The United States is in the process of transitioning ESG disclosure from voluntary, market-led reporting to a regulatory-driven scheme, principally led by the US Securities and Exchange Commission’s (SEC) anticipated (but delayed) disclosure requirements for public companies and investment advisers/companies, as well as evolving and divergent state legislation primarily aimed at those managing state assets.
This article recaps and provides an update for certain of the SEC’s proposed rule-makings and Congressional actions, as well as outlining the varying (and politicized) approaches adopted by state legislatures or administrative bodies to either restrict or encourage ESG measures.
Proposal to Enhance and Standardize Climate-Related Disclosures for Investors
On March 21, 2022, the SEC announced a proposed rule1 called "The Enhancement and Standardization of Climate-Related Disclosures for Investors" that would require public companies to provide certain climate-related financial data and greenhouse gas (GHG) emissions insights in public disclosure filings. These proposed SEC rules are intended to make US corporate ESG reporting more standardized and consistent with similar markets such as the European Union (EU).
The SEC final rules, which were initially anticipated to be released in April, are expected to require large filers to disclose material information about their climate risks, risk management approach, corporate ESG governance, and GHG emissions.2 Since publication, the SEC has received approximately 50,000 comments during an extended comment period.
Proposal to Enhance Disclosures by Certain Investment Advisers and Investment Companies about ESG Investment Practices
On May 25, 2022, the SEC followed up with two proposed form and rule amendments seeking to enhance and standardize disclosures related to ESG factors considered by funds and investment advisers, as well as to expand the regulation of the naming of funds with an ESG focus.3 These proposals trailed a settled enforcement action against a mutual fund adviser regarding misleading ESG disclosures and a complaint filed against an issuer for misleading investors in its ESG disclosure.4 Taken together with the recent formation of the SEC's Climate and ESG Task Force in the Division of Enforcement, it is clear that the SEC Staff is increasingly focused on the appropriateness of ESG disclosures.
The SEC disclosure proposal would impact registered investment companies, business development companies (referred together as funds) and registered investment advisers and certain exempt reporting advisers (referred together as advisers). To summarize, the proposed changes would augment the existing disclosures by amending existing rules and forms to:
- Require specific disclosures on ESG strategies in fund prospectuses, annual reports, and adviser brochures;
- Introduce a standard table for ESG funds to disclose information allowing investors to compare ESG funds quickly; and
- Require certain environmentally focused funds to disclose GHG emissions of their portfolio investments; funds that disclose they do not consider GHG emissions as part of their ESG strategy would not be expected to report this metric.
The degree of disclosure required of a fund depends on the degree to which ESG factors are core to a fund's strategy. The proposal identifies three categories of ESG funds: Integration Funds, ESG-Focused Funds, and Impact Funds.5
Under the disclosure proposal, advisers would be obligated to make similar disclosures in their brochures (Form ADV Part 2A) regarding the consideration of ESG factors in investment strategies, the methods of analysis employed in considering those factors, and would be required to disclose certain ESG information in annual SEC filings. This intended effect is to standardize ESG disclosure practices to prevent funds and investment advisers from "greenwashing" their investment decisions. Greenwashing has dominated concerns for investors over the past year, and SEC Chair Gary Gensler has warned companies about it since his term began.
The fund names proposal would expand the scope of the Fund Names Rule to any fund name that includes terms which suggest the fund focuses on investments that have, or whose issuers possess, particular characteristics, incorporating one or more ESG factors. These ESG terms could include: socially responsible investing, sustainable, green, ethical, impact, or good governance. The proposal would require disclosure in fund prospectuses defining the terms used in the fund’s name and the criteria used to select the investments the term describes. In general, an ESG fund subject to the rule would be required to invest 80% of its assets in a manner consistent with the investment theme suggested by its name.
When the SEC revealed its Spring 2023 Regulatory Flexibility Act Agenda, (which serves as an agenda the SEC will focus on and provides the status of each rulemaking), in June 2023, the status of each proposal was updated as moving to the “final rule stage” and a target date of October 2023 was set for the adoption of final rules with respect to each proposal.
Congressional Action
On June 21, 2023, Representative Andy Barr (R., Ky) introduced legislation (H.R. 4237) that would amend the Investment Advisers Act of 1940 and the Employee Retirement Income Security Act of 1974 (ERISA) to generally require broker-dealers, investment advisers and ERISA fiduciaries to consider only pecuniary factors when selecting, recommending and managing investments. No further action has been taken on this legislation.
A Patchwork of State-Level Legislation
Largely driven by political alignment, recent years have seen a spate of proposed or enacted laws by state legislatures that seek to encourage or restrict ESG measures. Broadly, these can be grouped into six categories (please note that states have been categorized on the basis of its primary ESG-related measures):
- State laws to restrict consideration of ESG in state investment factors: AK, AL, AR, AZ, GA, IN, KS, KY, MI, MO, MS, MT, NE, NH, ND, OK, SD, UT and VA
- State anti-boycott laws: ID, IA, LA, NC, ND, OK, SC, TN, MN, TX, WV and WY.
- State measures that combine anti-boycott and anti-ESG investing: FL.
- State laws promoting the consideration of ESG in state investment factors: CO, IL, MD, NM and OR
- State measures prohibiting investment in certain industries: CA, CT, DE, NJ, NV, NY, MA, ME, OR, RI and VT.
- State measures requiring companies to disclose GHG or climate related risks to the state: CA.
Understandably, this disparity complicates compliance for financial institutions and fund managers managing state pension assets, where the political battle is predominantly being played out. Such stakes have been raised by threatened action against such parties by various states, the most notable of which is a multi-state action directed at two proxy voting services for alleged violation of “their legal and contractual duties as proxy advisers, with respect to advocating for and acting in alignment with climate change goals.”6
One of the most publicized pieces of state legislation restricting the consideration of ESG factors in investment decisions is Florida’s “Act Relating to Government and Corporate Activism” (HB 3) passed in the Florida State Senate on April 19 and was signed into law on May 2. The legislation formalizes and expands the directive Governor Ron DeSantis announced last August for the State Board of Administration to invest funds of the Florida Retirement System Defined Benefit Plan (and to exercise shareholder proxy voting rights) solely based on pecuniary factors, without sacrificing investment returns to promote non-pecuniary factors such as ESG goals. HB 3 extends this policy to cover all funds invested by state and local governments, including general revenue, trusts dedicated to specific purposes, money held by retirement plans, and surplus funds. These restrictions will apply to all contracts executed, amended or renewed beginning July 1, 2023. The legislation also will put in place new requirements and restrictions applicable to state and municipal bond issuances, government contracting and banks and other financial institutions.
However, not all proposals to restrict ESG factors are enjoying success on the legislative floor. For instance, two bills introduced in Wyoming – one an anti-boycott proposal, the other restricting the consideration of ESG for the investment of state funds – failed to pass. In Indiana, HB 1008 that would have required the state’s public retirement system to cease engagement with companies or funds having regard to ESG factors when investing, was amended to exempt private markets, following vocal opposition of the Indiana Chamber of Commerce.7 Similarly, despite being introduced with some fanfare, SB 1446 ran out of time to be fully considered in the last session of the Texas Legislature, meaning that it will have to be reintroduced in the next term.
On the other side of the divide, a number of states have enacted requirements to enhance diversity on corporate boards, address climate change, and incentivize corporate climate, ESG, and sustainability investment. Possibly the most comprehensive is California’s Climate Accountability Package (the Package), which was introduced in the California Senate on January 30, 2023. The Package consists of three bills: the Climate Corporate Data Accountability Act (SB 253); the Climate-Related Financial Risk Act (SB 261) and the Fossil Fuel Divestment Act (SB 252). The Climate Corporate Data Accountability Act and the Climate-Related Financial Risk Act would create significant climate risk disclosure and other compliance obligations for larger companies doing business in California, which, in at least some respects, would go beyond the climate disclosure rules proposed by the SEC. The Fossil Fuel Divestment Act would limit investments by California’s public pension funds in fossil fuel companies.8
Approaching the Future with Caution
The pace of ESG-focused legislation and regulatory activity is unlikely to slow down in the near future, especially with the commencement of the US presidential election calendar acting as a catalyst for the political bifurcation towards the subject amongst representatives, organizations, and the electorate. Attention will also be focused on the financial and non-financial impact of such measures, the methodologies used to assess them, as well as the interpretation and enforcement of largely untested laws. Perhaps, the greatest attention will be paid to asset managers, and related service providers, who face increasing scrutiny at state and federal of their decision-making and reporting of ESG factors, particularly where it concerns the management of public pension funds. Considered analysis, conflict management of competing requirements, and caution are advised.
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1 Securities Act Release No. 11042 (Mar. 21, 2022), 87 Fed. Reg. 21334, 21344 (Apr. 11, 2022).
2 The rules would require disclosure of:
- climate-related risks reasonably likely to have a material impact on the registrant’s business or consolidated financial statements, within the existing definition of materiality;
- the actual and potential impacts of material climate-related risks on a registrant’s strategy, business model, and outlook;
- the manner in which a registrant’s board oversees climate-related risks and management’s role in assessing and managing those risks;
- processes for identifying, assessing, and managing climate-related risks;
- various climate-related financial statement metrics;
- climate-related targets and goals, if the registrant has set them;
- direct (Scope 1) and indirect (Scope 2) GHG emissions data, as well as additional upstream/downstream indirect GHG emissions (Scope 3) if material or if the registrant has set targets for Scope 3 emissions.
3 Securities Act Release No. 11068 (May 25, 2022), 87 Fed. Reg. 36654 (June 17, 2022) (“disclosure proposal”); Securities Act Rel. No. 11067 (May 25, 2022), 87 FR 36594 (June 17, 2022) (“fund names proposal”)
4 SEC Press Releases: SEC Charges BNY Mellon Investment Advisor for Misstatements and Omissions Concerning ESG Considerations; SEC Charges Brazilian Mining Company with Misleading Investors about Safety Prior to Deadly Dam Collapse.
5 Integration Funds integrate both ESG factors and non-ESG factors in their investment decisions such that ESG factors are not considered dispositive. Integration Funds would be required to disclose how ESG factors guide their investment process. The disclosure would be brief to avoid overstating the role of ESG factors. Integration Funds that consider GHG emissions would be required to disclose how the fund considers GHG emissions, including the methodology and data sources consulted by the fund.
ESG-Focused Funds significantly center or focus on ESG factors and would be required to submit detailed disclosures, including in the form of an ESG strategy overview table. The proposal would also obligate certain ESG-Focused Funds to provide about their ESG strategies, including any inclusionary or exclusionary screens, and information about the impacts they are pursuing. ESG-Focused Funds that utilize proxy voting or engagement with issuers to implement its ESG strategy would also be required to disclose how it voted proxies relating to portfolio securities on particular ESG-related voting matters and information regarding its ESG engagement meetings. ESG-Focused Funds that have environmentally focused investment strategies would be required to disclose additional information on the GHG emissions associated with their investments, including the carbon footprint and the weighted average carbon intensity of their portfolio.
Impact Funds are a subset of ESG-Focused Funds pursuing a specific ESG impact (e.g., financing the construction of affordable housing, or improving availability of clean water). Impact Funds would be required to disclose how it measures progress (in qualitative and quantitative terms) and summarize achievements towards its stated ESG goal.
8 The Climate Corporate Data Accountability Act (SB 253): this Act comes less than six months after the Climate Corporate Accountability Act (SB 260) failed to pass the California Assembly. The disclosure requirements under the current bill and the bill that failed to pass last session are almost identical.
The Act would apply to US-organized entities that do business in California and have total annual revenues in excess of $1 billion. According to Politico, approximately 5,400 companies doing business in California would be required to make disclosures under the Act as proposed.
The Act would require the California State Air Resources Board, on or before January 1, 2025, to develop and adopt regulations requiring subject companies to publicly disclose their scope 1, scope 2 and scope 3 GHG emissions to an emissions registry. Under the Act, the implementing regulations adopted by the State Air Resources Board would be required to be structured to streamline and maximize reporting entities’ ability to use reports under the Act to meet the requirements of other leading climate disclosure programs and standards. Annual reporting would commence in 2026 (on or by a date to be determined by the State Air Resources Board) for the prior calendar year.
The Climate-Related Financial Risk Act (SB 261): this Act would apply to US-organized entities that do business in California and have total annual revenues that exceed $500 million. Companies subject to regulation by the California Department of Insurance or that are in the business of insurance in any other state would be excluded. The financial threshold is lower than that under the Climate Corporate Data Accountability Act. Therefore, if passed with the current threshold, many companies that are not required to report on GHG emissions under the Climate Corporate Data Accountability Act would have obligations under the Climate-Related Financial Risk Act. Subject companies would be required to annually prepare a climate-related financial risk report. The first report would be required to be prepared by December 31, 2024.
The Fossil Fuel Divestment Act (SB 252): this Act would expand upon existing California law. Current legislation generally prohibits the boards of the California Public Employees’ Retirement System and the California State Teachers’ Retirement System from making new investments or renewing existing investments of public employee retirement funds in thermal coal companies and requires the boards to liquidate preexisting investments in these companies.
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