Cooley LLP

In 2018, in recognition of the increasing expectation of shareholders to see disclosure regarding material environmental, social and governance issues that affect financial performance and communities, Senator Mark Warner asked the GAO to prepare a report on public company disclosure regarding ESG.  That report has now been issued.  According to Warner, “[m]ost institutional investors find current company financial disclosures limited in their usefulness, and augment company disclosures through burdensome engagement with the company, purchasing third party compilation data, or initiating shareholder proposals. It is time for the SEC to establish a task force to establish a robust set of quantifiable and comparable ESG metrics that all public companies can adhere to.”  Although SEC Chair Jay Clayton has acknowledged “the growing drumbeat for ESG reporting standards,” he has made clear his lack of enthusiasm for imposing a prescriptive sustainability disclosure requirement that goes beyond principles-based materiality. (See, e.g., this PubCo post and this PubCo post.)  Will the SEC address the drumbeat?

The GAO report analyzes primarily “(1) why investors seek ESG disclosures, (2) public companies’ disclosures of ESG factors, and (3) the advantages and disadvantages of ESG disclosure policy options.” To conduct its study, the GAO looked at disclosures from 32 large and mid-sized public companies in eight industries across a variety of sectors. The GAO focused on 33 ESG topics in eight categories—climate change, resource management, human rights, personnel management, workforce diversity, board accountability, data security and occupational health and safety—frequently cited as important to investors. In addition, the GAO looked at various ESG policy studies and interviewed a number of market participants, from institutional investors to public companies, and “market observers,” such as ESG standard-setting organizations and academics as well as representatives from international governments, stock exchanges and industry associations.

What investors want. GAO found that most institutional investors wanted to use ESG information to understand and compare companies’ risks to protect long-term value, to monitor risk management and to inform voting and investment. About half said that they engaged with companies that were less transparent than their peers to understand their risk-management strategies and encourage more disclosure.  Some investors also considered ESG to promote social goals, such as for ESG-focused funds. Importantly, most also said that they have to engage with companies or otherwise seek out “additional ESG disclosures to address gaps and inconsistencies in companies’ disclosures that limit their usefulness.”  And, it should come as no surprise that investors cited as problematic

“the variety of different metrics that companies used to report on the same topics, unclear calculations, or changing methods for calculating a metric. For example, five of 14 investors said that companies’ disclosures on environmental or social issues use a variety of metrics to describe the same topic. A few studies have reported that the lack of consistent and comparable metric standards have hindered companies’ ability to effectively report on ESG topics, because they are unsure what information investors want. In addition, some investors said that companies may change which metrics they use to disclose on an ESG topic from one year to the next, making disclosures hard to compare within the same company over time.”

Investors also noted gaps in narrative discussions—such as use of generic language, lack of specificity to the company  or failure to focus on materiality—that limited their ability to understand context or strategies to address ESG risks.

What companies disclose. Supporting those concerns, the GAO found substantial inconsistencies—in definitions, in metrics and methodologies—that would limit comparability. The GAO found “instances where companies defined terms differently or calculated similar information in different ways,” most often in connection with climate change, personnel management, resource management and workforce diversity.  for example, companies used different groupings for employee demographics or reported greenhouse gas emissions data differently, combining carbon dioxide and other greenhouse gases in some cases, while reporting carbon dioxide emissions alone in other cases.

Companies also used different calculation methods or units of measure, with some reporting reductions year-over-year, while many others “reported reductions over multiple years with no consistency within or across industries.” Even when companies used the same ESG framework, they did not always disclose consistently. For example, among companies using the GRI framework, the GAO identified four different methods for reporting workforce diversity.

Most of the companies told GAO that, beyond regulatory requirements, they determined the type of ESG information to disclose on the basis of engagement with various stakeholders as well as internal assessments of potential risks. They also referred to various ESG frameworks, such as SASB and GRI. Many also viewed their voluntary sustainability reports as appropriate locations for ESG information that could be of interest to stakeholders but may not be sufficiently material for inclusion in SEC filings. Most of these companies also published issue-specific ESG reports, typically on climate change, and also posted ESG information on their websites and delivered it in various presentations, including in some cases, in earnings calls.

Of the 32 companies examined, the GAO identified the most disclosure in the categories of board accountability, climate change and workforce diversity and the least related to human rights. (Note, however, that the data is pre-COVID-19, where employee health and safety have shot to the forefront of concern.)  Nineteen companies disclosed information on all eight categories, and 30 companies addressed at least six categories. With regard to the 33 identified more specific topics within those categories, 23 companies included disclosures on over half of the 33 topics, with choice of topics dependent in many cases on business relevance. Most frequently, companies disclosed information related to the topics of  board governance (e.g., conflicts, independent directors) and data security risks, and most often on narrative topics rather than quantitative information.  Less frequently, companies reported on topics related to the number of self-identified human rights violations and the number of data security incidents.

Policy options. The GAO observed that, as noted above, the SEC has generally advocated a principles-based approach to ESG disclosure, relying on companies to determine what information is material, and has required disclosure in SEC filings based on materiality.  In its letter responding to the GAO report, Clayton reiterated that the SEC’s “approach to these issues is largely rooted in materiality.  As you have made clear, our principles-based disclosure regime emphasizes materiality and is focused on requiring public companies to provide information that a reasonable investor would consider important in making informed investment and voting decisions.”

According to the GAO, Corp Fin generally defers to companies’ determinations about selection of ESG information to disclose, although the staff also performs company- and industry-specific background research as part of its reviews to determine if there is material information, such as potential risks, that may be relevant to a company’s filing. In a webcast conversation in June with non-profit FCLT Global, Clayton noted that the staff also looks at “heat maps” and frameworks from advocacy groups in developing issuer comments.

Possible policy approaches, from legislative and regulatory to industry frameworks, each require trade-offs.  Accordng to the GAO, many investors are advocating some type of prescriptive rulemaking to promote comparability and reduce information disparities between large and small investors.  However, there is little consensus on the precise information that should be disclosed, and increased requirements would increase costs for companies. Some observers noted that prescriptive rules “can become outdated as issues evolve and that these types of disclosures would reduce flexibility for companies. Line-item or issue-specific disclosures also may not be relevant for all companies, possibly resulting in large volumes of immaterial information.”

Some observers recommended that the SEC endorse the use of a framework, such as SASB or GRI, which the SEC has done on prior occasions, for example, with COSO for internal controls. However, there appeared to be little consensus on the right framework to adopt.

Although the SEC has previously issued some guidance on ESG topics, such as climate change and cybersecurity, investors contended that there was still insufficient disclosure on climate and little comparability. The GAO reported that staff reviews of disclosures on climate change showed that companies had provided some climate-related information in 10-Ks with varying levels of detail, and the staff decided against recommending further interpretive releases. (Notably, the SEC has included in a pending proposal to modernize Reg S-K an expanded requirement to discuss human capital, providing non-exclusive examples of potentially material human capital measures and objectives. In light of serious concerns that have arisen about workforce health and safety arising out of COVID-19, as well as demand for information about workforce composition (diversity), the SEC may well decide to further enhance the disclosure requirement. (See this PubCo post.))

Other market participants, including some institutional investors, have recommended that companies use private-sector approaches, including industry-specific frameworks, such as the standards developed to guide electric and natural gas companies’ ESG reporting. However, not all companies fit cleanly within industry groups and, even within groups, it may be difficult to find consensus. The interests of companies and trade associations may diverge from those of investors and other stakeholders and, the GAO reports, two academics contended that “individual companies do not have an incentive to work towards standardized ESG reporting standards and will not do so on their own.” Although neither the NYSE nor Nasdaq requires ESG reporting as part of its listing standards, the GAO indicated that “ESG reporting endorsements from stock exchanges has been shown to accelerate the adoption of integrated reporting in other countries.” However, the competition among exchanges for listings may deter the exchanges from imposing these requirements. Finally, some institutional investors, companies and market observers suggested “that it was too early to prescribe standards for ESG disclosures, because there is not consensus among companies, investors, and market observers on which ESG issues should be disclosed.”

What can we expect? Certainly, various associations will continue to develop and perhaps integrate ESG frameworks as discussed above.  But given the perspective of the current SEC commissioners, it seems unlikely that the SEC will move toward advocacy of a particular framework, much less adopt prescriptive requirements any time soon.  However, in his FCLT interview, Clayton hinted that, instead of prescriptive requirements, he would view the type of principles-based guidance that the Corp Fin staff issued in connection with COVID-19 disclosure—that is, Disclosure Guidance Topic Nos. 9 and 9A—as a good model for sustainability disclosure guidance. That guidance included a series of detailed questions designed to help companies assess, and to elicit effective disclosure regarding, the impact of COVID-19.  And, in his press release, Warner indicates that the “SEC is considering issuing principles-based guidance on ESG reporting,” although “it is only a step in the right direction.” Could we see more Corp Fin ESG-related disclosure guidance topics in response to the “drumbeat” for ESG reporting standards?  (See this PubCo post and this PubCo post.)

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