Regulating Sustainability in Corporate Governance Standards

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Experts discuss the future of sustainability in financial regulation.

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In response to a growing understanding of climate change as a financial risk, President Joseph R. Biden issued an executive order earlier this spring, asking officials to submit reports on how to address climate-related financial risk by fall 2021.

This executive order reflects mounting interest in environmental, social, and corporate governance (ESG) practices which seek to incorporate broader societal values into financial decision-making. Analysts predict that, by 2025, assets aligned with ESG values may reach $53 trillion, which would represent more than one-third of all assets managed globally.

With ESG’s rise in popularity comes concern over the current global and local patchwork of varied ESG policies and regulations. The U.S. Securities and Exchange Commission (SEC), for example, released a risk alert this April about inconsistencies in approaches to ESG.

To mitigate the negative impact from discrepancies, as well as to respond to President Biden’s executive order, the SEC issued a request for public comment on disclosure requirements that the agency might impose to help make ESG and climate related risk disclosures more consistent.

Some experts argue that the information needed to disclose all of the climate-related risks that a company might create would exceed the requirements of current law, which only requires that “material” risks be disclosed. Others claim it is not possible to have the kind of clear, accurate, comparable, climate risk data the Biden Administration seems to be seeking about climate risks. Others, however, remain optimistic that, despite the difficulty in the assessment of climate risk, the severity of the problem supports, rather than undermines, regulatory efforts to compel greater disclosure of climate risks.

The European Union has already adopted regulations for sustainable risk disclosure as a part of its Green Deal. Administrative agencies in the United States now face the task of determining how to wade through a tangled regulatory framework that currently impacts sustainable finance and determine effective measures for disclosing climate risks.

How can U.S. regulators create a regulatory framework that effectively balances economic, social, and environmental needs? In this week’s Saturday Seminar, experts discuss the future of sustainability in financial regulation.

  • The SEC should mandate sustainability information in financial reporting, argues Jill Fisch of the University of Pennsylvania Law School in an article in The Georgetown Law Journal. Fisch proposes including a sustainability discussion and analysis section in annual financial reports as a practical, cost-effective first step. She elaborates that the disclosure would require issuers to identify and discuss the three most significant sustainability issues that a corporation’s board of directors believes are material to the business. Fisch contends that such a sustainability analysis will also enable investors to evaluate issues of risk management, business practices, and economic vulnerability.
  • In an article published in the Villanova Law Review, Virginia Harper Ho of the University of Kansas School of Law assesses industry concerns about “disclosure overload”—the fear of inundating investors with immaterial information in a way that obscures pertinent information. Ho finds that worries about overloading investors are out-of-date. Instead, most investors are fearful of under-disclosure of information. The open question, Ho explains, is how to incorporate and standardize ESG risk disclosures into existing disclosure forms in a way that corporate management will view those long-term risks as material.
  • Until accurate financial data about the profitability of ESG investments becomes available, regulators are effectively regulating “in the dark,” argue Dirk A. Zetzsche of the University of Luxembourg and Linn Anker-Sørensen of EY in a recent working paper. Without accurate and extensive information about sustainability financial regulations, new sustainability frameworks may result in misallocation of resources and miscalculated risks that undermine financial stability, explain Anker-Sørensen and Zetzsche. Not only does this void of information possibly challenge financial markets, the unreliability of currently available data may jeopardize market acceptance of sustainability reporting regimes in the future. Anker-Sørensen and Zetzsche argue that innovation should be encouraged but also carefully regulated, such as through regulatory sandboxes and other smart regulation tools in the fintech industry.
  • In a recent report released by Ceres, Veena Ramani of FCLTGlobal, offers 50 recommendations for seven U.S. agencies to manage climate risk in financial systems. Ramani recommends that the Federal Housing Finance Authority acknowledge climate risk on the housing market and research the impact of climate change on government-sponsored enterprises, such as Sallie Mae. She also recommends establishing long-term strategies to address the disproportionate impact of climate change on vulnerable communities. Ramani urges the SEC to encourage credit raters to disclose more about how climate risk is used in rating decisions and to establish that corporations need to engage in sound ESG practices to comply with their fiduciary duties to their investors.
  • Financial regulators must guide financial institutions toward clean energy to protect the financial system, economy, and humanity, argues David Arkush of Public Citizen in a report for the Roosevelt Institute. Arkush claims that overinvestment in assets that produce high carbon emissions has contributed to a “carbon bubble” that may “pop spectacularly” if regulators do not oversee a rapid transition away from greenhouse gas emissions. Arguing that widespread uncertainty of grave climate threats demands proactivity, Arkush urges financial regulators to integrate climate risks into supervisory guidance and examination frameworks.
  • In a brief issued by the Strathclyde Centre for Environmental Law and Governance, Chrysa Alexandraki of the University of Luxembourg examines the EU Action Plan on Sustainable Growth as a model for sustainable development in other parts of the world. Alexandraki explains that the key piece of legislation in the EU’s coordinated sustainability effort is the EU taxonomy regulation, which sets forth the criteria for economic activities to qualify as environmentally sustainable. Although the EU’s directive focuses on the sustainable regulation of finance, Alexandraki notes that the overarching promotion of transparency—solidified through legislation—will have positive effects in other sectors.

The Saturday Seminar is a weekly feature that aims to put into written form the kind of content that would be conveyed in a live seminar involving regulatory experts. Each week, The Regulatory Review publishes a brief overview of a selected regulatory topic and then distills recent research and scholarly writing on that topic.