Modernizing ESG and Climate Risk Disclosure

On November 3, timed to coincide with the United Nation’s COP26 climate summit in Glasgow, the IFRS Foundation announced prototype global reporting standards for corporate climate and sustainability disclosures, and the formation of the International Sustainability Standards Board (ISSB) to further develop them.  It also announced that it would consolidate under the ISSB two leading sources of climate disclosure guidance, the Climate Disclosure Standards Board (CDSB) and the Value Reporting Foundation. (Earlier in 2021 the VRF had already brought together two other highly influential standard-setters — the Sustainability Accounting Standards Board (SASB) and the International Integrated Reporting Council).

These important steps come at a time when the future of ESG disclosure reform in the United States is at a crossroads. In March of this year, the SEC invited public comment on the need for climate change disclosure reform and the approach the SEC should take. Over the past year, the SEC has also made clear that it is working on potentially mandatory climate disclosure rules that may be proposed by the end of 2021 and has announced that it is working on amendments to the rules on “human capital” (i.e. workforce-related) disclosure and considering rules on board diversity and cybersecurity risk. If adopted, the new rules would be the first significant step in over a decade to changing how companies report environmental, social, and governance (“ESG”) information to investors. The Commodity Futures Trading Commission, the Financial Stability Board, and the House of Representatives have already concluded that climate risk poses a systemic threat to the financial system.

In a forthcoming article, I present a roadmap for modernizing the rules governing corporate ESG disclosure that can help the SEC align with these emerging international standards.  This article is the first to identify how the current reporting rules under Regulation S-K of the ‘34 Act should be amended in order to leverage the reporting guidance of the Task Force on Climate-Related Financial Disclosures (TCFD) and the SASB/Value Reporting Foundation disclosure standards, which are a basis of the newly released ISSB prototypes. The article also clarifies the primary rationales for mandatory ESG disclosure and explains the extent to which these goals justify or may go beyond the SEC’s current statutory authority.

The article’s core proposals focus on ESG information that the SEC has already identified for proposed rulemaking and that are within the scope of its current regulatory authority — human capital, climate-related financial risk, and related corporate governance information. The article also considers how the SEC could extend the same approach to other ESG information.

In each area, the article identifies specific amendments to integrate these widely accepted international standards for climate-related and other ESG risk disclosures into Items 101, 105, 303, 307, 402, and 407 of Regulation S-K. The article also addresses the key threshold choices the SEC must confront in crafting a new approach to ESG disclosure:

  • Approach & Scope – the “What” of ESG Reporting:
    • Reporting should follow a tiered approach, consistent with existing international frameworks. Core ESG factors that are expected to be material across all sectors should be mandatory for all reporting companies; additional ESG factors should also be required for specific industries, based on existing frameworks that align with the definition of materiality under the federal securities laws.
    • Because the main goal of ESG disclosure reform is to improve its comparability, consistency, and reliability, the SEC should take a primarily prescriptive approach to ESG reporting rules.
    • Where greater flexibility is needed, for example, with respect to ESG risk mitigation or climate risk scenario analysis, new requirements proposed in the article should apply on a comply-or-explain basis.
  • The “Where” and “When” of ESG Reporting:
    • Climate and other ESG disclosures should be incorporated into the annual report and proxy statements, since more frequent periodic reporting will not be feasible for most ESG factors.
    • The SEC should also consider amending Regulation S-K to allow material risk factors under Item 105 and long-term environmental and climate-related trends and uncertainties in the MD&A to be reported annually, rather than quarterly.
  • Phased Implementation: The proposed rules should be phased in over a three-year period for “emerging growth companies” and “smaller reporting companies.”
  • Harmonization: The reporting framework under Regulation S-K should be aligned with internationally accepted ESG reporting standards, namely the TCFD Guidance and the SASB/Value Reporting Foundation standards, and should facilitate harmonization with the forthcoming ISSB global reporting framework.
  • Substantiation: Under its existing statutory authority, the SEC should not be required to meet a particularized materiality standard in order to justify introducing the rules proposed here. Attempting to do so would ignore the purpose of the reforms, which is to respond to hidden ESG risk in the financial system and encourage better reporting of material forward-looking and risk-related information.

In making the case for mandatory ESG disclosure, my article explains its diverse rationales and responds to the primary objections that may be raised against it.

Finally, the article goes beyond proposals that have been made in legislation to date and identifies steps that Congress could take to confirm that the SEC has full authority to adopt ESG disclosure reforms that are needed immediately to respond to climate-related financial risk.  It also outlines more ambitious proposals that Congress could also take to require companies to report on their environmental impacts as part of a national climate response, to extend some form of ESG disclosure mandate to large private companies, or to allow sustainability information to be integrated across the financial system.

If adopted, disclosure mandates along these lines would enable markets to more accurately price ESG risk and could direct capital to more sustainable uses. In addition to giving investors the information they need for investment analysis, investors’ ability to more reliably compare companies’ ESG performance with industry peers could indirectly encourage companies to reduce their carbon footprint, improve ESG risk management practices, and better prepare for a post-carbon transition.

This post comes to us from Virginia Harper Ho, Earl B. Shurtz Research Professor at the University of Kansas School of Law. It is based on her recent article, “Modernizing ESG Disclosure,” forthcoming in the University of Illinois Law Review and available here.

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