Whether you’re a private firm, publicly listed company, or governmental institution, the road towards disclosing your organization’s Environmental, Social and Governance (ESG) risks, practices and impacts is rife with challenges. Apart from the immediate hurdles of determining which ESG issues are financially relevant and quantifying and disclosing their effects, securities issuers seeking to shore up their ESG credentials face the added burden of producing data that adheres to distinct ESG disclosure frameworks, yields favorable scores from competing ESG rating providers, and, of course, satisfies the expectations of their investors.
As one might expect, the inconsistently useful ESG data produced in this environment poses challenges for investors, too. Without data that is uniform in its relevance, accuracy, timeliness, consistency, completeness and auditability, ESG-focused investors have little capacity to confidently select sustainable investments, confirm the positive sustainability outcomes of those investments or assure their clients that those outcomes offer any legitimate financial advantage.
We need clear standards for ESG data and for clarifying what even qualifies as an ESG investment. To its credit, the U.S. Securities and Exchange Commission (SEC) is preparing to step in to bring transparency and credibility to ESG investments in the U.S., particularly as they relate to climate risk. But the devil is in the details. The SEC’s ultimate rules need to prioritize accuracy, environmental and bottom line impact, and “double materiality.”
First, while some may not like standards, they are absolutely necessary. To improve the relevance, or rather, the usefulness of ESG disclosures, some 76% of corporate finance leaders and 91% of investors recently surveyed by Ernst & Young (EY) say it would help for policymakers to step-in and develop consistent standards for measuring and communicating ESG performance in a manner that’s consistent with widely accepted standards in place for financial reporting. Without universal standards,there are too many potholes in the road towards producing decision-useful, investment-grade ESG data; too many opportunities for misrepresented ESG performance (either deliberate or unintentional) and, in turn, misguided investing.
Voluntary frameworks are beneficial but not sufficient. The International Sustainability Standards Board (ISSB), formed at COP26, is useful, as are the standards stock exchanges, industry organizations, and investor coalitions have put in place. Still, there’s mounting consensus that universal, comparable, and financially-relevant disclosures will require regulation—which roughly 75% of the largest respondents to the SEC’s 2021 request for comment on regulating ESG and climate-related disclosures say should be mandatory.
Drafting and implementing rules with regulatory force behind them is no easy task. Even in the EU, considered a global leader in regulating corporate sustainability claims and performance, the twice-delayed Sustainable Finance Disclosure Regulation (SFDR), has been years in the making. Yet getting it right is essential. First and foremost, getting it right means the SEC must direct its focus to the root cause of faulty ESG data: the failure of disclosing entities to accurately portray both the impact of ESG issues on their bottom lines and the efficacy of their management of those issues. Issuers required to make ESG disclosures not only need to know what to measure, but how to measure it and package it for disclosure.
In practice, for climate-related disclosures especially, the SEC must establish which ESG issues are relevant for public companies to disclose. This would require the SEC to deviate from its principles-based approach to issuer disclosures of climate risks, as reflected in its 2010 guidance. That approach offers little more than guidelines for issuers to consult when determining which climate risks are financially relevant enough to disclose. Instead, the SEC should offer guidance for collecting mandatory line-item disclosures that are financially relevant to companies and their investors, regardless of extenuating circumstances companies may claim. That way, SEC-mandated ESG disclosures would at least have a baseline level of comparability for investors.
The SEC rules, of course, must also track against the financial relevance; it needs to provide guidance to companies on what ESG performance data is relevant to the bottom line, and thus relevant to investors. Here, the SEC need not reinvent the wheel. They can rely on excellent private systems like the Sustainability Accounting Standards Board (SASB) (full disclosure: Benchmark Digital, my employer, is a member of this board.) Specifically, the SEC should require each issuer to perform and disclose their own, company-specific materiality assessment using SASB (or similar) industry definitions of material ESG issues.
Further, the SEC should mimic Brussels’ approach and incorporate the concept of “double materiality” in ESG disclosures. Double materiality, or the notion that ESG issues affect both the issuer’s financial value and the environment and society in general, gets at the spirit of ESG investing, not just the sheer dollars and cents. While this may be unlikely considering the mandate of the SEC within contemporary securities law, impact investors growing increasingly skeptical of ESG would welcome bifurcating the world’s impact on companies and companies’ impact on the world.
Come what may, issuers, their investors, and their respective stakeholders stand to benefit from greater government oversight of ESG in the U.S. financial system. The momentum in U.S. capital markets is moving in the right direction. A rapidly growing number of issuers are reporting ESG performance in alignment with voluntary disclosure frameworks as tens of billions flow into ESG funds every quarter.
Yet the SEC must make these investments more transparent. It must put in rules ensuring investments intended to help the environment actually do so. Most of all, it must put in place rules that are not so onerous as to kill the golden goose.
If all they demand is accuracy, relevance, and “double materiality,” they’ll meet the objective.
Hornsby is the Corporate Development and Strategy Officer at Benchmark Digital Partners.