Environmental, social and governance (ESG) investment-financial assets that meet certain minimum social and environmental standards are expected to reach $ 50 trillion by 2025. Although this implies a significant redistribution of capital towards sustainable activities, the amount of ESG investment advance climate change is unclear because of the lack of standardization in their classification. The explosive growth of ESG investments over the past two decades has taken place in the context of a loose regulatory system for sustainability. Corporate managers were free to choose what to publish and in what format, resulting in a hodgepodge of voluntary disclosure values. The result is ESG data that is incomplete, unreliable and difficult to compare across the firm.
For years after Greenwashing’s allegations, the United States and the EU seem to be at the forefront of formalizing sustainability disclosure with the adoption of new disclosure laws in the last two years. In April 2021, the EU issued a Corporate Sustainability Reporting Guide (CSRD) that mandated strict disclosure standards to increase the coverage and reliability of sustainability reports. The CSRD, which will take effect in 2023, will improve the existing Non-Financial Disclosure Act by providing clearer and more streamlined reporting standards.
The US Securities and Exchange Commission (SEC) has also reversed its long-standing reluctance to control ESG disclosure. In March 2022, the SEC took a major step by proposing a new set of rules on climate-related disclosures to provide more transparency for investors. The proposed law would amend SEC regulations to require corporations to disclose exposure to their climate-related risks and the implications of their financial metrics. The SEC’s proposal, which is now open to the public for comment, will have a phased date that varies according to the size of the company, the first of which will be FY 2023.
The new law would significantly expand the scope of greenhouse gas (GHG) reporting in the United States, which is currently required only from extremely heavy emissions. Although 90 percent of S&P 500 companies voluntarily disclose some ESG data, analysis by the SEC reveals that only one-third of public companies cite climate change in their filings. The law would force public companies to take climate-related risks seriously and integrate them with their governance and management strategies. The use of mandatory standards will also reduce the problem of election reporting and green washing, thus significantly improving the comparison and reliability of climate-related ESG data.
Ideally, corporate reporting on global issues such as climate change should be guided by a globally integrated disclosure system. In the absence of such a system, values such as the ISSB could serve as a backstop for bridging the rules of diversified expression across countries and regions.
While these are positive developments, the lack of common sustainability disclosure criteria between the United States and the EU could hamper trade and investment flows across the Atlantic and hinder the spread of global sustainability. To better understand these risks, it is helpful to compare the key features of these two emerging sustainability regimes.
Disclosure Rules: US vs. EU
1 chance.
The law proposed by the SEC is very specific and comprehensive in terms of climate-related disclosures. However, its scope is narrower than that of the EU’s CSRD, which is expected to provide a broad range of values across multiple environmental, social and administrative domains. The SEC has future plans to create a disclosure law for human capital, but it is unlikely to extend to other ESG domains. In terms of coverage, EU law would require disclosure between 49,000 medium and large companies, covering all private and public companies, including at least 500 employees. The SEC rule, however, will make disclosure mandatory only among public companies that sell securities, which could create an unequal playing field with private companies. Most of the 6,933 companies that submitted their annual reports in 10-K forms in 2021 will be covered by the new regulations.
2. Disclosure policy.
Implementing the EU’s CSRD so-called “dual materialism” policy, companies are required to disclose information that is relevant to investors as well as other social stakeholders and the environment. The proposed SEC rules, on the other hand, are based on the “single material” principle, as it emphasizes investor-centered risk regulation and financial materiality. In light of the SEC’s narrow mandate to protect investors, the proposed legislation does not intend to advance green transformation, as does the EU’s disclosure law. Instead, it was created as a way to help investors make better decisions about corporate “climate-related risk exposure and management, and special conversion risk.”
The proposed rule thus avoids (politically controversial) questions about whether climate change is real and how companies contribute to it. It treats climate-related physical and migration risks just like any other business risk that is covered by existing disclosure laws. The use of the concept of potential risk also reduces the burden of proof on climate science: unless climate risk can be sufficient material for investors, it falls under the purview of the SEC’s regulatory authority.
The response to the SEC’s new rules has been mixed, with technology companies like Apple and asset managers like BlackRock supporting it while businesses in the energy and transportation sectors oppose it. Despite its reliance on narrow material policy, the SEC may still face legal challenges for overstepping its statutory rule-making authority and demanding more information than materially relevant. The proposed legislation could garner widespread and mixed reactions from industry associations and politicians, leading to a sanitation process that could water down key components during the final amendment.
3. Hardness of expression.
The requirement for disclosure in the EU’s CSRD is somewhat stricter than the proposed SEC legislation. Although the United States rejoined the Paris Agreement under President Biden, it lacked a national climate change strategy mandated by Congress. On the other hand, the European Union has adopted European climate law and is legally committed to meeting the goals of the Paris Agreement. Due to the lack of a similar, legally binding national law, the SEC has adopted a narrow, investor-centered concept of materialism, which also limits the rigidity of the proposed rules. For example, the proposed EU standard requires companies to align their activities with the goal of limiting global warming to 1.5 degrees Celsius in the Paris Agreement. In contrast, the SEC’s proposed legislation does not go far enough to require the disclosure of corporate risk strategies under a spectrum of predictable future climatic conditions.
An important part of the proposed SEC rules is the expression of GHG emissions from direct power consumption (Scope 1) and purchased electricity or heat (Scope 2). Disclosure of emissions from price chain activity (Scope 3) is required only if companies have Scope 3 emissions reduction targets or if emissions are considered component. Requirements for disclosure include quantitative information, as well as qualitative information in the form of descriptive discussions on the impact of climate risk on strategies, business models and future prospects. Quantitative disclosure is required for “expected losses” from physical and transfer risks equivalent to at least one percent of the value of the critical financial metrics in a given year. Given the wide range of climate risks – from extreme weather events to regulatory changes – these guidelines leave much room for interpretation.
4. The value of expression.
Interestingly, both EU and US regulators have chosen to create their own disclosure guidelines and standards, apparently to overcome the lack of comparison between third party standards that are currently in use. The SEC’s disclosure guidelines draw heavily on the task force on climate-related financial disclosure criteria, which is widely used around the world. This seems to be aimed at facilitating a smooth transition to the new publishing system, with reasonably high exposure comparisons across borders. The European Financial Reporting Advisory Group, tasked with developing the EU’s disclosure standard, is also developing the Global Reporting Initiative, currently the most widely used third-party reporting standard worldwide. The reliance of EU and US regulators on existing, well-recognized standards for creating mandatory standards could create a level of balance between the two disclosure systems. However, EU regulatory standards will be more complex, covering at least five major domains (climate change, water and ecosystems, workers and communities, value chains and corporate governance). It will also include sector-specific metrics, setting up different disclosure rules for less than 40 industries. These huge differences in scope will inevitably lead to considerable gaps in the comparability and consistency of expression from the two regimes.
5. Assurance.
The SEC’s proposed rules require large companies to provide attestation reports by independent verifiers for their scope 1 and 2 emissions. There is a grace period of one to three years for providing “limited” guarantees, followed by stricter “reasonable guarantees”, as well as a period that varies between large and small companies. The EU’s proposed directive similarly requires companies to receive “limited” assurances from third-party auditors within three years of the implementation of the directive, with the possibility of moving on to “reasonable” assurances at a later stage, including indefinite plans.
Bridging the transatlantic divide
Given the lack of direct comparisons between the publishing standards of the United States and the European Union, friction in the transatlantic flow of trade and investment is probably inevitable. An example is the EU’s proposed Carbon Border Adjustment Mechanism, which would impose carbon tariffs on imports of carbon-intensive products from countries without a carbon tax. Conflicts over jurisdiction are also inevitable, as European entities with subsidiaries in the United States and American entities with subsidiaries in the European Union are bound to adhere to two different standards.
Apparently fortunately, a global third-party standard for sustainable reporting is emerging at the same time. In November 2021, the International Financial Reporting Standards (IFRS) Foundation, which governs IFRS accounting standards, established the International Sustainability Standards Board (ISSB) to create an integrated set of Sustainability Standards. The ISSB has made significant progress in developing this standard, which seems to be close to the spirit of the SEC’s investor-centric regulations. These standards, which were approved by the G-7 and G-20, could serve as a way to resolve potential EU-US disputes in the face of competitive disclosures, such as in the case of American corporations operating in the EU and vice versa.
Ideally, corporate reporting on global issues such as climate change should be guided by a globally integrated disclosure system. In the absence of such a system, values such as the ISSB could serve as a backstop for bridging the rules of diversified expression across countries and regions.