By: John Ward
I. Abstract
This blog post provides an overview of the debate around the current state of ESG, ESG disclosure practices, and the perceived need for the SEC to establish a system of mandatory ESG disclosures. This overview will explore the problematic nature of quantifying ESG and the tools to establish market ratings. Finally, exploring the ESG moving effect on businesses predominately operating in energy & natural resources. Additionally, this blog post will address the inconsistencies of ESG self-reporting, the influence it has had on the market, the potential investor, and the board of directors tasked with implementing these “environmentally friendly” regulations. This blog post will also touch on general market efficiency and U.S. capital market competitiveness and ultimately explore the next steps this regulation needs to take to operate effectively in a marketplace still predominately controlled by oil and gas.
Corporations have received growing criticism for contributing to climate change and failing to address environmental and social issues that persist in society. However, this change and need for efficacy in the marketplace must be done selectively and with the proper requirements if any real change is going to be implemented.
The flow of assets into ESG is one of the most dramatic trends in asset management in recent market history. However, the question remains as to whether this regulation is affecting any actual change that supports the purpose of the regulation or is hindering business production while only positively benefiting the environment “on paper.”
II. ESG – Environmental and Social Governance
ESG stands for Environmental and Social Governance, and its core pertains to the governance of publicly traded companies in addressing their impact on the environment and social systemic issues.[1] The idea of ESG has evolved into a way for ‘forward-thinking’ investors to invest in sustainable companies doing right by society and the environment—or so they think. Investopedia defines ESG as a set of criteria that a company’s operations must follow to maintain a socially conscious business model for investors.[2]
ESG factors cover a wide spectrum of criteria that have, until recently, not been considered in financial models, relevance, or analysis. How companies deal with climate change and carbon offset, water management and waste, and supply chains and outsourced labor, are all taken into consideration from the prospective of the investor and the board room.[3] The term ESG was first coined in 2005, and its rapid growth and initiative taken up by the Securities and Exchange Commission is part of a socially responsible investment movement to ensure everyone is taking a closer look at the impact companies are having on our environment.[4] In 2018, the ESG investor space was valued at over $20 trillion in assets under management (AUM); today, that number is estimated to have surpassed $41 trillion in AUM.[5] This growing interest in ESG not only takes place between fund managers and investors, but regulators have also begun to heighten the scrutiny and standard that companies must hold themselves to in order to be considered ESG assets. In the summer of 2022, the SEC proposed enhanced disclosure requirements by certain investment advisers and companies about ESG practices.[6]
III. Disclosure Under “E”
In 2016, the Paris Agreement established a framework designed to enhance the disclosure requirements required of companies to combat the negative effects of “climate change.”[7] The crux of the plan was to ensure that companies were deemed to be “up to par” in terms of nationally determined contributions (NDC).[8] In June 2017, the Trump Administration was in talks of withdrawing from the Paris Agreement; surprisingly, many titans of the Oil and Gas industry were against the withdrawal—stating in opposition, “the agreement provides for greater clarity on policy direction, enabling better long-term planning and investment.”[9] Since then, the Oil and Gas industry has taken the initiative as an industry to comply with the overall goal of limiting temperature rise to less than 2 degrees Celsius.[10]This stance by the industry is not only effective from an environmental standpoint, but also serves as a viable strategic move for the industry in an attempt to avoid being the “fall-guy” for the negative effects that greenhouse emissions have on the climate.
However, the issue with environmental disclosure under ESG is not the disclosure itself but the inconsistencies with the sustainability standards. There are at least 230 corporate sustainability standards initiatives in more than 80 sectors of business.[11] Thus, the information that oil and gas companies have been willing to disclose is limited in application.[12]Oftentimes, the environmental disclosure that is taking place across industries reflects insignificant public relations and carbon offsetting rather than details of emissions and countermeasures.[13] As a result, contradictory disclosure standards leave oil and gas companies in a delicate position. Many industry leaders may be subject to the threat of litigation due to inaccurate disclosure of information that would not otherwise need to be disclosed by SEC rules.
IV. SEC v. Vale S.A.
In Summer 2022, the SEC brought its first major ESG enforcement action: SEC v. Vale S.A.[14] Vale is a Brazilian based corporation known for being one of the world’s largest producers of iron ore in the world.[15] The SEC charged Vale with securities fraud in relation to ESG disclosures.[16] Specifically, Vale allegedly made false claims about the safety of its dam prior to its collapse.[17] According to the SEC’s complaint, Vale manipulated dam safety audits, obtained numerous fraudulent stability certificates; and regularly misled local governments, communities, and investors through their ESG disclosures.[18] The SEC’s complaints algo alleges that for years, Vale was aware of toxic byproducts from mining operations that did not suffice internationally recognized standards.[19] However, Vale’s ESG reports assured investors that the company adhered to the “strictest international practices” in evaluating dam safety and condition.[20] Director of SEC’s Division of Enforcement, Gubir S. Grewal, said that many investors rely on ESG disclosures to make informed investment decisions.[21] By allegedly manipulating those disclosures, Vale compounded the social and environmental harm to the community and undermined investor’s ability to evaluate the risk posed by Vale’s securities.[22] This enforcement action by the SEC is pivotal to shed light on the future of ESG disclosure, as well as the future of enforcement actions that the government now has at their disposal.
V. How Companies can Go Forward
In the wake of litigation, the Securities and Exchange Commission released two proposals aimed at combatting “greenwashing.”[23] These proposals would raise the bar for the disclosure requirements of those who makes ESG investment related decisions and accreditations. The proposed rules would require public companies to provide detailed information about potential financial risk related to climate change and greenhouse gas production. Such a disclosure requirement would likely prevent or significantly hinder the possibility of exposing investors to another “Vale S.A” risk tolerance. If adopted, the proposed rules, among other things, would (1) revise Form ADV[24] to improve disclosures by investment advisers purporting to take ESG factors into consideration and (2) update the rule reflecting that the names of ESG-marketed registered funds accurately reflect the risk and focuses of that investment vehicle.
Going forward, as investment demand in ESG grows, investment advisers that incorporate ESG factors into their investment strategies and practices should be well-advised to review the accuracy of their ESG-related disclosures and ensure that their compliance policies and procedures are consistent with their disclosures and the disclosures of the company represented by the fund or investment vehicle. Public companies—especially those dealing with oil and gas or raw materials—should anticipate more rigorous engagement from their ESG focused investors and regulators. The SEC’s scrutiny will not be limited to investment funds going forward; instead, it will have a similar effect to that which was shown in the Vale litigation. More will be required and expected from companies who are making representations to the public, regulators, and investors about the status of their environmental sustainability reports. Public companies and investment funds alike are best suited to approach the future of ESG disclosure from a proactive approach in order to get out of such issues capable of causing reputational damage as well as both legal and regulatory provocation.
[1] James Chen & Gordon Scott, Environmental, Social, and Governance Criteria, investopedia,https://www.investopedia.com/terms/e/environmental-social-and-governance-esg-criteria.asp [https://perma.cc/UU76-QEVY] (last updated Sept. 27, 2022).
[2] Id.
[3] Georg Kell, The Remarkable Rise of ESG, Forbes, (Jul. 11, 2018), https://www.forbes.com/sites/georgkell/2018/07/11/the-remarkable-rise-of-esg/?sh=576c49931695 [https://perma.cc/EC8G-FAB7].
[4] Id.
[5] Id.; Adeline Diab, ESG May Surpass $41 Trillion Assets in 2022, But Not Without Challenges, Finds Bloomberg Intelligence, bloomberg, (Jan. 24, 2022) https://www.bloomberg.com/company/press/esg-may-surpass-41-trillion-assets-in-2022-but-not-without-challenges-finds-bloomberg-intelligence/ [https://perma.cc/RYU5-CULA].
[6] SEC Proposes Additional Disclosures by Certain Investment Advisers and Funds about ESG Investment Practices, Dechert (June 1, 2022), https://www.dechert.com/knowledge/onpoint/2022/6/sec-proposes-additional-disclosures-by-certain-investment-advise.html [https://perma.cc/WH9J-R2G9].
[7] Gokce Mete, Transition of Global Governance of Energy and Extractive Sectors; Proliferation of Transparency & Accountability, OGEL (2018), https://www.ogel.org/article.asp?key=3765 [https://perma.cc/W4BC-VL5W].
[8] Id. (A NDC is a climate action plan to cut emissions and adapt to climate impacts. NDCs are measured on a country-by-country basis of those countries involved in the Paris Agreement. These contribution efforts are aimed predominately at reducing the amount of greenhouse gas emissions produced by participating countries.).
[9] Paul Rissman & Diana Kearney, Rise of the Shadow ESG Regulators: Investment Advisors, Sustainability Accounting, and Their Effects on Corporate Social Responsibility, 49 Env’t L. Rep. New & Analysis 10155, 10159 n.38 (2019).
[10] Id.
[11] Chris Gaetano, As Sustainability Frameworks Multiply, Navigating Them Becomes a Concern, NYSSCPA (Jul. 16, 2019), https://www.nysscpa.org/news/publications/the-trusted-professional/article/as-sustainability-frameworks-multiply-navigating-them-becomes-a-concern-071619 [https://perma.cc/3CDQ-ALEU].
[12] See Susan N. Gray, Best Interests in the Long Term: Fiduciary Duties and ESG Integration, 90 U. Colo. L. Rev. 733, 734 (2019).
[13] See Andy Green, Making Capital Markets Work for Workers, Investors, and the Public ESG Disclosure and Corporate Long-Termism, 69 Case W. Rsrv. L. Rev. 909,919 (2019).
[14] S.E.C. v. Vale S.A., E.D. N.Y., Civil Action No. 22-cv-2405, (Filed 04/28/22) https://www.sec.gov/news/press-release/2022-72[https://perma.cc/L6FZ-FH7R].
[15] Id.
[16] Id.
[17] Id. (The collapse killed 270 people and caused immeasurable environmental and social harm leading to a loss of more than $4 billion in market capitalization).
[18] Id.
[19] Id.
[20] Id.
[21] Id.
[22] Id.
[23] Commissioner Hester M Pierce, Statement on Environmental, Social and Governance Disclosures for Investment Advisers and Investment Companies, U.S. Sec. and Exch. Comm’n, (May 25, 2022) https://www.sec.gov/news/statement/peirce-statement-esg-052522 [https://perma.cc/7BJW-QT2J ] (Greenwashing is misleading claims by investment funds and their investment advisers regarding their ESG credentials.).
[24] U.S. Securities and Exchange Commission, Form ADV, investor.org https://www.investor.gov/introduction-investing/investing-basics/glossary/form-adv [https://perma.cc/F5VJ-VCMU] (Form ADV is the uniform form used by investment advisers to register with both the SEC and state securities authorities. The form consists of two parts, both of which are available to the public on the SEC’s Investment Adviser Public Disclosure (IADP)).