John Coates, the Acting Director of the Division of Corporation Finance of the Securities and Exchange Commission (SEC), issued a public statement entitled “ESG Disclosure – Keeping Pace with Developments Affecting Investors, Public Companies and the Capital Markets” in connection with the 33rd Annual Tulane Corporate Law Institute.
In his March 11, 2021 remarks, Mr. Coates noted the growing importance of Environmental, Social, and Governance (ESG) issues to investors, public companies, and capital markets and the rapid pace of ESG developments.
Mr. Coates began his remarks by noting the increasing demand for ESG disclosures by investors and the role ESG plays in investor decision-making. He also discussed some of the challenges in evaluating ESG disclosures, highlighting the fact that such disclosures are highly individualized and that a “one-size-fits-all” framework may not effectively measure ESG for everyone.
The remarks then focused on four issues at the forefront of the debate around ESG disclosures: how to create an ESG disclosure system, the pitfalls of not having an ESG disclosure system, mandatory vs. voluntary ESG disclosures, and the benefits of a standard global ESG disclosure framework.
We briefly discuss each of these issues below.
Considerations for an Effective ESG Disclosure System
Mr. Coates emphasized that a truly effective disclosure system is one with flexible standards to accommodate developments in the ESG space. He then outlined some of the questions the SEC will grapple with as they develop a framework for ESG disclosures, including:
- What disclosures are most useful?
- What is the right balance between principles and metrics?
- How much standardization can be achieved across industries?
- How and when should standards evolve?
- What is the best way to verify or provide assurance about disclosures?
- Where and how should disclosures be globally comparable?
- Where and how can disclosures be aligned with information companies already use to make decisions?
These questions, along with others, will drive the SEC’s discussions about ESG going forward.
Costs of No ESG Disclosure Requirements
Next, Mr. Coates discussed some of the concerns associated with an ESG disclosure system—in particular highlighting the costs of measuring and preparing such disclosures as an issue raised by critics. While Mr. Coates acknowledged that there may be financial costs associated with preparing ESG disclosures, he emphasized what is, in his view, a larger cost—that is, the cost of not having an ESG disclosure framework at all. In his view, a lack of ESG data may drive a reduction in market support as investors struggle to find the information they need to make informed investment decisions. Moreover, while the costs of compiling ESG data and disclosures may be particularly onerous to smaller reporting companies, they are less likely to be able to absorb higher costs of capital.
Mandatory vs. Voluntary Disclosure
In addition to the content of ESG disclosures, Mr. Coates touched on the debates surrounding mandatory as opposed to voluntary ESG reporting. While not disclosing a preference of one system over the other, Mr. Coates noted the range of approaches the SEC currently takes with respect to reporting: mandatory disclosures, mandatory disclosures subject to materiality thresholds, and “comply or explain” disclosures, which give public companies the option to explain why they do not disclose certain information.
Given the nuanced approach the SEC currently takes to its disclosure regime, it should come as no surprise that Mr. Coates expects any ESG disclosure framework to be equally nuanced.
The Virtues of Achieving a Single Global ESG Reporting Framework
Finally, Mr. Coates emphasized that, as ESG risks are global, so should be the solutions. One reason for this approach is efficiency—multiple regulatory frameworks addressing the same ESG issues would be redundant. But with a truly global ESG framework comes a number of considerations: adequate funding to implement such a framework, staffing of truly independent experts to develop the framework, and ensuring adequate transparency of the process to create the framework, among others.
What’s Next for ESG Disclosure?
While the statement includes the standard disclaimer that it reflects Mr. Coates’ own views and not the views of the SEC, his remarks were well-aligned with other recent public statements coming from the SEC’s Divisions of Corporation Finance, Examinations, and Enforcement and from the Acting Chair of the SEC and other SEC Commissioner. For example, the statement from Commissioners Hester M. Peirce and Elad L. Roisman on climate change disclosure, the Acting Chair Allison Herren Lee’s direction to the Division of Corporation Finance to review climate-related disclosure and begin a process for enhanced climate change disclosure, the formation of a Climate and ESG Task Force in the Division of Enforcement, the Division of Examinations focus on climate-related risks as a keystone of its 2021 enforcement priorities, the appointment of Satyam Khanna in the new role of Senior Policy Advisor for Climate and ESG, and the investor alert on ESG funds from the SEC’s Office of Investor Education and Advocacy.
From these activities, we can conclude that ESG disclosure will become a regulatory reality for public companies, whether by enforcement, guidance, or rulemaking or most likely, a combination of the three. Implicit within the volume of these announcements over the last several months is the SEC’s sense of urgency on ESG-related regulatory actions. For public companies, this regulatory reality will be coming very soon.
The SEC has often said that disclosure of complex, uncertain, and evolving risks should allow investors to see the company through the eyes of management. Mr. Coates’ remarks should be a call to action to management to carefully survey the landscape of business risk for ESG-related risks, including climate change-related risk in particular.
A critical first step to be prepared for what comes next from the SEC is to explicitly identify and internally articulate the ESG-related issues impacting the business. The second step is assessing these risks for materiality to the business—an important topic Mr. Coates did not address in his remarks. For public companies with robust ESG engagement with institutional investors, some of what is considered material has already been defined by the needs and interests of those investors. Even for companies that are relatively advanced on their ESG journey, now is the right time to assess which ESG topics are now, or are likely in the future to become, material. All companies should include climate change impacts as an area deserving special scrutiny for materiality.
Over the last several years, institutional investors have been telling public companies that it is not enough to manage ESG-related risks without disclosure. In the absence of robust disclosures, investors have increasingly concluded that companies are not adequately managing ESG-related risks. The SEC seems to have come to the same conclusion and is now on a clear path toward development of ESG-related disclosure.