The SEC Needs to Catch Up on Sustainability

One issue that's sure to be on Gary Gensler’s agenda if he's confirmed as the new chair of the Securities and Exchange Commission is climate-change-related disclosure. The two Democrats on the five-member commission, Allison Lee and Caroline Crenshaw, have already indicated support for the idea. So the real question is: What will be the scope of any new rules, and will they cover the expanding universe of environmental, social and governance issues — and sustainability in general? 

It would be easy to say that the SEC hasn't acted in this area because of the Donald Trump administration’s opposition to climate change and ESG initiatives. But that's too simplistic. I believe Jay Clayton, the SEC chair for almost all of Trump’s term, has been reluctant to act because of his honestly held views about what's appropriate under the law. It’s worth considering the reasons Republican commissioners have articulated their objections, because any new SEC action will need to show why those concerns aren't persuasive. 

The primary argument against new rules has been that the existing principles-based disclosure regime, which requires disclosure of any information that's material to a reasonable investor, is sufficient. If Exxon Mobil Corp.’s plans to cope with potential stranded assets or its carbon footprint, or Amazon.com Inc.’s record on racial or gender equality, is material to an investor, then those companies already are required to disclose that information. If it's not truly material, the SEC shouldn't force disclosure through the adoption of specific requirements.

A second argument has been that mandating specific ESG disclosure beyond today's principles-based rules would be equivalent to harnessing the disclosure regime to serve policy objectives outside of securities laws. Unless Congress directs it to do so, that's not the SEC’s job. Third, the critics would say more prescriptive, specific ESG-related requirements can't work when there is no consensus on which issues are even considered to be ESG. Any attempt to impose specific requirements would involve highly subjective choices about what should be covered and what information should be provided. Finally, companies can decide voluntarily whether to respond to ESG-based rating systems; the SEC need not be the enforcer.   

The problem with the first argument is that it ignores both the history of disclosure requirements as well as what investors are saying today. While the same principles have animated the Securities Act since its passage in 1933, disclosure requirements have been expanded repeatedly and significantly over the years. The original version of the law set forth all the disclosure requirements in a short schedule.  But that schedule has been superseded by hundreds of pages of rules, which have been necessary not because we changed the basic principles, but because of the evolving needs of the market. The SEC has mandated additional rules because they are the best way to achieve the disclosure that investors want. They're far more effective than bringing enforcement actions alleging violations of the general duty to disclose. 

The evidence is abundant today that investors consider climate change and ESG issues to be important. Investors with nearly $100 trillion of assets under management have signed on to the United Nations-backed Principles for Responsible Investment, by which they pledged to incorporate ESG issues into investment analysis and seek appropriate disclosure.  Financial institutions responsible for $150 trillion of assets have expressed support for the recommendations issued by the Task Force on Climate-Related Financial Disclosure, or TCFD.

Support will likely increase if the Department of Labor reverts to its 2015 guidance to fiduciaries of the Employee Retirement Income Security Act, which stipulated that while ESG factors can't be prioritized above investment performance, they can be “components  ... of [an] analysis of the economic merits of competing investment choices.” The Trump administration changed that guidance so as to effectively prohibit consideration of such factors. 

Rising investor interest also shows why the second objection isn't accurate. ESG investing has moved from being “values-driven” — where it was a reflection of an investor’s personal values — to being “value driven.” Increasingly, ESG issues are seen as material to a company’s long-term performance and a reflection of future risks and opportunities. In short, it's about sustainability.

The need for more information on sustainability isn't unlike the evolution of disclosure on financial information. In 1989 the SEC issued guidance stating that historical financial statements needed to be supplemented by a “management’s discussion and analysis” so that trends and uncertainties that might become material in the future were disclosed. Similarly, we have reached a point where the existing requirements for discussion of risk factors and other forward-looking information are simply not sufficient to meet investor needs. 

But getting it right isn't easy. The SEC did issue guidance on climate change disclosure in 2010 in response to a petition, but that guidance has largely been seen as ineffective.

Internationally, other regulators have gone much further, but their approaches don't always fit the traditional approach of U.S. securities law. In 2014 the European Union passed a non-financial reporting directive requiring companies of a certain size to “disclose certain information on the way they operate and manage social and environmental challenges.” But the EU embraced a “double materiality” standard that includes not only whether the issue is material to the value of the company but whether it's material in its environmental or social impacts on society. Major Japanese corporations have been issuing sustainability reports since the early 2000s. In 2018, the Japanese Ministry of Economy, Trade and Industry published robust guidance for companies. In 2020, 100% of the country’s largest 100 companies issued sustainability reports.

There is a vast range of voluntary standards, and some suggest that's good enough, or that consolidating those standards would be more helpful than official action. But the landscape is difficult to navigate, with numerous disclosure frameworks and little clarity around who should use which ones. Ninety percent of companies in the S&P 500 Index provided some sort of sustainability report in 2019, but without regulatory requirements, many had little useful information. Voluntary standards can also emphasize ratings over information — deeming a company green or good based on a particular scale — that can produce questionable judgments. We need standards that promote disclosure of underlying trends, risks or uncertainties that can contribute to analysis and competing views.  

So what should the SEC do?  How does it mandate disclosure of important ESG issues while avoiding the subjective selection of topics that some critics fear? How does it chart a course between too-general requirements that produce limited-value disclosures, and rules that are so detailed they create excessive burdens that outweigh the value of the information? 

One approach would be to mandate disclosures based on an existing framework such as the one recommended by the TCFD.  It was established in 2015 by the Financial Stability Board, which represents all G-20 countries, and its recommendations have been endorsed by, or incorporated into disclosure frameworks in, several countries.  Widespread adoption would promote comparability across companies. However, the TCFD framework doesn't address the “social” and “governance” elements of ESG.

Another approach is to require a “sustainability disclosure and analysis” as suggested by Professor Jill Fisch of the University of Pennsylvania Law School, which would require public companies to discuss the three sustainability issues that are most significant. While the selection of three is arbitrary, it's an attempt to require something meaningful without being burdensome. 

Whatever the SEC mandates will evolve and change over time. Once greater sustainability disclosures are required, the SEC staff will review and comment on individual companies’ filings, and that should help improve both quality and comparability. Investors’ and analysts’ reactions will shape what is helpful and what isn't. The SEC has lagged in this area. It needs to take a step forward now.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Timothy Massad is a senior fellow at the John F. Kennedy School of Government at Harvard University. He served as chairman of the Commodities Futures Trading Commission from 2014 to 2017 and was the U.S. Treasury Department's assistant secretary for the Office of Financial Stability, which oversaw the Troubled Asset Relief Program.

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