An example of a new trend towards recognizing “Environmental, Social and Governance” (“ESG”) impacts from business operations is the recently introduced Climate Risk Disclosure Act of 2021 (“the Act”). As currently drafted, the Act would require significant new public disclosures from publicly traded companies regarding financial risks to their operations and profitability from climate change (e.g., air emissions, risks to facilities from storms, lending and insurance costs, etc.). Such disclosures could also indirectly impact non-publicly traded companies (domestic or foreign) who provide goods and services to publicly traded companies.
ESG is a topic increasingly accepted as central to legal, corporate and financial risk assessment and strategy for business leaders. The environmental stewardship aspect of ESG can be evaluated in part by measuring a company’s greenhouse gas emissions, energy efficiency and overall sustainability. Social values often consider a company’s relationship with its employees, diversity and inclusion policies, labor standards, and contributions to the communities in which it operates. Lastly, the governance facet of ESG considers a company’s leadership, internal structure, and core values.
Board-level executives across industries are grappling with how to address and leverage ESG related issues to both mitigate risks as well as create long-term value for their organizations. ESG is a complex topic attracting comment from various stakeholders including shareholders, customers, suppliers, financial lenders and employees. We are now seeing more ESG initiatives in legislation, as described below.
Specifically, the Act would amend the existing Securities Exchange Act of 1934 by requiring regulated (U.S. publicly traded) companies to report in their annual (10K) reports:
- The identification and evaluation of potential financial impacts of physical and transitional risks posed by climate change, along with any related risk-management strategies;
- A description of any established corporate governance processes and structures to identify, assess, and manage climate-related risks;
- A description of specific actions that the covered issuer is taking to mitigate identified risks;
- A description of the resilience of any strategy the covered issuer has for addressing climate risks when differing climate scenarios are taken into consideration; and
- A description of how climate risk is incorporated into the overall risk management strategy of the covered issuer.
The Act would require the U.S. Securities and Exchange Commission (“SEC”) to (within two years of the Act’s passage) promulgate industry sector specific regulations to implement the Act’s intent. Industry sectors specifically named in the Act include: “finance, insurance, transportation, electric power, mining and non-renewable energy” but can also cover “any other sector determined appropriate [by the SEC] . . .” Further, reporting entities would have to estimate their “direct and indirect greenhouse gas emissions,” as well as make and support assumptions (e.g., present value discount rates, etc.) over 5, 10 and 20 year time periods.
If the SEC has not promulgated regulations within the two year period, the Act provides a “backstop:” regulated entities would be deemed in compliance if their annual reports “satisfy the recommendations of the Task Force on Climate-related Financial Disclosures of the Financial Stability Board (the “Task Force”) as reported in June 2017. Core recommendations from the Task Force include:
- Describing an organization’s governance around climate-related risks and opportunities;
- Describing the impact of climate-related risks and opportunities on an organization’s businesses; and
- Describing the organization’s processes for managing climate-related risks.
Additional Task Force recommendations can be found HERE.
The Act was introduced April 15 and was reported (and amended) by the House Committee on Financial Services May 20. It has 14 co-sponsors, but all are Democrats. While it could pass through the House of Representatives without Republican support, it will have a tougher slog through the U.S. Senate, where Democrats control only with a tie-breaking vice presidential vote, and moderate Democrats in Republican leaning states (e.g., Sen. Joe Manchin (W. VA)) may be more reticent to support the Act as currently drafted. While it is too early to predict the likelihood of the Act passing through Congress, there is a much greater likelihood a final bill will be amended (by softening disclosure obligations) to garner bi-partisan support. Historically, some Republicans have been critical of utilizing the SEC to regulate environmental disclosures.
Should the legislation pass, however, it should receive warm support in the White House, as the Biden administration was active behind the scenes in crafting the initial draft of the Act. The Act complements President Biden’s January 27, 2021 “Executive Order on Tackling the Climate Crisis at Home and Abroad.” Further, on May 20, 2021, President Biden announced an Executive Order on Climate-Related Financial Risk, with wide-ranging transparency, disclosure and investment implications for investors, companies and regulators. According to the White House, this latest executive order aims to help the federal government to address the climate crisis and mitigate the economic risks of climate change, beginning with the measurement and reporting of the financial impact of those risks and reflects current private-market demands for domestic companies to provide clearer information surrounding climate risk. The Executive Order directs the Financial Stability Oversight Council, which includes the SEC, to create a plan to realize that aim. Although the SEC was not mentioned in the Order, the Executive Order is expected to increase SEC scrutiny of mandatory climate disclosures and ESG reporting from market participants.
Even if the Act does not pass, and before this latest Executive Order, the SEC is in the process of collecting feedback on the concept of mandatory climate disclosures and ESG reporting from market participants. On March 15, the SEC issued its own Public Statement regarding “Public Input Welcomed on Climate Disclosures.” The statement invites public input on whether the SEC’s existing disclosure obligations (e.g., Regulation S-K of the Securities Act of 1933) adequately generates sufficient information relative to climate change risk information. Thousands of responses (short comments to formal letters documented by exhibits) have been submitted to date and can be viewed HERE. One comment of particular interest is a June 14, 2021 letter from the attorneys general of California, Connecticut, Delaware, Illinois, Maryland, Massachusetts, Michigan, Minnesota, New York, Oregon, Vermont and Wisconsin, urging the SEC to advance this ESG climate-related disclosure initiative.
Finally, we note that the breadth of this ESG initiative is unlikely to be limited to publicly traded companies. A publicly traded company reporting under the Act (or even existing Reg. S-K disclosures) is likely to take actions to minimize its climate change risks and become more “environmentally friendly.” That could mean changes in the types of raw materials or services purchased by that publicly traded company, as well as how those goods and services are transported or delivered to the reporting entity. Consequently, we predict a “trickle-up” impact (on smaller, non-publicly traded vendors and suppliers further up the supply chain) who may need to meet more stringent environmental / climate change impact standards if they want to continue selling to publicly traded companies.
In closing, even if the Act does not pass as currently drafted, it is evidence of a growing ESG influence on both the public and private sectors.
Reed Smith continues to track ESG and climate change issues, and we welcome your comments and questions on these trends and developments.