Turning Down the Heat on the ESG Debate: Separating Material Risk Disclosures from Salient Political Issues

With political battle lines drawn over environmental, social and governance (ESG) disclosures, it is fair to ask whether the sustainability movement is itself sustainable. As a registered Republican (Crowley) and a registered Democrat (Eccles), we do hope that it proves to be sustainable because we see this movement as fundamental to how the capital markets can support the well-being of all Americans. But the movement is currently facing grave political challenges. The underlying reason for this is the conflating of material risk disclosures wanted by investors and resisted by companies with related political issues. Being clear about the distinction between the two would be useful to both parties.

Many Democrats see ESG as an opportunity to pursue desired social change through collective action in the form of democratic capitalism.  Most Republicans view the ESG movement as an offshoot of the Green New Deal and therefore akin to thinly-veiled Marxism.  While there may be some truth to both views, neither accurately reflects marketplace and regulatory developments over the past quarter century.  Indeed, the history of major downturns in our financial markets is largely a history of management failure to disclose known business risks in time for investors to avoid catastrophic losses.  When such failures have become widespread, Congress and the U.S. Securities and Exchange Commission (SEC) have routinely stepped in to require additional corporate disclosures.  This article will retrace some of the key developments in order to demonstrate that sustainability is not new, nor is it mainly about scoring social justice warrior points.  Rather, it is about what regulations are necessary to ensure that the assumption of risk by investors is adequately informed.

The Investor Need for Disclosure

From the standpoint of investment management, it is important to note that conflicts of interest are inherent in the business of managing other peoples’ money. That is why, since the Great Depression, Congress has repeatedly tasked the SEC with administering a set of securities laws that are based on the notion that disclosure of financial results and business risks — specifically, those that are known to management — must be sufficient for investors to make informed decisions about how to allocate scarce capital.  In other words, our securities laws require disclosure of risks that would be “material” to investors.  In TSC Industries v. Northway, the U.S. Supreme Court ruled that a fact is “material” if there is “a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote,” or “a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.”

The modern era of corporate disclosure effectively began when, due primarily to extremely aggressive accounting practices and auditing shortcomings, Enron filed for bankruptcy on December 2, 2001.  At the time, it was the biggest bankruptcy in history.  Congress set about considering reforms, but enthusiasm waned until MCI WorldCom filed for bankruptcy on July 21, 2002.  Within a week of that even-bigger bankruptcy, Congress passed the Sarbanes-Oxley Act (SOX), which created the Public Company Accounting Oversight Board (PCAOB) and established an accounting support fee to fund both the PCAOB and the Financial Accounting Standards Board (FASB).  With respect to the FASB, the private-sector standard setting body responsible for issuing generally accepted accounting principles (GAAP), Congress determined that an independent and reliable source of funding was essential in order to insulate the FASB from political pressure to modify its standards, typically by special interests who seek in one way or another to avoid transparency.  Importantly, GAAP is a historical reflection of actual economic results.  Sustainability disclosures, on the other hand, while also based on past performance, are prospective in nature and relate to risks that may manifest in future financial results.  Both types of disclosure are important, but they serve fundamentally different purposes and therefore must not be conflated. We note that the SEC respects this fundamental dichotomy between accounting standards on the one hand and sustainability disclosures on the other in its pending climate risk disclosure rule.

During the “tech bubble” of the late 1990s, even before the Enron and MCI WorldCom bankruptcies, investors had grown increasingly concerned that corporate management was cooking the books in order to show steadily increasing returns quarter after quarter.  Such concerns resulted in a corporate disclosure revolution in which investors began seeking ways to determine corporate value without relying solely on quarterly results, particularly earnings per share (EPS).  The first manifestation of the “value reporting revolution” was in the form of Extensible Business Reporting Language (XBRL), a way of using technology to compare key value metrics between companies and across industries, which was released on December 31, 2003.  Then-Congressman (and later SEC Chairman) Christopher Cox (R-CA) was among the first advocates of such enhanced disclosure, primarily as an alternative to new government regulation.

Following the credit crisis of 2008-09, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank).  The impact of Dodd-Frank is beyond the scope of this article, but among its most enduring features is that, as a result of its enactment, financial regulatory policy issues have become highly partisan.  That is because Congressional Democrats, who were then  in control of Congress, revisited every major financial services law from the National Bank Act of 1864 through Sarbanes-Oxley over a short 14-month period with very little input from Republicans.  In this way, Dodd-Frank ushered in a new era of intense partisanship on financial policy issues that previously were thought to be nonpartisan (i.e., economic principles do not vary based on one’s political ideology).

Notably, during the credit crisis, hundreds of banks reported clean financial results only to be taken over the by the Federal Deposit Insurance Corporation (FDIC) for insolvency shortly thereafter.  The reason is that the existing “incurred loss” accounting model allowed these banks to not recognize the toxic assets on their balance sheets until the losses were realized. Consequently, global financial regulators suggested that the FASB and its international counterpart, the International Accounting Standards Board (IASB), consider moving to an “expected loss” standard.  Following a multi-year standard setting process, the current expected credit loss (CECL) standard was issued in response.  Predictably, certain banks did everything they could to derail the CECL standard, which once again exemplifies the need to insulate accounting standards from politicization.

Sustainability disclosures, on the other hand, include information which is material to investors as well as information that is important to other stakeholders who have concerns about a company’s activities and products that they perceive as creating negative externalities. In today’s parlance, the former is referred to as “single materiality,” the basis of the work of the Sustainability Accounting Standards Board (SASB), and the latter as “double materiality,” the basis of the work of the Global Reporting Initiative. The line between the two is not well-defined and thus makes sustainability fair game for policymakers. The task, then, is to determine which disclosures are material to investors and to balance that need with the cost to issuers. While the terms “sustainability” and “ESG” now mean very different things to different people, for us ESG factors are that subset of all sustainability issues that matter to investors and are thus important for enterprise value creation.

The Climate Crisis

Concerns about environmental degradation generally, and climate change in particular, prompted Pope Francis to release an encyclical titled “On Care for Our Common Home” on May 24, 2015.  Shortly thereafter, the UN 2030 Agenda for Sustainable Development was adopted.  Before the end of that year, the Financial Stability Board (FSB) established the Task Force on Climate-Related Financial Disclosures (TCFD) to develop recommendations for more effective climate-related disclosures.  On April 22, 2016, the U.S. and 194 other signatories signed the Paris Agreement under the United Nations Framework Convention on Climate Change (Paris Agreement).  The TCFD released its final report on climate-related financial disclosures and began the “TCFD Pilot Project” on June 15, 2017.

The Europeans always seem to be a few years ahead of the U.S. in many ways, whether it is on fashion, art, cuisine, data privacy, climate, or sustainability.  On October 28, 2017, the European Commission announced the creation of the High-Level Expert Group on Sustainable Finance.  On March 9, 2018, the European Commission released an action plan for financing sustainable growth in response to recommendations from the High-Level Expert Group on Sustainable Finance.  On June 13, 2018, the European Commission’s Technical expert group on sustainable finance was established.

In the U.S., the Green New Deal was first introduced in the House of Representatives on February 7, 2019.  Perhaps more significantly, on August 19, 2019, the Business Roundtable (BRT) released its Statement on the Purpose of a Corporation proclaiming a fundamental corporate commitment to all stakeholders, not just to shareholders.  Some saw the BRT statement as calling into question the traditional view that the responsibility of corporate management is to maximize return to shareholders.  However, these alternative approaches are not in conflict.  Rather, they are complementary.  In other words, corporations who appropriately consider the interests of key stakeholders are likely to be better managed and therefore produce higher returns to shareholders over time. A similar analysis applies to sustainability, particularly for investors with a long-term investment horizon and for whom materiality has a temporal dimension (e.g., climate change may or may not be material over the next calendar quarter, but it clearly might be over a 40-year investment time horizon).

ESG and the Biden Administration

As a practical matter, the Biden legacy items, the policy issues for which President Biden will be most remembered, such as his executive orders and so forth, boil down to two big buckets: (1) climate change and (2) social equity.  Translating those policy priorities into ESG means that, for all practical purposes, the “E” in ESG relates to climate change, and not much else (e.g., no one in D.C. policy circles talks much about plastics in the ocean), the “S” means human capital, and the “G” relates to lowering any barriers that investors or other stakeholders may face when trying to communicate their policy preferences on “E” and “S” issues to corporate management through the proxy voting process.  In other words, these policy priorities are very much embedded in the discussion about the need for enhanced corporate disclosures.  While this is true, the result has been a political backlash against ESG as a proxy for concerns about these Biden policy priorities.

Shortly after the 2020 Presidential election, the SEC’s Asset Management Advisory Committee ESG Subcommittee recommended adopting disclosure standards for material ESG risks.  A week later, the Investment Company Institute called for enhanced ESG disclosure by corporate issuers.    Shortly after his inauguration, President Biden issued an executive order creating a National Climate Task Force and directing government-wide solutions aligned with the Paris Agreement.  A month later, the International Organization of Securities Commissioners (IOSCO) publicly supported the creation of a Sustainability Standards Board under the International Financial Reporting Standards Foundation (IFRSF). The International Sustainability Standards Board was officially launched on November 3, 2021.

On March 15, 2021, the SEC requested comments on climate change disclosures.  On October 14, 2021, the DOL published a proposed rule that clarifies the consideration of ESG factors by fiduciaries under ERISA.  On March 15, 2022, the SEC finally issued its long-awaited (and yet to be finalized) proposed rule requiring certain climate-related risk disclosures. It has received over 5,000 comment letters that range from “we need a lot more” to “we don’t want any of this at all.”

Going beyond disclosures relevant to investors and into the realm of public policy, the Biden Administration’s intense focus on hastening the transition to alternative forms of clean energy has resulted in a political backlash which forced Saule Omarova to withdraw her nomination to head the Office of the Comptroller of the Currency (OCC) on December 7, 2021, and Sarah Bloom Raskin to withdraw her nomination to serve as Vice Chair for Supervision of the Federal Reserve on March 14, 2022.  In both cases, these nominees proved to be unconfirmable because of their truth: that the Biden climate change agenda is seeking to dramatically limit the production of oil and gas, raising concerns about energy prices and energy security.

The GOP reaction to these policy priorities has been predictable.  On May 26, 2022, former Vice President Mike Pence authored an op-ed stating that the promotion of ESG was by activists rather than shareholders.  Two weeks later, 131 (of 211) House Republicans signed a letter to SEC Chair Gary Gensler demanding that the SEC rescind its proposed climate risk disclosure rule, while Republican members of the Senate Banking Committee issued a letter to Chairman Gensler requesting information regarding the SEC’s ESG-related rulemaking activities.  However, Republican concerns about the Biden agenda must be distinguished from investors’ need for material information.

The Challenge for Fiduciaries

Modern portfolio theory allows investors to maximize expected return for a given level of risk.  Of course, portfolio theory continues to evolve.  Forty years ago, most business schools taught that the best way to manage portfolio risk is through diversification among equities with different return profiles (i.e., their covariance).  Before long, it was observed that by adding other asset classes, the risk associated with a particular level of return could be reduced. Asset allocation models are growing ever more sophisticated, and many now include an ESG overlay.  As the world becomes increasingly complicated, fiduciaries are compelled to adopt new analytic techniques.  These developments have nothing to do with public policy debates.  Instead, they pertain to investor need for material information about their investments.

Following the 2016 presidential election, the Trump Transition Team set about putting the ESG toothpaste back into the tube by revisiting Department of Labor (DOL) guidance issued during the Obama Administration which, for the first time, opened the door to considering ESG factors by ERISA plan fiduciaries.  However, when the Trump DOL finally issued the Financial Factors in Selecting Plan Investments rule on November 13, 2020, it essentially ratified 90% of the Obama era guidance.  In short, the Trump DOL established that ERISA plan fiduciaries may only focus on “pecuniary” considerations.  At the same time, they confirmed that pecuniary returns can be directly impacted by ESG factors.

There are those who advocate for divestment of companies that do not adhere to their ESG concerns. This is especially prominent in the oil and gas industry. However, as a practical matter, many large institutional investors benchmark their returns against an index created by an independent provider, which may preclude divestment as a strategy.  Moreover, divestment presents its own risk of missing out on returns.  Instead, most fiduciaries choose to engage with management in order to convey their preferences on major policy issues by exercising their rights as shareholders through the proxy process.  Which is the more responsible approach, divestment or engagement?  If engagement is the better course, it is not a stretch to conclude that investors need disclosure of material risk information that is known by management.

Of course, investor confidence in the integrity and accuracy of reported financial results is the sine qua non for robust capital markets.  Investors and their fiduciaries depend entirely on the accuracy of financial statements.  That is why it is so important not to politicize the accounting standard setting process or to confuse accounting standards on the one hand with sustainability regulations on the other.  The FASB is not a governmental body, but rather a private sector standard-setter endorsed by the SEC that has no rulemaking, examination, enforcement or policymaking authority.  Instead, Congress has given the SEC the responsibility of ensuring the adequacy of its disclosure regime.

It is thus up to the SEC to determine what additional disclosures companies should provide to investors about material risks. The benefits to investors of these disclosures must be balanced against the costs to the companies for providing them. As the SEC considers the many comments it has received on its promised climate disclosure rule, it must maintain this focus. Policymakers with different views about whether and how to address climate change need to recognize that this legitimate political debate is a separate issue from the need for companies to disclose known, material risks to investors.