Tackling ESG: Concerns about regulation and materiality
In this second part of our three-part series, we share responses from a study conducted by Curley Global IR (CGIR) that show asset managers’ deep need for companies to outline what companies believe is most material, coupled with a fear of over-regulation. We also highlight the appropriate contact point for asset managers when engaging with issuers.
The need for material disclosure is not new; the SEC recognized that ESG was fast becoming a mainstay of the corporate and investment community before 2016. SEC regulations state that when issues – including those relating to E, S and G – rise to material matters they should be disclosed in a company’s filings.
In April 2016 commissioner Kara Stein said the agency was interested in the adoption of ESG measures because the data was clear: companies may perform better with an ESG framework in place. Stein said: ‘Today, investors make their decisions based on an array of information, which goes beyond mere profit and loss. More importantly for investors, companies that adopt certain environmental, social and corporate governance or ESG measures may perform better than those that do not.’
One of the most significant organizations that has helped companies and investors understand ESG and sustainability matters is the Sustainability Accounting Standards Board (SASB). SASB’s sustainability accounting standards – for 79 industries in 11 sectors – are designed to help public corporations disclose financially material information to investors in a cost-effective and decision-useful format.
SASB’s transparent, inclusive and rigorous standards-setting process is materiality focused, evidence-based and market-informed. In its most recent disclosure report, which was published in 2017 based on 2016 data, SASB finds that of the possible entries analyzed across all sectors and topics, more than 82 percent include some type of sustainability disclosure. Across all sectors, 73 percent of companies report on at least three quarters of the sustainability topics included in their industry’s SASB standard, and 42 percent provide disclosure on every SASB topic.
SASB also analyzes the disclosure quality compared with the previous report, and finds that the quality of corporate disclosure on such topics remains lacking in FY 2016. The statistics show that less than one third of available disclosures contain performance metrics and more than half of the reports use boilerplate language.
This illustrates why global standards that define ESG practices can be helpful, both to companies and their investors. Since 1997, the Global Reporting Initiative (GRI) has worked with corporations and governments worldwide to ‘understand and communicate their impact on critical sustainability issues such as climate change, human rights, governance and social well-being. This enables real action to create social, environmental and economic benefits for everyone. The GRI Sustainability Reporting Standards are developed with true multi-stakeholder contributions and rooted in the public interest.’
Thomas Kuh and Paul Schutzman, executive directors at MSCI, recently discussed their views on what constitutes ESG investing. They asked: ’How can we articulate and incorporate ESG beliefs into our investment policies? With the term integration, for example, many asset owners aren’t sure where to get started or how to understand if their external managers are effectively incorporating ESG factors into their portfolios.’
They noted that ‘we still have many asset owners with concerns about the potential impact on performance and their roles as fiduciaries and stewards of capital tasked with maximizing long-term returns.’
VARIANCES IN REPORTING
A company’s ESG index is now a formal measure that is being reported as companies face growing pressure to demonstrate to investors their compliance with certain criteria, including measures around diversity, gender pay and climate-related risks.
In discussions with CGIR, asset managers stress the need for companies to disclose what each feels is ‘material.’ Several asset managers complain about the variances in disclosure, citing it as poor and difficult to use for comparison purposes. Nearly all asset managers support integrated reporting.
Four individuals indicate that they do not use avoidance (negative) screening, but they go on to explain that, in some instances, the firm’s clients mandate it. For example, BlackRock has announced it is expanding its SRI footprint at the request of clients that want to screen out gun makers and retailers that sell guns.
As one head of sustainable investing puts it during CGIR’s research:
‘There are two things that [go] hand in hand. [First], the quality of disclosure by issuers of ESG performance data. As you know, all other financial reporting data is codified under regulations. But on the ESG side it’s unstructured and unregulated data, and to get the quality data out of issuers is the biggest piece of that. And [second] closely related – and I’m hoping this is the opportunity for you to steer your clients toward – is issuers trying to understand which of these performance factors companies should focus on.’
COULD WE FACE OVER-REGULATION?
But some asset managers voice a fear that if companies don’t start providing meaningful disclosure, the SEC will include some form of regulation to mandate it. The largest fear voiced is that ESG disclosure might become ‘the next Dodd-Frank Act’ requirement. When asked about integrated reporting, and whether the SEC should mandate it, one asset management firm states:
‘[The disclosure] depends on how it’s done. The [Sarbanes-Oxley Act] stuff is overdone. It depends on how it’s implemented. Generally speaking, what I hate about governance is that it’s so rules-based as opposed to principles-based.’
On April 10, SEC chair Jay Clayton said: ‘Regulations that promote public access to material information can empower investors and also energize the competitive forces that benefit investors. In this way, transparency can substantially reduce the need for overly specific and prescriptive restrictions on conduct that can impede competitive forces and, in an evolving, complex system, can become outdated, ineffective and counterproductive.’
He announced a series of roundtable meetings to facilitate discussion between SEC officials and other parties with the aim of informing agency decisions. ‘After the roundtables and considering the comments that may have been submitted, I would expect that our staff will have a clearer view of areas for improvement and what, if any, rulemaking proposals should be made to the commission,’ he said.
The SEC is undertaking a review of regulations that reflects its mission: the protection of investors, maintenance of fair, orderly and efficient markets, and facilitation of capital formation. As it reviews requests by companies for no-action decisions on shareholder proposals, under Rule 14a-8, the SEC’s division of corporation finance may be considering whether the current level of ESG disclosure is material for investors, as it did in early April for Amazon.
THE ROLE OF THE IRO
To whom do asset managers turn for this information? CGIR’s study finds that – overwhelmingly – IR is the first point of contact for ESG questions. Questions and conversations are then escalated as needed to the C-suite, the office of general counsel and/or the board of directors, depending on the situation.
A few firms specifically state that they do not wish to speak with a chief sustainability officer (CSO) or like-named individual, as their experience has not been productive when doing so. One study participant comments:
‘I’ve been reaching out to IR to get its assessment of ESG from a company standpoint. Each team should treat this as another component of traditional fundamental analysis, so it would be IR. Because we are [United Nations-supported Principles for Responsible Investment] signatories, one of the initiatives is to get assessment from IR teams as to how they are progressing with integrated reporting as well as pushing SASB standards. We don’t deal with a CSO at all. I’ve never really understood what they do.’
Interestingly, the commentary around CSOs stretches in a few instances to communications departments. The concept is best summed up here:
‘We typically go through IR first. But who we speak with depends on the different types of conversations. If it’s a governance issue, we will want to speak with a board member, independent director or chairman. If it’s an E&S or risk issue, we will want a country head or someone who does product quality work. We’re happy to have people from sustainability functions, but it’s also a worry if that function sits within a marketing or communications department. These guys try to face off on all constituencies and they aren’t expert enough for investors.’
And yet a few asset managers specifically comment on how they are hearing from IROs ‘struggling’ with ESG communications:
‘IR tends to come to us for ESG – IR teams are struggling with what is most important to disclose to investors.’
So what is driving this need for material disclosure, and the frustration along with it? One can surmise that with the explosion of ESG investing that has hit the mainstream, the company’s ESG approach must be a topic IR teams feel capable of discussing with investors at a granular level. It won’t cut it to provide low-level, vanilla reports anymore.
All participants cite reduction of risk as a key factor, including the need to eliminate or significantly mitigate reputational risk. In our concluding article, we’ll discuss this concept, the need for boards to step up on ESG reporting, and the ‘puppy index.'
Sally Curley, IRC, is founder and CEO of Curley Global IR. Carol Nolan Drake, Esq, is president and CEO of Carlow Consulting, LLC.