The proposal of US Securities and Exchange Commision (SEC) to make companies disclose their climate risks, their greenhouse gas emissions and other environmental metrics and in doing so tightening ESG regulations has caused an uproar in the corporate and investing worlds. It’s also seen as controversial by corporate lawyers, mainly because it seems at variance with the SEC’s main objective, to protect all investors, rather than just some (those interested in ESG issues). The SEC’s move may be a clumsy attempt by regulators to achieve an objective that may be much better met by incisive data analysis and good self-regulation.
ESG regulations and the need for accuracy
The weakness of the SEC’s proposal is best demonstrated by examining the more general risk disclosures the SEC requires. In the 10-K filings of large US companies, it is not unusual to find 20-30 pages or more identifying risks. These risks are usually unprioritized in terms of their likelihood or impact, with no analysis of interdependence between them. They are not much use to investors.
A further problem with heavy-handed regulation is that the scope of ESG reporting is so broad that many companies find it hard to provide comprehensive and accurate reporting, particularly of Scope 3 emissions – those generated by the upstream and downstream activities associated with a company.
Recent research at Stanford University has confirmed just how hard it is to quantify these. Scope 1 and Scope 2 emissions are difficult enough to quantify. So regulators, including those in the EU (whose regulatory proposals suffer from many of the weaknesses of the SEC’s), should think hard about the problems they are causing, particularly compliance costs.
The fine imposed by the SEC recently on BNY Mellon on the grounds of the inaccuracy of its green assertions is a warning of things to come. It is understandable that companies and funds want to appear green, particularly in the light of the relatively good performance of ESG investments in the recent sell-off (though research highlights that it is not certain that this performance may not continue as the whole investment market becomes greener).
It is of course right to penalise companies that knowingly make misleading statements. However, accuracy is hard to achieve in ESG reporting, so a heavy-handed regulatory approach may not help investors make decisions, particularly when complicated by differences in emphasis of regulatory regimes, particularly between the US and the EU.
Time to slow down and think
It may be time, as a recent article in Forbes suggests, to slow down and think. Forcing senior executives to focus on ensuring that their companies present their ESG performance accurately may distract them from actually improving that performance. This would be sad, given that a recent report from IBM identifies how many CEOs are (at last) focused on ESG performance.
Furthermore, ethical investors may be becoming sceptical about disclosure initiatives. If they know their financial history, they will know that regulators find it hard to decide what to do, while companies chasing profit are good at finding ways round regulation.
ESG regulations are easy to create, effective regulation is not! In fact, as The Economist has pointed out, in the last financial crisis, and in all similar financial crises, clear evidence of serious financial problems was available but not taken seriously enough by most governments, companies or indeed investors.
Today, the same is true of ESG performance. The data on what companies are doing is available. Why rely on infrequent summaries of ESG performance, prepared by companies in ways that make the best of whatever they are doing? Why wait for regulators to produce workable ESG regulations? Instead, investors can find out whether a company they are considering investing in has got ESG issues, using our data.
