The SEC will take ESG seriously

Combined with a Final Rule Change in November, the announcement of Allison Herren Lee as Acting Chair of the SEC is excellent news from an ESG (Environmental, Social, Governance) and Sustainability reporting perspective. Rest assured, the new US administration’s acceptance of the science of Climate Change and stated understanding that there are already major impacts on the environment, are going to result in a major shake-up in corporate reporting.

For too many years the SEC has paid lip service to the need for ESG reporting.

No rule change will be needed

This means, finally, there will be real movement in requiring companies to provide ESG reporting. Way back in 2009, I wrote to the SEC in support of the Social Investment Forum (SIF) vision of what mandatory Environmental, Social and Governance (ESG) disclosure should look like. I pointed out there than the existing Reg S-K already mandated reporting on ESG in the MD&A.

Companies listed on the US markets are required to file various forms with the SEC, with the most notable being the Form 10-K, the annual filing that includes both financial information, and significant additional information included in the "Management Discussion and Analysis" (MD&A) section. The content of the Form 10-K is controlled by Regulation S-K, and there is some specific wording that applies to ESG and Sustainability reporting. However, it does not explicitly state ESG or Sustainability. 

I argued then, and still believe, that the "known trends" and "uncertainties" requirement was enough.

There is already the requirement under §229.303 for companies to "Describe any known trends or uncertainties that have had or that the registrant reasonably expects will have a material favorable or unfavorable impact on net sales or revenues or income from continuing operations."

I believe that Climate Change and the wide range of potential negative impacts, raises to the standard of a "known trend", or at a minimum, based on the overwhelming amount of scientific research undertaken to date, an "uncertainty". Equally, Social and Governance issues have a significant impact on liquidity and operations, and therefore should rise to the level of "known trends" or "uncertainties".

The SEC has acted on the "known trend" or "uncertainty" clause before, when Y2K reporting was mandated. At that time the SEC also took the bold step of stating that boilerplate reporting would not be acceptable, and that filers had to provide detailed discussion of their plans, including potential impact on customers, and the cost to address. “No net impact” was not an acceptable response. The SEC's actions in relation to Y2K could form the basis for similar action in relation to Climate Change and ESG reporting.

Allison Herren Lee's appointment as Acting Chair of the agency will bring about a sea change in ESG reporting.

“During my time as Commissioner, I have focused on climate and sustainability, and those issues will continue to be a priority for me,”

Read those words again “those issues will continue to be a priority”. Finally, we will have some real reporting on ESG and sustainability in annual filings, and hopefully not the boilerplate. Investors and the public should begin to see what companies really think are the risks (and opportunities), and will need to say exactly what they plan to do to address the potential impact of Climate Change.

The Rules have changed

In November 2020, a Final Rule from the SEC strengthened the reporting requirement. In their Final Rule, they discuss the change from "will" have a material impact, to "reasonably likely" to have a material impact. 

"Item 303(a)(3)(ii) currently requires a registrant to describe any known trends or uncertainties that have had or that the registrant reasonably expects will have a material impact (favorable or unfavorable) on net sales or revenues or income from continuing operations".

The Commission's final Rule says:

"We are adopting Item 303(b)(2)(ii) with these amendments substantially as proposed, but with slight modifications to clarify that the “reasonably likely” threshold applies throughout Item 303. Furthermore, our amendments to Item 303(a) state that, as part of MD&A’s objectives, whether a matter is “reasonably likely” to have a material impact on future operations is based on “management’s assessment.”

I could contend that it will be the very brave, or very disconnected, company executive who, in "management's assessment", determines that Climate Change cannot be considered "reasonably likely" to have an impact on "continuing operations".

Preparing for the change

So with this change and increased reporting, what should reporting companies be doing?

First, consider a complete review of your CRS reporting. CSR has too frequently been seen as something owned by or shared with Marketing and Communications. The greater the ‘power’ in Marketing for the production of CRS reporting, the greater the risk that what you are reporting does not fully map to the reality of your operations or strategic expectations.

There is a risk of shareholder, regulator or customer sanction if your CSR reporting is not in sync with your internal strategic plans and the assumptions used to create those plans and, more importantly, with what you have been reporting in SEC other regulated filings. If there is a disconnect, then there is a risk to reputation and a risk that a regulator (or the markets) will respond punitively to a belief that the company has been ‘hiding’ information, or spinning and ‘greenwashing’.

CRS and Sustainability have just jumped to the top, or near the top, of the Internal Audit risk universe. What controls are in place over the production of the CSR report? What processes are in place to validate the information that is reported? Does management override play a part in the production of such reporting?

Instead of repeating myself, I’ll just point you to my post on the subject from all the way back in 2015; Why CSR is an important part of your risk universe.

Pick a Standard

There are several ‘competing’ CSR and Sustainability reporting standards. Do your research. Each has its strength, but so far we do not know which one will be the ‘one true standard’ the way COSO became the presumptive standard for internal control following SOX.

My own betting would be on either (or both) the SASB and the GRI standards. Both are comprehensive and established. SASB is modelled on the need for rules-based reporting and standards used in corporate financial reporting, and the very name pays homage to the FASB. The GRI standard, however, is global and has been around for close to 20 years. There may be some flaws, but it is a comprehensive standard for wider ESG reporting.

Plan ahead

Expect ESG reporting to expand, and expect scrutiny of reported information to increase. Mismatches between current and historical CSR and Sustainability reporting and corporate communications will come to light, so be prepared if you are concerned that there may have been mismatches.

With Climate Change on the agenda (finally) and with a new SEC Chair nominated (with clear views on ESG) there can be little doubt that ESG and Sustainability reporting will no longer be something for the marketing people; it is now center stage for regulatory reporting.