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Spring 2023: Comparative and Global Perspectives

Emerging ESG Frameworks: Global Implications and Local Impacts

Summary

  • Explores how a distinct shift in global ESG policy is occurring, as it moves from a voluntary reporting landscape to a mandatory one.
  • Discusses the differences between the European Union and United States’ ESG reporting frameworks.
  • Addresses potential implementation issues.
Emerging ESG Frameworks: Global Implications and Local Impacts
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Corporate disclosures of environmental, social, and governance (ESG) matters are taking on increased importance globally. Although ESG lacks a truly standardized definition, historically, the ESG movement has largely been a voluntary one, focused on driving transparency of information and accountability to stakeholders. Numerous voluntary corporate reporting frameworks and international sustainability standards bodies have attempted to set out comprehensive frameworks for companies to provide standardized and decision-useful information to financial market participants, governments, and other stakeholders to drive responsible investing, change behavior, and reform public policy. The uptake has been tremendous—some 90% of S&P 500 companies voluntarily disclose ESG data in some format each year—but has resulted in an overabundance of data provided in a patchwork manner, which some commentators have criticized for lacking the reliability, standardization, completeness, and comparability needed to drive action among interested stakeholders. But now, a distinct shift in global ESG policy is occurring, as it moves from a voluntary reporting landscape to a mandatory one.

We are seeing the emergence of regulatory schemes requiring ESG disclosure across various jurisdictions. The European Union’s ESG disclosure framework sits at the forefront, taking a sweeping approach that requires disclosures across the full spectrum of ESG considerations, informed by a “double materiality” view of material ESG risks and impacts, and extends reporting requirements to reach non–European Union (EU) based entities. The United States lags by comparison, with a narrower, climate-focused approach to mandatory ESG reporting proposed, and fervent domestic political opposition even to that more limited proposal. Yet, these divergent rules will touch many of the same corporations, requiring them to navigate compliance with different reporting frameworks and face differing risks associated with those disclosures, raising challenges around data collection and credibility. This article will highlight the key EU and U.S. ESG regulatory models, examine the discrepancies, and identify issues that may arise for those attempting to navigate the large gulf between them.

EU ESG Reporting Frameworks

The EU’s sustainable finance strategy includes a broad range of nonfinancial reporting requirements across ESG metrics as a key prong of its European Green Deal, aimed at achieving climate neutrality by 2050. The strategy comprises several key components: the Corporate Sustainability Reporting Directive (CSRD), which requires companies to disclose ESG-related information; the Sustainable Finance Disclosure Regulation, which provides an ESG reporting framework for financial market participants; and the Taxonomy Regulation, which provides criteria for classifying which economic activities are sustainable across different sectors.

We focus here on the CSRD, which amends the Non-Financial Reporting Directive (NFRD), a law instituted in 2014 requiring ESG disclosures on a more limited basis. The CSRD became law upon its publication in the EU Official Journal on December 16, 2022. 2022 O.J. (L 322) 15. It will require compliance by certain companies starting in 2024 and will significantly expand both the number of companies that must report ESG information—from around 11,000 companies under the NFRD, up to around 50,000—and the scope of ESG reporting requirements.

Under the CSRD, the EU will now require mandatory ESG disclosures from a far broader set of corporate entities, including (1) all “large” companies (those meeting at least two of three criteria: more than 250 employees, turnover of more than €40 million, or total assets of more than €20 million); (2) all companies “listed” on an EU index, including small and medium enterprises; and (3) even non-EU companies, if they generate a net turnover of over €150 million in the EU and have a subsidiary or branch in the EU. This expansion will impact non-EU companies with EU operations that are not already subject to sustainability reporting obligations equivalent to the CSRD. Therefore, U.S. companies may be required to disclose extensive sustainability information where they have not been previously mandated to disclose any.

In the United States, ESG regulatory developments are also occurring, most notably with the SEC proposal to require public companies to disclose a series of climate-related data points as part of their public financial filings.

The CSRD also significantly expands the breadth and depth of mandatory disclosure across all three pillars of ESG, creating both general and sector-specific disclosure requirements under the forthcoming European Sustainability Reporting Standards (ESRS). These standards are now under development by the European Financial Reporting Advisory Group (EFRAG) and set to be adopted by the E.U. in two tranches, in June 2023 and June 2024. Sector-specific standards have not yet been consulted on, but they will cover relevant metrics for sectors with high sustainability risks or impacts. EFRAG Paper 06-01 (Aug. 15, 2022).

Beyond these new specific reporting standards, the CSRD also reflects broader shifts in principles that will apply across multiple standards. Perhaps most significantly, the CSRD embraces the concept of double materiality, broadening the scope of ESG disclosures to include not just material risks and impacts of environmental and societal factors on the business (i.e., what is considered under a more traditional single materiality approach) but the reverse as well. 2022 O.J. (L 322) 24. This expansion represents a fundamental change in the expectations for companies around ESG, wherein entities must now consider and disclose on how their operations and activities pose risks externally. Also, the CSRD has broadened the required disclosures related to the company’s value chain to include relevant Scope 3 emissions, or those generated from activities not directly owned or operated by the reporting organization, but indirectly affected by the organization throughout its value chain. Companies of a certain size from defined “high risk” sectors will also be expected to disclose their due diligence process to assess and manage sustainability matters throughout their value chain. If adopted, the proposed Corporate Sustainability Due Diligence Directive, a separate prong of the EU ESG strategy, will require companies to prevent, end, or mitigate harmful effects of their operations on communities and the environment. Eur. Comm’n, Just and Sustainable Economy: Commission Lays Down Rules for Companies to Respect Human Rights and Environment in Global Value Chains (Feb. 23, 2022).

These innovations, among others, signify a shift toward a new frontier of the ESG movement with the EU at the helm.

U.S. ESG Reporting Framework

In the United States, ESG regulatory developments are also occurring, most notably with the Securities and Exchange Commission (SEC) proposal to require public companies to disclose a series of climate-related data points as part of their public financial filings. See The Enhancement and Standardization of Climate-Related Disclosures for Investors, 87 Fed. Reg. 21,334 (Apr. 11, 2022). Due to technical issues with the public comment submission process plaguing a number of recent SEC rulemakings, as of January 2023 the expected schedule for a final rule has been delayed.

Assuming the SEC formally adopts a rule substantially in the form of the proposed rule, at a high level, companies would be required to make five important types of disclosures, among others. First, regarding emissions data, disclosure of Scope 1 and Scope 2 emissions will be required and must be audited. Scope 1 covers emissions from sources that the reporting organization directly controls or owns, while Scope 2 covers emissions that the company causes through purchasing energy or electricity. Scope 3 emissions—those indirectly caused by the organization throughout its value chain—will only be required if they are material, or if the company has set a greenhouse gas emissions reduction target. Second, concerning risk assessment, companies will disclose on their process for identifying, assessing, and managing risks. Potential risks related to climate change may include physical risks to operations, regulatory risks, reputational risks, and financial risks. Third, disclosure of material impacts will be required, specifically how climate-related risks have impacted or are likely to have material impacts on business, operations, or financial statements. Fourth, companies that have set climate-related goals and targets, undertaken scenario analysis, or developed transition plans will need to disclose details of those strategies, including how they intend to meet targets. Lastly, with respect to risk management strategies, companies will need to disclose how climate-related risks are affecting their strategy, business model, and outlook, and how their board oversees climate-related risk management.

While this comprehensive set of climate-related disclosure rules denotes significant progress from the prior wholly voluntary disclosure system, it is less encompassing than the EU’s ambitious framework. Indeed, the proposal stands in stark contrast to the EU’s sweeping CSRD not just for its narrower, climate-only scope but also for the vociferous opposition to it from a large faction of the domestic political spectrum.

Key Inconsistencies

As a threshold matter, given that laws (generally) adhere to geopolitical jurisdictional borders, but global business operations do not, there will be companies that are subject to mandatory reporting obligations under both the EU CSRD and the SEC climate disclosure rule. Although the CSRD provides for a possible exemption for certain companies subject to “equivalent” reporting frameworks in other countries, the mechanism by which equivalence is determined is unclear and the availability of such exemptions as a practical matter is yet to be seen. 2022 O.J. (L 322) 45. Thus, entities potentially subject to both frameworks may face an increased burden in complying due to significant inconsistencies between the regulatory schemes. A few key divergences are worth highlighting: the high-level scope of each framework, conceptions of materiality, requirements around Scope 3 disclosure, mechanisms for ESG disclosure, and auditing requirements.

First, the EU’s CSRD requires mandatory disclosures spanning all three ESG pillars. Broadly, proposed environmental criteria under the CSRD focus on a company’s energy and emissions data, climate-related risks and management strategies, water use, circular economy, pollution, and biodiversity; social factors include working conditions, diversity, inclusion, and human rights; and governance factors pertain to business risk, strategy, and board oversight over the full range of sustainability information. EFRAG, First Set of Draft ESRS (Nov. 2022). The U.S. SEC proposal, by contrast, focuses primarily on climate change–related disclosures. Therefore, while companies disclosing under both frameworks may be able to utilize some aspects of their SEC-compiled data for the climate-related EU disclosures, the majority of the CSRD requirements will be applicable only to EU operations for U.S.-based companies, which could present difficulty around collecting and preparing the information. For stakeholders and other consumers of the information, it will also mean more limited transparency under US disclosures than in the EU.

Second, the EU and U.S. frameworks are underpinned by different concepts of materiality driving disclosures. The U.S. SEC climate disclosure rule reflects the more traditional concept of single materiality, or environmental and social risks that are material to the enterprise and thus necessitate disclosure. The EU’s CSRD, however, requires disclosures to consider double materiality, requiring consideration and disclosure of material impacts both to the organization and sustainability-related impacts of the organization on the environment or social systems. Whereas single materiality places emphasis on financial market participants understanding how sustainability risks may impact an organization’s financial health, double materiality caters to a broader group of stakeholders interested in the impact of corporate activities on environmental and social stability, without focus on the company’s bottom line. The CSRD’s embrace of the double materiality principle represents a massive departure from mainstream voluntary reporting frameworks, the SEC’s definition of materiality, and the EU’s prior system. Ultimately, companies disclosing under both the EU and the U.S. frameworks will be required to consider nonfinancial stakeholders to a much more significant degree in their EU reporting.

Third, the EU model takes a potentially broader approach to mandatory disclosure of Scope 3 emissions than does the US. Scope 3 emissions encompass all indirect emissions that occur across the value chain for the company, including both upstream and downstream emissions. The Greenhouse Gas Protocol for emissions accounting divides Scope 3 emissions into 15 categories—including transportation, purchased goods and services, business travel, and use of sold products—but not each category is relevant to each reporting organization. Under the U.S. SEC proposal, companies would only be required to disclose Scope 3 emissions if they have Scope 3 emissions reduction targets or if the emissions are deemed “material.” The EU standards require disclosure of Scope 3 emissions only for “relevant” categories. The ESRS will specify standards for reporting companies to disclose both on which categories of Scope 3 are relevant and the emissions in each of those categories. While neither the United States nor the EU requires disclosure of gross Scope 3 emissions, the EU’s standards for what categories are relevant may be broader than the SEC’s narrow definition of materiality, as discussed below.

Under the EU’s Corporate Sustainability Reporting Directive, companies will be expected to include all ESG information in a dedicated section of their company management report rather than in a separate report.

Fourth, the EU and the U.S. models will require reporting through different avenues. Under the CSRD, companies will be expected to include all ESG information in a dedicated section of their company management report rather than in a separate report. Companies will also be expected to digitally tag sustainability information so that the EU can maintain a single uniform streamlined database of disclosures under the CSRD. The proposed SEC framework would require climate-related disclosures to be made in registration statements and periodic public reports. This distinction will require companies subject to both requirements to disclose ESG information in multiple formats.

Lastly, both the EU and U.S. laws include an assurance component, but it’s not yet clear how similar the two approaches will be. Under the SEC proposed rule, the largest public companies would be required to provide an attestation report covering Scope 1 and Scope 2 emissions disclosures in their annual reports and registration statements. Instead of designating a specific attestation standard to be used, the SEC points to publicly available standards similar to those used for financial reporting. The proposed rule in the United States also would require public companies to use an attestation provider that meets certain requirements. The CSRD has not yet developed assurance standards, so it will initially require “limited” assurance, meaning “no matter has been identified by the practitioner to conclude that the subject matter is materially misstated.” 2022 O.J. (L 322) 34. Eventually, a more rigorous, “reasonable” assurance engagement will be required. Id. at 69. This standard will develop over time with the aim of ensuring high credibility and quality in sustainability reporting. Depending on how these standards evolve, companies may face different levels of audit for different portions of their ESG disclosures.

Potential Implementation Issues

The diverging regulatory schemes in the EU and the United States may pose difficulty for global companies with operations across these jurisdictions—let alone in other locations that may develop further regulatory regimes for ESG reporting—which may soon have to comply with inconsistent legal obligations. As discussed below, areas that may pose particular challenges for companies dealing with this complicated and burdensome implementation include defining materiality under different frameworks, quantifying Scope 3 emissions, facing potential litigation risk from public disclosures, and increasing strain on funds from state-level anti-ESG legislative efforts.

U.S. companies that must disclose increasingly more ESG information under the new EU rules could also face heightened litigation risks at home under a few different legal theories.

For disclosing entities, identifying what is material under differing standards may prove a major hurdle in providing responses under the EU and U.S. schemes. In the United States, the concept of materiality has been incorporated into SEC laws and regulations since the 1930s. Under the federal securities laws, a piece of information is material if “there is a substantial likelihood that a reasonable investor would attach importance in determining whether to purchase the security registered.” 17 C.F.R. § 230.405 (1982). U.S. courts have spent decades honing this standard and determining whether information at issue in securities disclosure is material to investors. The EFRAG, the advisory entity drafting the ESRS, is unsurprisingly not basing its standard on U.S. law and instead has proposed to define materiality to include information if “it reflects . . . capacity to meet the needs and expectations of the stakeholders of an undertaking . . . allowing for proper decision making, and more generally the needs for transparency corresponding to the public interest.” EFRAG, [Draft] European Sustainability Reporting Guidelines 1: Double Materiality Conceptual Guidelines for Standard Setting (Working paper, Jan. 2022). As these two definitions show, the SEC version of materiality is singularly focused on the relevance of information to investors, whereas the EU version focuses on stakeholders more generally and the public interest.

By some estimates, Scope 3 emissions account for an average of three-quarters of a company’s total emissions and can approach 100% of emissions for certain sectors. See CDP Technical Note: Relevance of Scope 3 Categories by Sector (Apr. 11, 2022). Attempting to estimate Scope 3 emissions is important for understanding the comprehensive picture of a company’s footprint and avoiding attempts to hide risk exposure outside of a company’s direct operations. It also comes with a host of practical issues. Collecting Scope 3 emissions data inherently relies on participation from third-party businesses throughout the corporate value chain. Often, smaller entities are less equipped to collect climate-related data for their suppliers and purchasers. Even if they can provide information, the receiving entity may encounter issues verifying those data, and may argue that they are unable to control the actions of other parties to reduce value chain impacts. Due to the lack of primary data from third parties, companies often use industry average data and modeling to estimate Scope 3, which raises accuracy concerns. Lastly, many point to the potential for double counting as an issue, where one reporting entity would disclose a set of emissions as Scope 1, while those same emissions are disclosed as Scope 3 for another reporting entity. As both the EU and U.S. frameworks will require some degree of Scope 3 disclosure, companies will have to grapple with these, among other, implementation issues around data collection, value chain engagement, and verification.

U.S. companies that must disclose increasingly more ESG information under the new EU rules could also face heightened litigation risks at home under a few different legal theories. For one, companies could face shareholder allegations of securities fraud if they make material misstatements about ESG initiatives. Where ESG information disclosed in any public filing is perceived as being misleading or incomplete, companies could be at risk for claims that it was deceptive. Similarly, investors or consumers could bring actions against companies for deceptive trade practices and “greenwashing” if they publicly overstate environmentally or socially friendly practices. As companies navigate the requirements to publicly disclose more ESG information through different regulatory schemes, which carry differing standards with respect to assurance, potential plaintiffs may find more opportunities to bring claims related to that information.

Lastly, U.S. companies, in particular, face strong crosswinds on the ESG front. There is a growing anti-ESG movement percolating in parts of the United States, while in other areas, states and local entities are seeking to expand ESG transparency beyond the SEC’s climate disclosures proposal.

For one, companies may start to face backlash against the ESG movement, creating tension for reporting corporations and financial institutions as they are increasingly expected to demonstrate stronger sustainability. For example, in 2021 Texas passed anti-ESG legislation barring local authorities from doing business with banks that have divested from Texas-based fossil fuel companies. Other states, including North Dakota, have enacted bills that don’t allow state funds to be used for ESG investment. See Lance Dial, The Challenge of Investing in the Face of State Anti-ESG Legislation, Reuters (Aug. 24, 2022). In October 2022, Louisiana announced the state treasurer would pull $800 million out of BlackRock due to BlackRock’s support of certain ESG investment strategies. Mark Segal, Louisiana Divesting $794 Million from BlackRock to “Protect” Funds from ESG Investing, ESG Today (Oct. 6, 2022). These types of anti-ESG bills may strain ESG funds that want to offer sustainable investment options while still doing business with state governments. And at the federal level, a bevy of disapproving comments were submitted on the SEC’s climate disclosure proposal that question not only the merits of the proposal but also the SEC’s authority to promulgate such a rule. Commw. Climate & L. Initiative, Review of Public Comments to US Securities and Exchange Commission Regarding the Proposed Rule for Climate Change Disclosures (Sept. 5, 2022). Beyond that, however, even federal legislators have waded into this territory, with a selection of U.S. senators recently sending letters to a long list of major law firms alleging potential anticompetitive practices of ESG efforts.

On the other end of the spectrum, state and local entities may attempt to establish more ambitious disclosure requirements than the SEC has proposed. For example, a recently proposed state law in California would mandate disclosure of Scope 1, 2, and 3 greenhouse gas emissions data by all U.S. entities with total annual revenues in excess of one billion dollars that do business in California. Climate Corporate Data Accountability Act, SB-253 (Cal. 2023). A separate proposed bill would require noninsurance U.S. financial entities with revenues in excess of $500 million that do business in California to prepare a climate-related financial risk disclosure. Climate-Related Financial Risk Act, SB-261 (Cal. 2023). If passed, these bills would impose requirements that exceed the scope of the proposed SEC rule and would reach thousands of companies and financial institutions based outside of California. Several other state legislatures have begun considering similar measures. This effort represents the potential for U.S. companies to be subject to even further differing disclosure mandates passed by state or local governments as they work to comply with changing federal and international schemes. Beyond the challenges presented by differing U.S. and EU ESG standards, these opposing domestic trends create a volatile mix for companies caught in the middle to navigate.

The shift toward comprehensive mandatory reporting schemes has the potential to correct many of the frustrations reporting entities and data users have experienced with the primarily voluntary model. But as ESG reporting moves from that largely voluntary basis, with often fungible standards that can easily transcend jurisdictional boundaries, and into a command-and-control regulatory model, we are seeing discrepancies in the scope and pace of those mandatory frameworks developing across jurisdictions. The critical differences between the EU and U.S. schemes highlighted here illustrate the looming challenges for reporting entities that will soon be mandated to disclose different information, in different formats, and may face different risks associated with those disclosures from one jurisdiction to another.