U.S. Climate Change Disclosure Regulation is Inevitable, Here’s What To Do About It Now
V&E Counsel Sarah Fortt and Partner Margaret Peloso
By Sarah Fortt and Margaret Peloso
Over the past few weeks, there has been a flurry of SEC ESG-related developments. As we predicted, the current SEC acting chair has wasted no time in indicating that the SEC’s 2010 climate change disclosure guidance is beyond dated. On February 24, 2021, Acting Chair Allison Herren Lee directed the SEC Division of Corporation Finance to focus on climate-related disclosures and use their insights to begin updating the 2010 guidance. On March 2, a climate bill was introduced in the U.S. House of Representatives revealing the new administration’s climate change goals, including a goal to fully decarbonize the economy by 2050 and proposed amendments to the ’34 Act to require the SEC to promulgate regulations for specific climate disclosures. In addition, the press, in response to the nomination hearing of President Biden’s pick for SEC Chair, Gary Gensler, has begun to provide endless speculation about how, but not whether, Chair Gensler will prioritize ESG, with some of his statements suggesting that possible disclosure topics could include climate change and political contributions. On March 3, the SEC Division of Examinations announced that one of its 2021 examination priorities is climate and ESG-related risks, with the press release indicating that the Division will continue to review the compliance programs of registered investment advisers, including with respect to the offering of ESG-related investment strategies. And on March 4, the SEC announced the creation of a Climate and ESG Task Force in the Division of Enforcement, stating that “[t]he initial focus will be to identify any material gaps or misstatements in issuers’ disclosure of climate risks under existing rules,” and “evaluate and pursue tips, referrals, and whistleblower complaints on ESG-related issues, and provide expertise and insight to teams working on ESG-related matters across the Division.” While each of these developments comes packed with its own implications and potential outcomes for market participants, together they mean that the SEC is rapidly creating an internal ESG infrastructure, which ultimately points to one conclusion — ESG disclosure regulation cometh.
For those who are new to the ESG space, these developments are either exciting or terrifying, but for those of us who have been in the ESG space for years, these developments simply mark the arrival of the inevitable. Now that the world around us is catching up, the real question is not what will happen next, but what to do now to prepare for what will happen next. We have been writing and presenting on these topics for a long time, but here we summarize both the top five likely developments and the top five practical takeaways for how companies can prepare for what is about to happen — U.S. ESG disclosure regulation.
Top Five Likely ESG Developments in 2021 -2022
Beyond Voluntary. Although the current focus is on when there will be U.S. federal ESG disclosure regulation, the truth is that ESG disclosure has been becoming less voluntary for a long time. Ask any large U.S. public company that has savvy investors who also have investments in the EU, any large financial institution competing in the global market, or any company in the traditional energy space. Regardless of the form that the first iterations of U.S. federal ESG disclosure regulation take, the truth is that companies are going to continue to face expanding demands for increasingly sophisticated ESG disclosures, including disclosures regarding how companies influence and are influenced by climate change. While U.S. federal ESG disclosure regulation may set a new baseline for U.S. public companies, it will by no means set the ceiling, which will continue to rise. Furthermore, Acting Chair Lee’s guidance to the Division of Corporation Finance leaves plenty or room for the SEC to start examining voluntary climate disclosures as part of its assessment of gaps in current climate disclosure practice, and others have suggested that the SEC’s current accounting rules already require the incorporation of physical and transition risks into current company accounting. Therefore, enhanced attention to ESG issues at the SEC could start to have enforceable consequences long before any disclosure regulations are promulgated.
Beyond Paris. Increasingly, it is not and will not be enough for companies to simply agree to align with the Paris Agreement. While net zero commitments are all the rage right now, there are likely more than just a few companies that have published commitments without so much as an inkling of how they are going to achieve them, and therein lies the rub — investors’ and the public’s patience with planless pledges will only last for so long. In his widely discussed 2021 CEO letter, BlackRock CEO Larry Fink stated, “[g]iven how central the energy transition will be to every company’s growth prospects, we are asking companies to disclose a plan for how their business model will be compatible with a net zero economy – that is, one where global warming is limited to well below 2oC, consistent with a global aspiration of net zero greenhouse gas emissions by 2050. We are asking you to disclose how this plan is incorporated into your long-term strategy and reviewed by your board of directors.”
Beyond Equity. While much of the focus in the ESG space to date has been on public company equity investment, other forms of capital are racing to catch up. ESG debt issuances are on the rise, with 2021 predicted to be The Year for green bonds. Just recently, Toyota Motor Corp. announced it plans to sell as much as 500 billion yen (approximately US$4.7 billion) in ESG debt to fund smart technology developments. Capital providers are also under mounting pressure to reduce greenhouse gas emissions attributable to their operations and financings, which could permanently alter the ability of certain sectors to access capital absent specific low-carbon commitments. With four of the major U.S. banks having made commitments to net-zero financed emissions, climate policies are going to have a significant influence in shaping access to capital in the near future.
Beyond Energy. Without a doubt, the traditional energy industry has been a primary focus of calls for increased disclosure regarding climate change considerations because of the significant transition risks it faces. While the energy industry is going to continue to play a crucial role in the global climate change discussion, increasingly other sectors, including, but not limited to, food manufacturing and related services, finance, transportation, and mining will find themselves at the center of discussions regarding their contributions to greenhouse gas emissions and their roles in implementing changes necessary to mitigate global climate change effects.
Beyond E and S and G. Having ESG discussions that only address one aspect of ESG is becoming a thing of the past. For example, those of us who have been in the ESG space for a long time rarely talk about climate change risk mitigation efforts in isolation, we also talk about the social impact of sustainability and low-carbon commitments. Increasingly, companies will be expected to address complex risk scenarios that cover multiple ESG concepts. As we look towards the future of ESG, we can expect to see companies challenged on the consistency of their positions and disclosures, particularly if the SEC adopts multiple types of ESG disclosure regulation, including, for example, political contributions disclosures.
Top Five Practical Takeaways: What To Do Now
Organize your data. When companies reach out to us to help them identify and implement their optimal ESG strategy, the data conversation is one of the first conversations we have, but we also never stop having this conversation. Understanding how a company tracks and measures its strategic goals, risks and operations is crucial to understanding what it is already doing from an ESG perspective, what it can do, and what is off the table. What does this mean practically speaking? It means if you have not talked to your enterprise risk management team about how they identify and measure nonfinancial risks, the time to do so is upon you. It is also appropriate to have conversations with the company’s traditional compliance function and operations to understand what ESG efforts and information may already exist, and what can be done to gap fill, to the extent appropriate. We also always recommend remaining educated on key developments in the ESG space.
Talk to internal controls. An ESG strategy cannot move forward without a company understanding how information is verified internally. While there are doubtless companies that have published ESG statements and reports without verifying the contents to the same level they verify their financial disclosure, producing ESG disclosure in that manner now needs to be a thing of the past. To the extent that the SEC adopts ESG disclosure rules, those rules may ultimately require companies to build out internal disclosure controls to address topics that existing controls may or may not be equipped to handle. Understanding the capacity and capabilities of the company’s internal audit function and internal disclosure controls will be a key part of implementing any rules that are ultimately adopted.
Talk to your independent auditor and your internal accounting department. Climate change risks will eventually be seen as material to many companies’ financial reporting, and it is possible that any SEC climate change disclosure regulation will accelerate this reality. Understanding how your accounting department and independent auditor are equipped to consider the materiality of the impact of climate change risks on the company’s financial condition or operational performance will be necessary sooner or later — even if the first iteration of U.S. federal climate change disclosure regulation does not demand it, investor calls for integrated reporting continue to rise. This means that at some point, climate change risk may be considered per sematerial, at least for certain sectors, and companies will need to be equipped to either disclose or explain why they are special. This disclosure will likely require more than a statement of potential climate impacts as risk factors and may require notes to audited financials to explain what climate scenarios are addressed in a company’s accounting. This means it is essential that companies develop a clear-eyed view of what climate risk information is available to them and when it will likely need to influence their accounting and auditing practices.
Find your ESG lawyers. To date, consultants and public relations firms have been assisting many companies in creating their glossy sustainability reports, but when compliance with an actual regulation is required, or if the SEC begins to bring enforcement actions against companies that have failed to live up to their voluntary disclosures and commitments, experienced lawyers become a necessity. It is also important to hire an ESG group that has the experience to provide you with advice on all aspects of ESG, as the related concerns touch corporate governance, environmental, labor, data privacy, and more. While just about every law firm is scrambling to identify internal “ESG experts” to handle the growing client demand for ESG assistance, Vinson & Elkins’ (“V&E”) cross practice ESG group, in part because of our long history of advising energy companies, has been providing advice for years on developing sophisticated, but also very practical, ESG policies and disclosure. However, whether you are our client or not, we will simply note that it is important to investigate the credentials of any ESG lawyer you use, given the wide range of capabilities and experience in the space.
Compare what you’ve said to what you’re doing. Finally, it is a good time to review what you have already said and compare it to what you are doing (or are able to do in the future). As discussed briefly above, consistency, both with respect to disclosures made and positions taken, is going to become even more important with the adoption of any ESG disclosure regulation and the increased possibility of enforcement. Assuming that there will be increased transparency required with respect to all areas of ESG — will there be anything that could threaten your company’s relationships with its regulators or its investors, its access to capital, or its social license to operate? If so, it is probably time to have some honest conversations internally (and with counsel) about how to best position the company to take on whatever the SEC decides to dish out.
As a reminder, V&E’s ESG Taskforce is a uniquely cross-functional team dedicated to helping companies proactively understand, manage, and, where appropriate, disclose their ESG risks and opportunities. Covering a broad range of topics and issues, including climate change, clean and sustainable energy, human rights, cybersecurity, and investor relations, the ESG Taskforce draws upon significant capabilities in our governance, environmental, and labor and employment teams. Below are a selection of the ESG Taskforce’s recent thought pieces and presentations on ESG developments and trends.
The ESG GC: How Your Role as Chief Legal Officer is Integral To Your Company’s ESG Efforts
The EIC and Midstream Energy Companies Embrace Standardized ESG Reporting
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