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Summer 2023: Net Zero

Between a Rock and a Green Place

Carolyn L McIntosh and Samuel Ballingrud


  • Surveys the evolving legal and regulatory landscape as it relates to the “E” in ESG.
  • Discusses the expectations of companies implementing ESG framework.
  • Examines ESG as both an important social issue and legal concept.
Between a Rock and a Green Place
Fredrik Findahl / 500px via Getty Images

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Ambiguity is the foundation of any good compromise. The more specific and the more concrete the terms, the sharper and clearer the divisions, and the more present and immediate the challenges. Ambiguity glosses over inconvenient issues, leaving disputes for another day when the temperature is lower. While perhaps not the foundation for a lasting settlement, ambiguity makes possible a present agreement.

And so it is with the evolving framework of environmental, social, and governance (ESG). Without definition, parties that would normally find themselves at loggerheads over any number of specific issues were all able to agree that “ESG” would be their common lodestar. Oil companies and environmentalists, activist investors and entrenched boards—with ambiguity came (relative) peace as each made their own definition and could focus on the “easy wins.” But with this ambiguity also came allegations of greenwashing—as the differences in each parties’ definition and expectations of ESG came into sharper focus, the definitional evolution has made strict adherence to “standards” a challenge. Pressure groups pointed out that companies were claiming ESG compliance by changing little to nothing about their operations, and yet touting success.

But storm clouds gather, as both domestically and internationally, regulators and circumstances are chipping away at the ambiguity that held this relative peace. Environmental issues, particularly climate change, are being defined with hard-and-fast standards that leave little room to hide. Social issues are forced to the forefront with war, forced labor, and human rights deterioration around the world. Governance issues are becoming harder to ignore as boards and C-suites remain profoundly monochromatic despite years of high-profile effort. The struggle to comply with an increasingly well-defined and government-enforced ESG framework, while trying to maintain the peace previously cultivated, will define the coming years of corporate governance and compliance.

This article surveys the evolving legal and regulatory landscape as it relates to the “E” in ESG. Although evolving, the legal and regulatory framework will give structure to compliance efforts and should help companies avoid the “greenwashing” allegations inherent in the absence of a clear governing standard. But it may also pose substantial risks for companies; these nascent standards may force companies into ever-closer working relationships with their supply chain partners, particularly in accounting for their emissions. Companies that understand their suppliers and customers and that clearly communicate their mission, values, and corporate culture, and that also establish metrics, measure the effects of their tangible actions, and disclose concrete data, will have greater success navigating the current ESG uncertainty. But already there is a growing backlash against ESG policies, which brings increased political risk and places companies in a potential no-win scenario. With ESG acolytes and activist investors on one hand, and anti-ESG partisans on the other, companies attempting to comply with an evolving regulatory framework find themselves between a rock and a green place.

Defining ESG

First, an effort at defining ESG. The term “ESG” can be understood as a set of priorities that emphasize long-term sustainability and social consciousness. Committing to a sustainable business model is basic corporate governance; what distinguishes ESG is the focus on sustainability beyond the “four corners” of the corporation, asking corporations to consider their long-term environmental sustainability beyond their immediate supply chain.

This is not particularly novel. President Theodore Roosevelt famously championed sustainable exploitation of natural resources during his presidency; the Royal Navy, whose ravenous need for a specific type and quality of timber led to extensive deforestation, recognized the importance of long-term timber sustainability hundreds of years before the United States was founded. The difference—if there is one—is primarily one of degree. The Royal Navy needed a sustainable supply of oak trees for its warships, particularly mature trees for their long and straight masts; ESG would ask that the Royal Navy consider oak forestation for its impact on biodiversity and carbon capture as well. If pondering what would actually change for an ESG-minded 17th century Royal Navy on a day-to-day basis, the answer is—nothing.

In modern times, environmental compliance has been a consistent focus of American businesses and their shareholders. As the American public became more environmentally conscious following the development of regulatory standards in the 1970s, systems for continuous improvement and going “beyond compliance” developed. Annual reporting of positive environmental compliance metrics was seen as a reflection of strong management and bottom-line strength. However, as climate change and greenhouse gas (GHG) emission concerns have risen to the forefront and the applicable legal framework lags behind public demand, investors have demanded more—in terms of both compliance and reporting—on environmental issues.

ESG as Business Strategy and Activist Goal

ESG as a corporate operations strategy has resulted in more effective long-term management and more sustainable business operations, which can be material factors in commercial success. While most corporate ESG operations started as environmental compliance and reporting efforts, operational ESG is now typically an integration of the governance (long viewed as a fundamental factor in evaluating the strength of a company) and social components of ESG. All three have rapidly evolved together, promoting board diversity and stronger community engagement and advancing to advocacy on social, political, and environmental issues. Operational ESG is materially different than, but has led to more investor focus on, “ESG investing.”

Thus, the rise of ESG activist investors has adjusted companies’ view of ESG as a compliance and sustainable business management issue to include a communication and public relations focus in response to core investor expectations. These have led to real successes; recently the Wall Street Journal reported on the dramatic improvement in rainforest conservation efforts in Indonesia, an issue long-pressed by ESG-minded investors and environmental groups. Jon Emont, Indonesia Shows It’s Possible to Tame Rainforest Destruction, Wall St. J. (Feb. 27, 2023).

Investors and the public are increasingly looking not at the distinct environmental, social, and governance issues in a vacuum, but more broadly at how companies reflect the investor’s values. Complementing pressure on discrete issues such as environmental racism, the current broad-based focus on ESG issues demands a more holistic review; few issues or industries avoid its gaze, and a single misstep can be fatal in the public’s eye. The pressure issues both from internal governance and investment managers, believing that long-term sustainable governance and operational practices lead to better financial results for shareholders, as well as the public, who are eager to have their products and services made green and sustainable. Companies are discovering that ESG “compliance” will bring reputational benefits to companies and win plaudits from ESG-minded investors; ESG “violations” will do the opposite—generating negative headlines and disqualification from certain investments, and incurring penalties and reputational risk.

The principal focus of the backlash against ESG is on the investing community, specifically large asset managers and institutional investors, as well as proxy voting services.

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.

Federal Reserve Chair Jerome Powell has taken a narrow view and largely disclaimed any intent to regulate climate change financial risks.

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.

The specific rules and regulations adopted by governments, self-regulatory organizations, and international organizations are beginning to establish an overall compliance and reporting framework.

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 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.

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.