There will be regulations for ESG investing

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Editor’s note: This is the latest in a series on stakeholder capitalism and the environment, society and governance (ESG) written by professors at the University of North Carolina at Chapel Hill, affiliated with the Kenan Institute of Private Enterprise. According to the Kenan Institute, stakeholder capitalism is the idea that companies would improve social outcomes by focusing on a broader mandate than that which only benefits shareholders. While this seems like a great idea in principle, implementing it in practice is challenging, especially when the interests of different stakeholders conflict, negating win-win solutions. The collection of work below provides rigorous solution-based analysis of stakeholder capitalism that promotes win-win solutions when they are available or can become available with the right policies, while also acknowledging and creating frameworks when difficult trade-offs need to be made.

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CHAPEL HILL – In early 2023, the Securities and Exchange Commission is expected to finalize its first ruling on mandatory disclosure of climate risks for publicly traded companies. The proposed rules, introduced last March as a way to improve transparency for investors, expand the requirements for corporate financial risk disclosures to cover climate-related risks and their potential impact on companies’ business models and financial prospects. Significantly, under the new rules, large companies would be required to disclose – and independently verify – the greenhouse gas emissions they generate or purchase, known as scope 1 and scope 2 emissions respectively.

The most controversial however, one aspect concerns indirect emissions generated by a company’s entire supply chain, namely scope 3 emissions, a broad category that extends from the extraction of raw materials it purchases from suppliers to the end use of goods it sells. These disclosures would be limited only to situations where they were deemed “material,” and scope 3 disclosures would require no third-party verification and would be protected from legal liability.

The proposal also increases the accountability of companies that have set emission targets and climate plans by requiring them to outline how they plan to achieve those targets, along with a timeline. Finally, the new rules would require companies to disclose internal carbon prices, if such measures are taken and how they are enacted.

The SEC’s proposed new ruling is ambitious. It significantly expands the scope of US greenhouse gas reporting, which is currently only required from the heaviest emitters. While 90% of S&P 500 companies voluntarily release statistics about carbon emissions or how much renewable energy they use, those statistics are generally not reviewed by regulators, and only a fraction of companies report similar statistics or mention climate change in their filings. Under the new law, companies should take climate-related risks more seriously in their governance and operational strategies.

Perhaps even more important are the mandatory reporting standards for climate risks. A standardized and reliable reporting regime has the potential to change the game and provide much-needed data useful to many stakeholders, from regulators to investors. Whether used as a basis for carbon taxes or to create a “shadow carbon price” where share prices of major emitters are effectively penalized by investors, the reporting requirement would provide the carbon emissions data essential to addressing climate change in any form. also. meaningful way.

Why is ESG (Environmental, Social and Governance) investing becoming such a controversial topic?

Big picture

Essentially, the SEC’s new disclosure rules aim to better measure climate risk — perhaps defining a coming-of-age moment for sustainability disclosures. According to some estimates, ESG-informed investments could add up $50 trillion in assets by 2025. However, it is still difficult to assess whether such a significant reallocation of capital to sustainable activities is decisive for the climate transition. The problem is that ESG data generally comes from a hodgepodge of fragmented, incomplete and voluntary disclosures that are not standardized.

However, the time seems to have come when regulators feel more urgency. Perhaps it is a realization that climate change is a more glaring economic risk and that the existing revelations are simply not sufficient to understand these risks. Another driver is demand from shareholders for more information – especially very vocal shareholders, institutional investors and asset managers, representing tens of trillions of dollars.

The SEC is not alone. Tighter regulatory oversight of ESG investment mandates is making progress on both sides of the Atlantic. In addition to the SEC, the International Sustainability Standards Board (ISSB), established by the International Financial Reporting Standards Foundation that administers IFRS accounting standards, is working to create a unified set of global third-party non-financial disclosure standards similar to financial standards used in corporate filings. The European Union, which has been consistently ahead of other regions, has already signed its own disclosure mandate into law: the Corporate Sustainability Reporting Directive (CSRD), which requires a comprehensive set of disclosure standards across multiple environmental, social and governance areas. In fact, CSRD goes beyond the SEC’s proposed rules in terms of coverage and extends to all private and public companies with at least 500 employees — nearly 50,000 medium and large companies. Importantly, EU rules apply the principle of “dual materiality”, requiring companies to directly measure their impact on people and the environment. In contrast, the proposed SEC rules emphasize investor-oriented risk management and financial materiality, given the SEC’s more limited mandate in investor protection.

Still, the SEC’s new ruling faces a tough road ahead. It has already been attacked by some pro-business groups, who claim it will drive up costs. Also important is whether the proposal exceeds the authority of the SEC. If the Supreme Court’s recent decision to curb the power of the Environmental Protection Agency is any indication of what the future might hold, it’s likely that the final rules will face legal challenges that will ultimately be decided at the highest level.

Nearly $2 trillion in environmental, social and governance (ESG) assets have disappeared

The case for optimism

There are several reasons to be careful on the impact of new sustainability disclosure rules. Accounting standards don’t stop companies from being creative with their earnings reports. As the old saying goes, what gets measured gets manipulated: Companies may report greenhouse gas emissions in their annual reports, but ensuring the quality of the data remains a challenge. Investors’ ability to make accurate and comprehensive assessments of companies’ climate-related risks depends largely on the reliability of their disclosures. At this time, widespread and reliable disclosures are not readily available. MSCI reports that of the nearly 10,000 publicly traded companies that make up the world index, disclosure rates for scope 1 and scope 2 issues are below 40%. This share is much smaller for private companies.

Measuring scope 3 emissions becomes even trickier. Is the oil company responsible for the emissions from a gas tank or the car company? What kind of jockey will that create? And what if banks were required to disclose their scope 3 emissions? Scope 3 emissions reporting remains at the center of the debate surrounding the SEC’s new proposal. While new rules only require the information if it is material — that is, what a reasonable investor would expect to find useful — environmental groups are concerned that they leave it to companies to determine the materiality of their emissions.

Still, mandatory regulation of such disclosures should tighten the process. The caveat, however, is that for the rules to have a global impact, the US needs to be on board. Only a consistent, globally coordinated disclosure standard from the ISSB, SEC and EU can reduce the burden on reporting companies and keep reporting costs manageable.

Ultimately, the challenge is whether the new rules can get companies to respond in a socially optimal way to the costs associated with generating greenhouse gas emissions – what economists call ‘internalising their externalities’. Investors and markets need reliable and easily accessible information to make this happen. Optimal disclosure requirements and regulatory oversight provide the information needed to direct capital where it best meets investor objectives – whether the objectives monetary or non-monetary. With more supervisory oversight and more standardized information on climate risks, investors can better assess risks and opportunities. It is also expected that such mandatory disclosure frameworks aimed at public investments will also trickle down to private investments. Investors who support market-based solutions hope that capital markets will eventually help companies internalize their externalities by rewarding those who reduce their carbon footprint with higher asset prices and lower costs of capital, and effectively punishing those who don’t.

Academic research demonstrates the value of standardized, audited financial information for capital market development, economic growth and corporate governance. Sustainability statements should be no different.

© Kenan Institute for Private Enterprise

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