ESG in 2022: 10 Things to Look Out For

Latham & Watkins LLP

Corporate reporting (including SEC developments), climate change,  energy transition, supply chain management, and the mitigation of ESG-related litigation risk are expected to be the leading ESG themes of this year.

As expected, 2021 saw continued emphasis on environmental, social, and governance (ESG) issues on a global scale, by governments, regulators, NGOs, the private sector, and other important stakeholders.  Indeed, 2021 has been variously described as “a watershed moment for ESG” and “the year of ESG investing”[1]. We do not expect this interest to recede, and given the societal importance that now appears to be placed on ESG issues, we expect this growth trend to continue throughout 2022.

This third instalment of Latham’s annual 10 Things to Look Out For blog post highlights the ESG-related developments and trends that we expect to remain in the headlines in 2022.

SEC – When and What to Expect

The US Securities and Exchange Commission (SEC) has in recent years placed greater emphasis and focus on ESG and, in particular, on climate change issues, a trend which continued in 2021. By March 2021, the SEC had hired its first Senior Policy Adviser for Climate and ESG, created a Climate and ESG Task Force as part of the Division of Enforcement (the Task Force), directed the Division of Corporation Finance to enhance its focus on climate change disclosures, and sought input on any such climate change disclosures in the form of a request for public comments. Further, public remarks from SEC Chair Gary Gensler requested that such a climate risk disclosure rule be mandated “by the end of [2021]”. Gensler has also indicated that the new rule may “learn from and be inspired by” the Recommendations of the Task Force on Climate-Related Financial Disclosures (TCFD), although some commentators believe that it is likely that a proposed new rule will be bespoke and not use an existing framework.

To date, the SEC has not released any such mandatory climate risk disclosure rule, and observers anticipate further developments in early 2022. If any such proposed rule is released by the SEC, then there have already been suggestions that a rule may well face a considerable amount of scrutiny. Notably, the public consultation saw multiple responses suggesting that climate disclosure rules will be challenged in court for being outside the SEC’s statutory authority. We will closely monitor the progress of the proposed rule and any related litigation throughout 2022.

Notwithstanding whether any proposed climate disclosure rule is subject to legal challenge, it is still expected that the Task Force will continue its work in relation to ESG-related enforcement actions (which would not require any specific new rule making). In September 2021, a sample comment letter was produced on the SEC website requesting information on various ESG issues and demonstrating the type of queries that issuers could receive in relation to ESG matters. The Wall Street Journal further reported that the SEC had sent tailored comment letters to “dozens” of companies relating to their climate change disclosures.

By way of example, one of the possible focus points for the SEC is combatting perceived greenwashing.  Commissioner Caroline Crenshaw, on 14 December 2021, noted that there is an increasing number of companies making public climate pledges or committing to a net zero strategy, whilst providing limited or no information in relation to how those pledges will be achieved. Crenshaw stated that “while net-zero emission pledges are an important step forward, they underscore the loud, repeated and sustained calls for decision-useful metrics… That is a core purpose of the SEC’s disclosure obligations”.

China – Uyghur Forced Labor Prevention Act

Additional regulatory developments in the US, which became law at the end of 2021, look as though they may have a profound impact on supply chains and on due diligence in 2022 and beyond.  On 23 December 2021, President Biden signed into law the Uyghur Forced Labor Prevention Act (UFLPA), in response to purported human rights abuses against Uyghurs and other ethnic minorities in the Xinjiang Uyghur Autonomous Region (XUAR). The UFLPA represents a significant expansion of existing US restrictions on items imported from, or with links to, the XUAR. The previous restrictions were limited to specific categories of items and items produced by specific suppliers. However, the UFLPA goes further by imposing a rebuttable presumption against imports from, or linked to, the XUAR. This effectively prohibits the import into the US of such products unless the importer can clearly demonstrate that the item was produced free from forced labor or human rights abuses. The UFLPA also requires the Forced Labor Enforcement Task Force (an existing entity established in 2020) to develop a strategy (the Strategy) to prevent the import of goods produced using forced labor in China. This Strategy will include guidance for importers on measures they may adopt to ensure that their Chinese-origin products are created free from forced labor, and also requires the Forced Labor Enforcement Task Force to produce a number of lists of entities and products that are linked to forced labor in China.

This Strategy, including the guidance and lists of products and entities, is required under the UFLPA to be released by mid-2022, and should provide further clarity to importers of Chinese goods, and those who use such goods in their supply chains, as to how the UFLPA will directly impact their business. These details will be particularly important in sectors such as silica and cotton where the XUAR plays a key role in global supply. For more information on the UFLPA, please see our blog post detailing the Act’s requirements.

Supply Chains – Tracking New Legal Proposals

UFLPA implementation is just one of the expected regulatory developments focused on ESG issues and supply chains that we expect to see in 2022. Governments and regulatory authorities are increasingly looking to establish requirements for large (typically multinational) companies to take further steps to manage their value chain.  A notable example of such an initiative is the European Commission’s expected proposed formal draft legislation in early 2022 on a mandatory supply chain due diligence law.

The European Commission’s action has already been pre-empted by certain national measures, as 2022 will see Germany continue the process of implementing its Supply Chain Act (which will initially require German companies with more than 3,000 employees worldwide to use their best efforts to prevent violations of human rights in their own business operations and in their supply chains). The law will also require German companies to conduct audits on their direct suppliers and extend risk analyses / risk mitigation measures to indirect suppliers to the extent those companies obtain substantial knowledge of a possible human rights or environmental violation. In addition, a number of cases are currently being pursued under the French Duty of Vigilance Act, in relation to companies having not performed adequate diligence on their supply chains.

This regulatory shift, placing an increased compliance burden on companies operating worldwide, is also resulting in greater consideration of technological solutions that companies can utilise to perform diligence on their supply chains.

Energy Transition/Technology

Climate change continues to be a leading ESG consideration.  The global transition towards a net zero economy is likely to continue at pace in 2022, with renewables projects and sustainable infrastructure worldwide continuing to be planned and developed. However, after the events of late 2021 that led to supply shortages of natural gas and elevated energy prices in Europe and the rest of the world, considerations relating to energy security and affordability may impact the pace of the transition in 2022.

In addition, whilst the concept of the differing pace of energy transition (whereby developed countries will transition more quickly to renewable sources of energy than developing countries) is widely accepted (including within the Paris Agreement), 2022 may see tensions as to how this should be reflected in practice. For example, there have been concerns by developing countries that, in light of the accelerated efforts to decarbonise in developed countries, public and private sector organisations in developed countries will be less willing to provide financing for new energy projects within developing countries.  Alternatively, products manufactured in developing countries may be subject to carbon taxation when imported (see, for example, the EU’s proposed carbon border adjustment mechanism).

Innovation and new technologies (from battery storage to advancements in hard-to-decarbonise industries such as steel and cement), may help navigate these tensions.  However, affordability and financing will be a key issue.  We can expect these issues to be topical matters for discussion at COP 27, which is meeting in Africa (Egypt) later this year – see below.

COP27

COP26, held in Glasgow in November 2021, met with mixed reviews as to its success in achieving progress towards limiting global temperature increases to satisfactory levels. The Glasgow Climate Pact (the Pact) established a number of new commitments by parties (see our blog post on our key takeaways from being on the ground in Glasgow), including the agreement of parties to the Pact to submit updated or revised Nationally Determined Contributions (NDCs) ahead of COP27 (which will take place in Egypt in November 2022). NDCs outline the efforts by each party to reduce national emissions and adapt to the impacts of climate change. The timeframe for updated NDCs is shorter than envisioned under the Paris Agreement, and the Pact requested that parties’ targets in their NDCs be strengthened, signalling the increasing efforts in accelerating the pace of the transition.

COP27 itself promises to also raise a number of interesting discussions, most notably on some of the issues in which COP26 was perceived by some as not having gone far enough. These issues include compensation to be paid to developing countries in relation to loss and damage from climate events and whether developed countries reach their target of providing US$100 billion per year in climate finance to help developing countries finance their transition. Early indications suggest that the topics of green and climate finance, both in relation to the public and private sectors, will also play a key role in discussions at COP27. Therefore the development of the narrative and discussions surrounding these topics in 2022 will be of considerable interest.

Taxonomies

The EU Taxonomy, a classification system that establishes a list of environmentally sustainable activities according to the EU, went live on 1 January 2022. The technical screening criteria (TSC) for two of the six environmental objectives (climate change mitigation and climate change adaptation) are in place, so companies and financial institutions are required to begin their initial disclosures.

The TSC for the other four environmental objectives are yet to be formally approved following a call for feedback that closed in September 2021. The coming year will therefore be notable for the EU Taxonomy, not only in relation to seeing the impact and requirements of Taxonomy-aligned disclosures in practice, but also with respect to continuing political and legal developments on nuclear and gas power. The Taxonomy-eligibility of nuclear and natural gas has been politically controversial for some time, and the European Commission began consultations with the Member States and the Platform on Sustainable Finance in  relation to the inclusion of certain gas and nuclear activities within the Taxonomy at the beginning of 2022. The EU is also due to report back on a potential extension of the environmental objectives in the Taxonomy, and the possible creation of a Social Taxonomy in 2022.

Outside of the EU, other jurisdictions are continuing to consider the implementation of environmental taxonomies. For example, the UK has indicated that it will adopt its own taxonomy and consult on the TSC for its climate change mitigation and climate change adaptation objectives in Q1 2022.

Reporting – ISSB/Rating Agencies to Be Regulated?

2021 saw the IFRS Foundation announce the creation of the International Sustainability Standards Board (ISSB), which aims to address concerns regarding the quality and consistency of ESG reporting. The goal of ISSB (at least initially) is to produce an authoritative set of standards and consolidate two of the leading sustainability standards organisations (the Climate Disclosure Standards Board and the Value Reporting Foundation) to form one leading body. The ISSB, chaired by former Danone Chair and CEO Emmanuel Faber, will consult on proposed general disclosure requirements in Q1 2022, and the process of attempting to form a globally recognised standard will continue to develop throughout the year. For more information on the remit of the ISSB, please read our blog post.

Scope 3 Emissions – Further Clarity Required

One particular aspect of ESG reporting that has become popular, and will likely continue to become more so in 2022, is the reporting of companies’ greenhouse gas inventories.  In jurisdictions such as the UK, there are already requirements to report on climate change matters in line with the recommendations of the TCFD for a considerable number of companies.

When reporting emissions, companies tend to split their emissions into three categories, or Scopes, as identified by the leading framework in this area, the Greenhouse Gas Protocol. These Scopes categorise emissions as direct emissions from the company (Scope 1); indirect emissions from the electricity, heating, and cooling that the company uses (Scope 2); and all other indirect emissions from the company’s value chain (Scope 3).

As mandatory requirements to report emissions continue to develop in 2022, how companies engage with Scope 3 emissions reporting remains challenging. Aside from the fact that a company in practice may have limited control over its Scope 3 emissions (as the emissions are stemming from the activities of business partners and not the company itself), such Scope 3 emissions are complex to accurately record given the diverse and widespread nature of the emissions sources. As a result, companies that currently report their Scope 3 emissions do so using a wide variety of methods. This means that drawing comparisons between the results of companies may not be appropriate. For example, Scope 3 emissions can often be double counted as a result of overlapping supply chains, companies report (or do not report) on different categories of Scope 3 emissions, and a company may have to report Scope 3 emissions at a higher level than the amount of greenhouse gas actually emitted into the atmosphere (e.g., if carbon capture technology has been utilised).

The existing frameworks underlying Scope 3 reporting were established a number of years ago and may not reflect current practices and technologies. However, as climate reporting becomes increasingly popular with investors, and in many cases mandatory, in 2022, increased scrutiny on the methodology behind Scope 3 reporting may lead to questions about required revisions to the framework or the role of Scope 3 emissions in mandatory reporting.

DEI/Value Chain

In 2022, we will likely see a continued focus on diversity, equity, and inclusion (DEI) matters throughout the public and private sectors. A World Business Research study in late 2021 found that 79% of organisations across a variety of industries were planning to allocate more budget and resources to DEI in 2022 than in 2021, demonstrating the increasingly important role DEI is having across businesses.

Key to DEI initiatives in 2022 will be companies’ approaches to remote and/or flexible working. Companies will face the possible challenge of ensuring that employees who choose to embrace remote working more fully are not disadvantaged by their lack of time spent in the office. We also expect to see further focus on diverse employee retention and development.

ESG Litigation/Disputes

Finally, given the rapid development and growth of ESG disclosure obligations and practices discussed above (as well as the societal focus on ESG), companies will need to continue to mitigate the risk of, and manage any ongoing, ESG litigation.  We expect the pace of ESG-related litigation to continue to increase as this litigation is likely to cover a broad and growing range of ESG factors.

To date, climate change has taken centre stage (and we expect will likely remain a key theme). However,  as noted above, supply chain issues are likely to play a growing role in non-climate change-related ESG litigation. Further, in the context of voluntary and mandatory disclosures, greenwashing claims (from regulators, shareholders, and other stakeholders) may increase as green marketing and ESG commitments become ever more important to consumers and investors. Climate change litigation will continue to develop in scope, as public and private entities that finance high-emitting companies and/or infrastructure projects face increased scrutiny on their role in such activities, and whether such financing aligns with their publicly stated commitments.

In addition, given the notable successes of 2021 in relation to the climate-related proxy battles, we expect to see more such campaigns in 2022, with activist investors seeking to impact the ESG-related policies of high-emitting companies through shareholder action.

Boards and senior management may wish to continue to develop their ESG strategies and look at mitigation measures and stakeholder engagement strategies to seek to address ESG litigation risk.

Endnote

[1] https://www.reuters.com/markets/us/how-2021-became-year-esg-investing-2021-12-23/

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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