Between a Rock and a Green Place

But as noted, there has also been pushback against the very concept of ESG. A principal focus of the backlash is on the investing community, specifically large asset managers and institutional investors, such as BlackRock, Inc., as well as proxy voting services, including Institutional Shareholder Services and Glass, Lewis & Co. The expressed concerns are threefold: first, that investors have a fiduciary duty to focus on financial returns, not social policies and “green” initiatives; second, that ESG policies can be weaponized to hurt certain industries (e.g., forcing elimination of fossil fuel investments to address climate change); and third, that participation in industrywide collaborative development of “best practices” may run afoul of antitrust laws. The backlash has surfaced in various forms. We have seen numerous state and federal legislative proposals to prohibit public pension investment decisions based on anything other than financial factors. For example, in early March, Congress exercised its Congressional Review Act authority to nullify a Department of Labor rule clarifying that ESG factors can be considered by financial advisers in making investment decisions, although the disapproval was later vetoed by President Biden. Biden Uses First Veto to Defend Rule on ESG Investing, Reuters (Mar. 20, 2023). Other proposals would require certification that the company/fund does not boycott certain industries (e.g., oil and gas). Congressional and state investigations, ever-present litigation threats from both state attorneys general and via private investor class actions, and threats to eliminate state contracts and pension fund investments for businesses with ESG investments and policies—the backlash has come from all angles.

ESG at the Forefront and Bringing Up the Rear

While ESG has become an increasingly important social issue and political football, its development as a legal concept has lagged behind. The nascent legal framework that has developed focuses on investor disclosures of material risks and performance factors, the foundation of U.S. securities regulation since the passage of the Securities and Exchange Acts, the Investment Company Act, and the Investment Advisers Act. Companies’ representations of all types have long been regulated under these Acts, their implementing regulations, and a host of deceptive trade practice statutes. ESG issues both fit under this existing framework and are subject to a developing body of law specific to ESG.

Under these disclosure-based approaches, companies have discretion in defining ESG, but they must disclose their definition and their applied measurement criteria. Investors and the public can thus hold companies accountable for a lukewarm definition that does not match what investors or the public had thought of as a proper ESG scope for the company. Forcing ESG definitions into the open may reveal policies that were long on abstract promises and short on operational specifics, or policies that are too narrowly focused. Few will bat an eye if a domestic agriculture company does not mention overseas social issues in its ESG policy; however, there may be some objections if a CAFO fails to mention methane emissions.

Many companies already engage in targeted disclosure, often focused on promoting their green or sustainable policies to consumers. When booking a flight, for example, European airlines and some domestic travel companies mention the carbon impact of potential flights to guide consumer decisions. Many airlines also permit a consumer to purchase carbon offsets when booking a flight. For example, Google currently advertises: “To help you make more sustainable travel choices, you can find carbon emission estimates on your flight search results and booking pages,” and now displays the carbon impact of a given flight when booking online. That is not to say that such targeted disclosure is improper or that these companies are concealing anything—but rather that companies can be deliberate about the subject matter of their disclosure. And notably, airlines all run a relatively limited set of airplanes with closely clustered relative per-passenger emissions, so these more focused calculations are relatively easy for them to make.

Codifying and Enforcing ESG Disclosures

GHG emissions are the clear focus of an evolving regulatory landscape by national and international regulators. However, in considering the scope of the new regulatory landscape, consider an important issue: Climate change may be the primary object of these regulations, but the concept of climate change itself refers to a complex interplay between the natural and built environment. Climate change is everything and everything is climate change. Deforestation, water conservation, even endangered species preservation all have some greater or lesser causal relation with climate change, which drives, and is driven by, desertification, drought, and habitat destruction. A single-minded focus on GHG emissions will miss the forest for the trees.

That said, GHG emissions remain the most important and prominent metric by far. Unfortunately, measuring emissions is a complex and technical challenge with ample room for disagreement. While no governing standard currently exists, the GHG Protocol, a nongovernmental reporting framework based on a partnership between the World Resources Institute and the World Business Council for Sustainable Development, is generally considered the most suitable framework. World Resources Institute, Guidance.

It is fairly simple for a company to consider its “direct” emissions. No matter which framework is applied, a company will always be measuring “at the smokestack,” and these data have long been reported by regulatory requirement. The question becomes more challenging when considering the upstream and downstream uses of your product line. For example, how should a car component manufacturer report their emissions—with or without consideration of the vehicles’ lifetime emissions? And what about indirect inputs; should that manufacturer consider the emissions of the electricity they use? These scopes are far more indefinite and sweep in significantly more ambiguously attributable emissions. The GHG Protocol considers these issues in its Scope 2 and Scope 3 Guidance; smokestack compliance is no longer sufficient, and even companies confident in their GHG impact may find eye-popping Scope 2 numbers to report.

The State Steps In

Currently, ESG regulation is proceeding in parallel with several different state and nonstate regulators, as exemplified below, while others have expressly bowed out. In the United States, Federal Reserve Chair Jerome Powell has taken a narrow view and largely disclaimed any intent to regulate climate change financial risks. That holds for now, and for the moment, the Securities and Exchange Commission (SEC) is taking the lead in crafting ESG/GHG reporting regulations.

It took over 10 years for the SEC to first issue rules concerning environmental disclosures, with its initial proposal in 1971 finalized in 1982. A similar story plays out today, with the SEC now finalizing GHG and environmental reporting standards, which stem from, among other sources, interpretive guidance first issued in 2010. Specifically, SEC Release No. 33-9106, the 2010 Climate Change Guidance, was an interpretive rule issued at the height of the debate over the American Clean Energy and Security Act, H.R. 2454 (111th Cong.), the cap-and-trade bill that passed the House but fell short in the Senate. This was just months after EPA issued its Clean Air Act section 202 endangerment and cause-or-contribution finding for GHGs. 74 Fed. Reg. 66,496 (Dec. 15, 2009).

SEC’s 2010 Climate Change Guidance focused less on the direct impacts of the changing climate. Instead, its main focus was the existence of the emerging regulatory scheme, both domestically and internationally—the Kyoto Protocol, the EPA endangerment finding, the prospect of major congressional action—and the potential physical impacts, including pricing, physical asset safety, and supply/distribution chain resilience. Noting a problem that remains to this day, the SEC stated that while some climate change–related information is required to be disclosed, “much more information is publicly available outside of public company disclosure documents filed with the SEC as a result of voluntary disclosure initiatives or other regulatory requirements.” Commission Guidance Regarding Disclosure Related to Climate Change, 75 Fed. Reg. 6289, 6292 (Feb. 8, 2010). While much has changed in the national and international regulatory landscape since 2010, the basic framework for reporting and reportable environmental issues still suffers from the same problems—more is publicly and readily available online than is required, leading to an inconsistent patchwork of disclosure. Two new rules from the SEC may change that.

The SEC is in the process of establishing ESG disclosure requirements through rulemaking. SEC’s approach is twofold: (1) amendments to its regulations under the Investment Company Act of 1940 and Investment Advisers Act of 1940 (published at 87 Fed. Reg. 36,654 (June 17, 2022)), to require more disclosure of what ESG means by those funds that self-describe as ESG funds, and (2) amendments to its regulations under the Securities and Exchange Acts (published at 87 Fed. Reg. 21,334 (June 17, 2022)), requiring disclosure of climate risks in registration statements and annual reports. Neither rule would itself define ESG, but both rules would require truth in advertising and force businesses to define their understanding of ESG and how they intend to implement it. The SEC is specifically focused on “exaggerated claims about ESG strategies,” 87 Fed. Reg. at 36,659, and so proposes certain minimum disclosure requirements. While there is no wrong definition of ESG, companies whose ESG policy has been long on promises and short on action may find themselves in a pinch with the SEC as well as landing a defendant’s role in shareholder litigation.

Nongovernmental bodies are making similar moves. Specifically, international accounting standards are also evolving, and misrepresentations in the numbers in the financial statements can be as fraught with difficulty as misrepresentations in a financial statement’s “Notes” section. The two major international accounting standards—generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS)—have both offered ESG-adjacent interpretations.

IFRS has been at the forefront. In November 2021, the IFRS Foundation created the International Sustainability Standards Board (ISSB) to govern ESG reporting and “deliver a comprehensive global baseline of sustainability-related disclosure standards.” Jelena Voilo et al., Staff Paper 15A ¶ 10, IFRS (Mar. 2022). ISSB has an ongoing project to establish general sustainability-related disclosures with its most recent meeting in December 2022 considering technical details on how to measure and report ESG metrics. For example, ISSB decided against requiring gas-by-gas GHG accounting.

The Financial Accounting Standards Board (FASB), which governs GAAP (as the IFRS Foundation does IFRS), has been less aggressive. But FASB has issued “Staff Papers” on ESG issues, most recently in March 2021, and is actively exploring its own ESG rules much as IFRS is, having decided to consider reporting requirements for GHG accounting at their May 2022 meeting.

The specific rules and regulations adopted by governments, self-regulatory organizations, and international organizations are beginning to establish an overall compliance and reporting framework. However, company compliance, alone, will soon be insufficient if we have not already reached that point. The Biden administration’s focus on “Buy American” and current geopolitical tensions regarding sourcing of raw materials, particularly critical minerals, will increase the scrutiny on supply chain issues. Not only will customers and investors be asking about where a given product was made, but also the source of all materials in the product, and with a focus on emissions attribution, particularly when accounting for Scope 3 emissions.

Scope 2 and 3 accounting is not only a technical challenge. By forcing a company to report the acts of its agents as its own, the risk is that a principal corporation will become responsible for its agent’s errors, omissions, and potential misrepresentations. If there are no safeguards or exculpation provisions for good faith reliance on representations from upstream and downstream suppliers and partners, the burden on regulated entities will be immense. Fortunately, the SEC Proposed Rule includes a Scope 3 Emissions Disclosure Safe Harbor and Other Accommodations provision, which would limit liability for good faith errors in reporting. But even if there is legal exculpation, there would undoubtedly be political and social consequences from, for example, discovering that Scope 2 emissions were misrepresented by a supplier.

It is surely an awkward spot for an overseas manufacturer to collaborate with a supplier on reporting GHG emissions while looking the other way at serious abuses by the supplier on other fronts. Many entities in both foreign and domestic supply chains are either unfamiliar with or uninterested in the granular details of fully and accurately accounting for emissions—let alone other ESG factors—and may be subject to different measurement requirements than those imposed in the United States. In many cases, principals will have to either subsidize their suppliers’ efforts at cost, make potentially faulty assumptions in the absence of good data, rely on statements they have cause to doubt, or wink at other issues.

The closer one works with supply chain partners to verify their accounting for ESG issues, the more potential exposure there is for companies to experience allegations of collusion, conspiracy, or vicarious liability for violations. For example, Nestlé was sued under the Alien Tort Statute based on its commercial relationship with suppliers allegedly engaged in forced labor practices.

Petitioners Nestlé USA and Cargill are U.S.-based companies that purchase, process, and sell cocoa. They did not own or operate farms in Ivory Coast. But they did buy cocoa from farms located there. They also provided those farms with technical and financial resources—such as training, fertilizer, tools, and cash—in exchange for the exclusive right to purchase cocoa. Respondents allege that they were enslaved on some of those farms. Nestlé USA, Inc. v. Doe, 141 S. Ct. 1931, 1935 (2021). Although Nestlé ultimately did not face exposure in this case under the Alien Tort Statute given their tangential involvement in the practices at issue and the precise language of the statute, it presents a cautionary tale for other companies as they are required to obtain increasingly detailed information from their suppliers on their operations and emissions.

The Road Ahead

The concept of ESG is far from maturity, but it is undergoing an important development as it transitions into a specific legal doctrine. How that doctrine applies in practice will take years to determine, as agencies issue final rules and those rules are challenged and enforced in court and before the agencies. But even after the courts have weighed in on the varying circumstances and requirements of these rules, companies should not expect their obligations to be clear-cut. The doctrine is simply too variable, and too causally expansive; and the concept of “materiality” similarly frustrates precise definition. The next few years will be critical as these rules are issued and work out in the courts.

To add to the mix, governments are far from the only entities with ESG definitions. Whatever accounting standard one meets, there is likely to be some relevant definition or principle to consider; wherever one has their securities listed, there may be a competing standard; and, of course, the public and various ESG pressure groups will have their own, entirely context-dependent definitions. As companies work to balance these considerations and competing definitions, they will inevitably be forced to more closely work with their supply chains, both upstream and downstream. For most, that will be a necessary step, but as noted above, it holds its own risks. It does not matter who you are, or in what industry you operate—the next few years will pose substantial legal and reputational challenges to navigate the ESG space.