Several voluntary frameworks have been developed to provide guidance for sustainability disclosures. Some of the most widely adopted frameworks include the Global Reporting Initiative (GRI), the Task Force on Climate-related Financial Disclosures (TCFD), the Sustainability Accounting Standards Board (SASB), and Carbon Disclosure Project (CDP).
These frameworks, however, fall short in a number of ways. For example, there are issues concerning the relative weight of various ESG factors. Some focus on Environmental issues, while others emphasize Social and Governance aspects. The discrepancies between frameworks often lead to inconsistencies and inefficiencies. For companies, it’s expensive and onerous to align their reports with multiple frameworks. For investors, it’s nearly impossible to compare and evaluate company disclosures across different frameworks.
These challenges might support the claim that there is greater need for some level of governmental regulation. However, national and global regulators have struggled to keep up with the fast-moving ESG industry.
New Existing and Impending Regulations in the EU
The EU has been a leader in sustainability disclosure mandates. In recent years, the EU has implemented several initiatives, including the Sustainable Finance Disclosure Regulation (SFDR) and the EU Taxonomy.
Effective March 2021, the SFDR requires sustainability related disclosures for financial market participants as well as the obligation to disclose adverse impacts on sustainability factors at both the entity and product level.
The EU Taxonomy is a classification system that seeks to define which economic activities are ‘sustainable’. Under this regulation, firms will be mandated to disclose alignment with the taxonomy, with some starting this year.
Both initiatives intend to promote sustainable investment, help companies become more sustainability-focused, and protect investors from greenwashing.
In 2014, the EU launched the Non-Financial Reporting Directive (NFRD). For public companies with more than 500 employees, this law mandates that certain ESG information be disclosed as part of a company’s annual public reporting obligations. In April 2021, the Commission adopted a proposal for a Corporate Sustainability Reporting Directive (CSRD), which would build on the NFRD, requiring an audit of the reported information, extending the directive to large private companies, and aligning the report with EU sustainability reporting standards.
Impending Regulations in the United States
In the U.S., federally mandated sustainability disclosure requirements are further behind. However, the Biden administration made it clear that climate and ESG-related risk disclosure is a top priority. In March 2022, the SEC proposed rule changes that would enhance and standardize climate-related disclosures. The proposed rule changes would require disclosure of:
How a company is addressing climate-related risks, including risk management processes
How climate-related risks have had or are likely to have a material impact on its business and consolidated financial statements
How climate-related risks have affected or are likely to affect the company’s strategy, business model and outlook
The impact of climate-related events and transition activities on the line items of a company’s consolidated financial statements, as well as on the financial estimates and assumptions used in the financial statements
Additionally, the proposed changes would require companies to disclose greenhouse gas (GHG) emissions.
Are Global Sustainability Standards Coming?
Other countries around the world are also implementing or strengthening ESG regulations. According to a late 2021 study, nearly 30 countries have mandated ESG disclosures. As more regions move towards ESG mandates and oversight, it will be important for regulations to be based on standardized frameworks and definitions. Is a global framework possible?
The IFRS Foundation is currently working on one. The IFRS Foundation is the governing body of the International Accounting Standards Board, which sets the accounting rules for financial statements of public companies used by most countries. At the end of 2021, the IFRS Foundation announced the creation of the International Sustainability Standards Board (ISSB).
The goal of the ISSB is to “deliver a comprehensive global baseline of sustainability-related disclosure standards that provide investors and other capital market participants with information about companies’ sustainability-related risks and opportunities to help them make informed decisions.” The board is currently soliciting feedback from TCFD and other existing frameworks to build the foundation of its standards. Once developed, it will be up to countries to decide whether to require companies in their jurisdictions to adopt these standards.
How Companies Can Prepare
It’s important for companies to take these impending regulations seriously. To prepare for the impending regulations, companies can:
Be aware and follow the news of impending regulation changes; educate your organization
Review the SEC’s proposed rule; begin to collect and document the requested climate risk disclosures, as they may soon be required for inclusion in annual filings
Look for developments from the International Sustainability Standards Board (ISSB) and country adoption
Regulation and oversight of sustainability disclosure standards will help combat greenwashing, reduce reporting inefficiencies and, we can hope, foster a more sustainable economy and environment.
If your company would like guidance on ESG standards and reporting, help is a click away. Drop a note to The Global Imprint and we’ll be delighted to help.