While the United States has been a leader in developing technology to combat climate-related risks, there is one area where it lags Europe, Asia and other regions of the world.
The US Securities and Exchange Commission (SEC) has been slow to craft and adopt global ESG reporting standards. Proposed regulations being developed elsewhere are a work in progress but they have begun to bring some clarity.
In the US, however, the burden of inconsistent or absent standards will continue to fall heavily on companies and investors. How the US addresses this issue will have broad implications for asset owners and managers.
Downsides of falling behind
US-based fund managers won’t have clear ESG standards for their domestic investors. They could also be constrained by geographic boundaries causing them to miss out on opportunities in Europe, Asia and other regions which have structured ESG regimes in place. Selling into these markets will force them to confront a patchwork of domestic and global metrics and reporting standards, raising the complexity level and causing inefficiencies in the process.
Research shows that investors are already frustrated by the amount, quality and consistency of research available to them. The 2020 EY Climate Change and Sustainability Services (CCaSS) Institutional Investor survey found that 91% of respondents agree nonfinancial performance played a pivotal role in investment decision-making.
Yet many are not satisfied with the information available to them. More than four out of 10 respondents said there was inadequate disclosure of social and governance risks, and the proportion that are dissatisfied with environmental risk disclosures has increased by 14% since 2018.
Investor-driven reporting standards
While it’s not fully clear what existing or hybrid standards will prevail, harmonization efforts are coming together. The Group of Five, a coalition of major standards-setters, is collaborating on a common set of sustainability disclosures. Further, the International Financial Reporting Standards Foundation has established an International Sustainability Standards Board (ISSB). The ISSB launched at COP26 in November and will offer baseline standards that will also allow for reporting requirements that are specific to particular jurisdictions.
While the need is acute, the SEC has been reluctant to take a leading role or even engage much in the harmonization process although that appears to be changing somewhat. Its leaders have expressed that ESG reporting standards should be largely investor-driven and not the purview of federal regulators. It has also stressed that “materiality,” its traditional criteria for reporting, is not always a fit for ESG standards.
SEC commissioner Hester Peirce wrote in Eurofi Magazine April that, “A single set of metrics will constrain decision making and impede creative thinking. Unlike financial accounting, which lends itself to a common set of comparable metrics, ESG factors, which continue to evolve, are complex and not readily comparable across issuers and industries.”
Nonetheless, the SEC is taking some actions, if slightly belatedly. Earlier this year, the SEC’s Enforcement Division announced its Climate and ESG Task Force – an effort to proactively identify ESG-related misconduct and “greenwashing.”
According to the SEC, the task force will look for “gaps or mis-statements in issuers’ disclosure of climate risks under existing rules” and analyse “disclosure and compliance issues relating to investment advisers’ and funds’ ESG strategies.”
An SEC risk alert this year also seeks to examine how “the variability and imprecision of industry ESG definitions and terms can create confusion among investors if investment advisers and funds have not clearly and consistently articulated how they define ESG and how they use ESG-related terms, especially when offering products or services to retail investors.“
Noting global standards
A positive statement from the SEC Chair Gary Gensler that the commission will consider global standards while crafting, by early next year, a proposal for mandatory climate risk disclosures for consideration by SEC commissioners.
The proposal, which was very well-received, would require companies to report metrics such as greenhouse gas emissions, financial impacts of climate change and progress towards climate-related goals.
Further, the SEC’s Division of Corporate Finance in September released a sample comment letter that requests additional information from companies related to climate change. While the letter does not create substantive new law, it demonstrates the SEC’s increased interest in ESG and climate-related disclosures under the Biden administration.
As efforts continue, whether they’re red hot or lukewarm, some organizations and firms are taking a practical approach to how reporting metrics might be implemented. A study by industry group Irish Funds, for example, is looking at whether data vendors have the capability to meet the Level 2 — Regulatory Technical Standards (RTS) EU— of the Sustainable Finance Disclosure Regulation (SFDR).
These Level 2 measures will become effective in July 2022 and look at the principal adverse impacts (PAI) of investment decisions on sustainability factors. The draft RTS set out mandatory and optional PAI indicators. The indicators span greenhouse gas emissions, biodiversity, water, waste, environment, and social and employee issues, among others.
In a measure of how difficult compliance and measurement might be, the information that data vendors will supply to gauge PAI is incomplete and inconsistent. For example, the vendor survey found that data is generally available for only eight of the 14 mandatory PAIs relating to investee companies, and that there is a wide range of variance in the reported data with low levels of comparability between data vendors.
While there is much that needs to be worked out, it’s clear that Europe and other regions of the world are far ahead of the US, leaving that country and its investors with much more uncertainty even as demand soars for ESG assets and reliable metrics related to those assets.
In the preceding five years, having gone through the difficult process of establishing SFDR and the EU taxonomy, Europe will be even further ahead in terms of reporting. The European road map is clearly defined and will continue despite any changes in regimes.
In the US, however, politics and hesitancy will continue to slow advancement, despite recent efforts to make some progress.
As investors look ahead, the trend is clear: the US will lag and will further hamper the efforts of fund managers who operate in the US and also globally. It will also put a heavy burden on companies that won’t have the clarity and guidance they need. In a global world, cooperation and collaboration are essential.
To make the move toward meaningful and accurate global reporting, every country and region, including the US, must participate actively or be left behind.