The SEC Paves a Path to Formally Address ESG From All Sides

Navigating an organization’s environmental, social and governance (“ESG”) risks and opportunities remains somewhat of a frustrating mystery for organizations and investors alike.  What is not a mystery is the clear (and vocal) marketplace shift in investor requests for disclosure and standardization in order to evaluate an organization’s ESG profile and risk management strategy.  There are a number of voluntary disclosure frameworks established by third-party standard setters and mandatory disclosures under international regulations.  In the United States, the Securities and Exchange Commission (“SEC”) has - for the most part - stayed on the sidelines of the ESG disclosure debate, historically leaving it to organizations to decide whether or not its ESG initiatives, if any, rise to a level of materiality for disclosure. Until now.

In the past few weeks, the SEC has announced a number of actions that include, among others, a task force designed to harmonize the efforts of the SEC’s Divisions and Offices, consideration of future comprehensive ESG disclosure guidance, ESG as an exam priority, and addressing shareholder rights and creating accountability in statements and conduct.   This alert elaborates on the path the SEC has articulated for addressing ESG.

ESG as Risk Management

The investor community – domestically and globally – is increasingly asking organizations for more robust and detailed disclosure on a variety of ESG topics, such as climate risk, board and workforce diversity, human capital and talent management and human rights.  The view is that an organization’s assessment of these systemic risks have a real effect on long-term shareholder value, and markets and businesses have a role to play.  The supply chain disruptions triggered by the COVID-19 pandemic and the social justice events of 2020 with their impacts on markets and businesses only have accelerated that focus.  For an overview of ESG, including its origins, the actors shaping the dialogue, and fiduciary duty and litigation risks, please see part one, two, three, and four of our 4-part alert series.

Climate has historically dominated the ESG discussion, but the 2020 events have shown that climate, social and governance issues are intertwined, as most recently seen in the winter storm impacts in Texas.  These events also illustrate that climate, social and governance risks are not far-off contingencies which organizations can continue to afford to ignore or procrastinate, or simply hedge.  The storm (informally dubbed Winter Storm Uri after the naming conventions for tropical weather systems), an uncharacteristic but neither unforeseen nor unprecedented extreme winter weather phenomenon, knocked out power to most of Texas, through a series of rolling blackouts.[1]  The power outages cascaded into food shortages, water system contamination, damage to infrastructure and at least 70 deaths.  Total damage was estimated at nearly $200 billion.

Current assessments and analyses point to the lack of winterization and other deferred maintenance in power-generating facilities as a cause for the failure of the power system.  Public reporting noted that these issues had been identified as a response to a similar extreme winter weather ten years earlier. This appears to have been the assessment of the public and Governor Greg Abbott-- within a month after the storm, five members of the Electric Reliability Council of Texas (ERCOT) had resigned[3], as well as ERCOT’s CEO and two successive chairpersons of the state agency overseeing the energy industry.  Though the storm itself was not preventable by ordinary means, this event illustrates the ever growing focus on the role of governance in addressing systemic climate risks.[2] 

Another systemic risk that the Texas incident illustrates is the interaction between an extreme event and governance and management structures unique to Texas.  Unlike many other states, Texas power generation is heavily decentralized and exposed to market pressures and forces (because power generating facilities are largely insulated from the consumer and industrial purchasers of electricity) in ways that public utilities in other states are not.  What began as a climate event, was then multiplied by overlapping governance decisions by private industry and public entities alike that didn’t seem to consider the impact of changing systemic risks, and quickly turned into a social and human rights crisis.

SEC Positions Itself to Address ESG from All Angles

The SEC has made several notable changes to position itself for a holistic look at ESG.  These actions include:

• On February 1, 2021, the SEC announced the appointment of its first Senior Policy Advisor for Climate and ESG, Satyam Khanna, dedicated to advising the SEC on ESG matters and initiatives.
• On March 4, 2021, the SEC announced its new Climate and ESG Task Force (“Task Force”) in its Division of Enforcement. This announcement came a day after the SEC’s Division of Enforcement identified ESG among its exam priorities of registered investment advisors (RIAs).

The SEC is consolidating its information on climate and ESG with a dedicated webpage that was launched last week.

These actions should not come as any real surprise as they align with the Biden administration’s priorities, particularly climate, as evidenced by the administration’s re-engagement with the Paris Agreement.  The Biden administration’s focus on climate cuts across a number of agencies, including the Department of Treasury and the Department of State, as reported by Bloomberg.  

But, it will come with many expected Republican challenges.  Senator Pat Toomey, the top Republican on the Senate Banking Committee, made headlines with a March 24, 2021 letter to Acting Chair Lee requesting the SEC to brief the Committee on its ESG related plans. 

In the meantime, a number of organizations routinely make statements and claims regarding their climate actions, which has raised concerns of “greenwashing” where organizations may overstate their sustainability actions.  The Task Force’s initial priority is to evaluate existing climate risk disclosures under the SEC’s existing guidance issued in 2010 for any material gaps or misstatements.  The Task Force will similarly evaluate disclosure and compliance issues to assess alignment between processes and disclosures made by investment advisors and funds that offer ESG labeled funds and/or strategies.  The Task Force will have a broader agenda that includes working with the Divisions of Finance, Examinations and Investment Management and evaluating and pursuing whistleblower complaints. 

These actions by the SEC underscore the importance of organizations carefully ensuring alignment between their statements and actions on ESG matters.

 “It’s the investor community that gets to decide what’s material to them.”

The investor community has been waiting to see if the SEC will step more actively into the ESG conversation.  Responding to the Republican Party’s comments that securities laws are not the place for discussions on matters related to climate and other social inequities, Gary Gensler made it clear, at his confirmation hearing, that the investor community decides what is material to their community.  Echoing Larry Fink’s 2019 Letter to CEOs in which he stated that profit and purpose are inextricably linked, Acting Chair Allison Lee stated, in a speech to the Center for American Progress, that the distinction “between what’s ‘good’ and what’s profitable, between what’s sustainable environmentally and what’s sustainable economically, between acting in pursuit of the public interest and acting to maximize the bottom line—is increasingly diminished.”

In her speech, Acting Chair Lee acknowledged that the ESG topics are fundamental to the economic markets and elaborated on the path that the SEC plans to take on meeting the investor demand.

• ESG Disclosures. As noted above, the Task Force’s starting point is to evaluate current climate disclosures in an effort to update the 2010 guidance.  In addition, the SEC expects to advance on a broader, comprehensive ESG disclosure scheme with considerations for providing more specific guidance on human capital or board diversity.  When the current Regulation S-K human capital disclosure requirements were adopted by the SEC, then Commissioner Lee along with Commissioner Caroline Crenshaw dissented on the adoption primarily on the grounds of vagueness. See their dissenting comments here and here. Issuers can likely expect more specificity on the disclosure, including the reporting of metrics like workforce diversity, in any additional guidance the SEC may promulgate.
• Shareholder Proposals. Recognizing the swath of ESG related issues present in shareholder proposals, Ms. Lee explained that she has asked the Division of Corporate Finance to develop proposals that revise the no-action process and, potentially, Rule 14a-8.  She articulated the goal is to “bring greater clarity to the no-action relief process, increase the number of proposals on the ballot that are well-designed for shareholder deliberation and votes, and reduce the number that are not.”  When faced with a potentially controversial shareholder resolution, companies can request from the SEC whether it would recommend an enforcement action if a proposal is left off the ballot.  According to research by the Sustainable Investments Institute, only 8% of climate change resolutions were omitted in 2016.  That number rose to 21% in 2020.  Now, under a new administration, shareholder resolutions on ESG issues are likely to find more support from SEC leadership. Indeed, companies that have previously ignored shareholder proposals may find themselves on the receiving end of an SEC enforcement action if they refuse to include and allow shareholder votes on ESG proposals.
• Proxy Voting. Acknowledging that index funds are significant voters in annual company elections and that fund investors are demanding companies adopt ESG strategies and opportunities, the SEC will place more focus on fund and advisor voting duties and disclosures. Specifically, the SEC will require more transparency in how a fund casts its proxy votes on shareholders’ behalf so that investors can be sure the votes support ESG initiatives.
• Examinations. Not all the focus will be on an issuer’s ESG disclosures. The Division of Enforcement will also be reviewing whether funds that “claim” to be ESG funds really are.  It expects to issue a ESG risk related alert in the upcoming weeks.

In moving forward, Acting Chair Lee recognized the need to work collaboratively both domestically and internationally as ESG issues do not recognize boundaries. 

 Preparing for What’s Ahead

Although the formal rulemaking process could take years to play out, issuers can position themselves well to meet the challenge of mandatory ESG disclosures.  The marketplace has been very vocal on the ESG issues that dominate their focus and the voluntary disclosure frameworks, such as SASB, TCFD and GRI offer a guide to both qualitative and quantitative ESG topics relevant to sectors and industries.  See our alert that describes these frameworks.  To prepare, companies should:

1. Develop a roadmap to assessing the material ESG issues for the organization.
2. Engage with internal and external stakeholders to understand and synthesize the ESG issues.
3. Create the pathways for dialogue on ESG issues with the board, senior management, general counsel, and operations.
4. Understand the commitments and statements currently being made by the organization and ensure consistency with actions and initiatives.
5. Develop, revise and enhance practices and procedures for monitoring and following through with initiatives.

[1] It is key to note here that Texas’ power grid is largely independent and disconnected from the other major power grids in the continental United States.

[2] It also bears mentioning here that Texas experiences its own share of extreme weather during the Atlantic hurricane season, but sound governance processes accounting for changes in long-term climate patterns anticipated by the scientific consensus should have anticipated the possibility of extreme winter weather, resulting in the kind of risks that Texas has not historically planned for.

[3] None of the resigning members were residents of Texas.  This may illustrate both the need for local expertise and a sensitivity felt by lawmakers and the public around the importance of shared sacrifice.  The resigning members did not experience the power outage, and so were not felt by many to have “skin in the game.”