Introduction
Environmental, social and governance (“ESG”) has had a rise in popularity in recent years. This paper will focus primarily on the “E” in “ESG,” or, more specifically, environmental policies and disclosure. There is a longstanding issue with the policy aims of ESG disclosure, especially when they are not closely connected to the aims of securities regulations. This issue has become more salient with the recent developments in the United States of America’s (“U.S.”) Securities and Exchange Commission (“SEC”) climate related disclosure framework. But it is equally an issue for other jurisdictions, like Canada. While new climate-related disclosure may contribute to some of the aims of securities regulation (e.g., mitigating systemic risks by addressing the “existential” threat of climate change) an alternative explanation is that securities regulations are being instrumentalized for other policy aims that are largely unrelated to capital markets. If the alternative explanation is correct, then this can lead to problems when the policy aims conflict, especially in the form of inefficiencies in the market. To be clear, materiality standards are less adept at accommodating moral or political aims, such as climate change, and therefore such aims are frequently cast under the guise of financial value. There needs to be a demarcation between policy rationale based on ethics or other political benefits (e.g., ESG vis-à-vis combatting climate change and doing good in the world), and policy rationale based on financial value (e.g., ESG vis-à-vis risk-adjusted returns and valuable financial information for investors). I argue that it is important to identify and distinguish policy aims because it informs how materiality standards should be shaped for ESG disclosure; moreover, securities regulators must be explicit and clear about their policy aims and not guise one policy aim under another.
In the first part of this paper, I provide an overview of the root of ESG and trace how it arose to its current popularity. I also locate ESG within securities regulations and outline some of the challenges with integrating ESG into traditional disclosure regimes. Second, to provide further context of securities regulation, I provide a brief sketch of the securities landscape in both Canada and the U.S., and how each jurisdiction has started to deal with ESG. I suggest that the distinction between financial materiality and moral or political materiality is crucial for our analysis. Third, I take a closer look at the justification securities regulators have put forth with respect to ESG and how this aligns with the policy objectives of these regulatory bodies. I take a particularly close look at the new U.S. climate-related disclosure framework. Finally, I shift to a look at the lessons Canada might learn from the U.S. disclosure framework with respect to ESG.
What is ESG, and where does it fit into securities regulations and disclosure?
ESG has its roots in the related concept of corporate social responsibility (“CSR”). CSR arose in the US in the 1970s by the Committee for Economic Development.[1] ESG arose out of the socially responsible investing movement in the 1980s whereby investors grew sensitive to the moral consequences of their investing, such as divesting from South Africa’s apartheid regime.[2] While the aims are similar, ESG is can be distinguished from CSR by its focus on measurable criteria and specific targets. CSR is more about general accountability in the form of high-level mission statements or business commitments, and sometimes ESG is understood as a subset of CSR. ESG has steadily grown in popularity and some early critiques have suggested that ESG was a temporary fad. However, the recent years suggest that ESG is here to stay, and ESG has had a profound impact on capital markets worldwide.
There has been a recent growth in ESG investing and institutional investors have come out in favor of ESG. In 2020, there were an estimated 300 ESG funds which focus their investment portfolios on ESG-based criteria.[3] Even absent any legal requirement, it is becoming market practice among companies to voluntarily disclose ESG information to meet market demand. For instance, companies have been pledging to be climate-neutral have doubled since COVID-19.[4] Companies largely track and respond to investor attitudes towards ESG and it is not clear that there is a pattern with ESG focused investors becoming more concerned with the moral or political aims of ESG. For example, instead of arguing that investing in fossil fuel is inconsistent with environmental ethical obligations, an ESG investor may argue that fossil fuel increases long-term regulatory or litigation risks and thereby has worse risk-adjusted returns or affects on financial performance. One meta-study noted that 88% of sources find that companies with robust sustainability practice have increased operational performance translating into cashflows.[5] The fact that renewable energy avoids such risks and is also the morally preferably choice might be understood as a happy coincidence. However, some scholars have even attributed the increase in ESG to institutions tracking sentiments to attract millennial investors who are increasingly taking ethical considerations into their investment decisions.[6] Even if there is no pattern in the morality of corporations, there might be an evolution or shifting of attitudes among retail investors which can have upstream effects on the moral behavior of corporations. Increased ESG transparency certainly has wider benefits beyond investors, including its impact on employees, customers, communities, and other stakeholders.
John Coffee argues that U.S. capital markets have underdone three changes which triggered to the recent explosion in the popularity of ESG.[7] First, large institutional investors now dominate trading and stock ownership over retail investors. Second, ownership of stocks has been concentrated, and the largest institutional investors hold much of the shares and voting power in S&P 500 companies. Third, institutional investors have been diversified and have been more sensitive to systematic risk. The increased attention to systematic risk overlaps with ESG and it is therefore rational that such diversified institutional investors would demand increased ESG.[8] Coffee essentially attributes the recent popularity of ESG to institutional investors over the influence of retail investors, and this seems like a more plausible thesis. For example, Blackrock had a pivotal role in pushing for more ESG transparency, which had a ripple effect on other large funds.[9] Indeed large institutional players in the capital markets, independent of retail investors, have emphasized the correlation between mitigating ESG risks and increased profit.
More cynical views on ESG question its role and function in the capital markets. There is some legitimacy to these concerns. ESG has colloquially become a buzzword in business discussions, and it is often put forth in imprecise and nebulous terms. To take a closer look at the concept of ESG, there is no strong conceptual tie between “environmental,” “social,” and “governance.” Although one might tie these concepts together by ascribing a shared aspiration of morality or ethics, they are distinct categories of concerns which focus on independent issues. The legal framework around ESG can be understood as operationalizing ESG as a tool used to nudge corporations towards aspirational aims through incentives of penalties and punishments. To be clear, most policies work with incentives and assume corporations are egoistic or interested in maximizing profit. Even under a principles-based approach, it is difficult to force a conscience onto corporations and make them moral or discretely altruistic. For instance, Canadian corporate law promotes the care for a plurality of stakeholders beyond the shareholder, including the environment, the community, and employees. Yet Canada still struggles to get corporations to independently care about the aspirational aims of ESG. Accordingly, the skeptic argues, as market forces die down, the financial creation will also die down; as such, tying the morality of ESG to its value creation is ultimately a fleeting and ineffective way of achieving moral policy objectives such as combatting climate.[10] In any case, the use of incentives should inform how materiality standards in securities law should be shaped for ESG.
Interestingly, with the rise in popularity of ESG, firms have been voluntarily disclosing their ESG. This is surprising because ESG disclosure is costly and resource intensive, and companies must have some outweighing incentive after a cost-benefit analysis. The possible incentives for companies to voluntarily disclose their ESG include responding to investors, bolstering public relations, and strategically addressing climate-related risks. Again, cynical attitudes towards ESG argue that ESG evolved out of a fad that made ESG extremely profitable for those involved in it (e.g., consultants, rating agencies, specialists, etc.) while failing to produce positive financial outcomes or contributing minimally to ESG’s aspirational goals.[11] If there really is no financial benefit for companies, companies might also deem it is less costly to take on the risks of regulatory penalties than comply with expensive ESG changes and disclosure. Even worse, companies may try to “greenwash” and manipulate their company’s ESG metrics to appear to be more compliant than they really are. On an more optimistic note, one meta-study noted that 88% of sources find that companies with robust sustainability practice have better operational performance translating into cashflows.[12] The hope is that the moral considerations of ESG and the financial considerations of ESG are compatible and complementary.[13] Still, others have taken a more attenuated approach and argue that ESG as an investment strategy is too variegated to be commensurable and that ultimately something must be sacrificed from profit maximization in order to accommodate moral ESG considerations.[14]
From a policy perspective, the prime worry for capital markets regulators is indeed deceptive ESG practices that amount to fraud. While sophisticated investing decisions are largely determined by financial analysis and modelling, retail investors often take a more subjective approach which includes personal morality. Due to their lack of sophistication, retail investors are susceptible to misinformation, manipulation, and misdirection, and their vulnerability needs to be protected.[15] Without consulting technical details and poring over disclosure documents, retail investors are much more susceptible to green washing.[16] Companies may deceive investors with an empty claim of ESG and lure vulnerable investors. This can take more subtle forms of equivocal language and vague commitments which creep into the lines of dishonesty and deception. Deceptive practices which prey on an investor’s moral sentiments, information asymmetry, and false perception of competitive advantage needs to be penalized. This is where the need for a robust disclosure framework for ESG becomes necessary for securities regulators.
A core issue for tracking both quantitative and qualitative information on ESG is the problem of metrics. Metrics must accurately track some standard that is consistently applied and widely applicable across variations in market industries. The common analogy for accounting metrics is GAAP and it is difficult to find an analogue for ESG. The problem for ESG is that the categories of ESG have varied goals and it is not clear that these goals can be harmonized or are even internally consistent. Any conceivable standard must track onto the existing legal frameworks for disclosure and materiality, and it remains an open question whether the existing frameworks are flexible enough to absorb the complexities of ESG or whether a new standard altogether is needed. There are many prominent ESG rating agencies that claim to provide a standardized ESG rating, similar to credit rating agencies, with varying degrees of veracity.[17] Many institutions are working on standards for ESG criteria in the investment process, such as the Sustainability Accounting Standards Board, the Global Reporting Initiative, and the United Nation Sustainable Development Goals.[18] Moreover, regulatory bodies are increasingly sharpening its views on ESG with respect to its place in the capital markets regulatory framework, such as the Task Force on Climate-Related Disclosures.[19]
The question of materiality is a central question for regulating ESG disclosure. It is not clear that all ESG information is directly relevant to investment decisions or share price. It might be beneficial for many stakeholders to have transparency into a firm’s ESG impact, but some information simply does not fall into the scope of capital markets policy aims. It may therefore be odd to require firms to disclose information that is not relevant for assessing value and instead contributes towards an entirely different policy aim, such as environmental reform or social justice initiatives. In other words, there is a gap is disclosing what shareholders might care about and what corporations are required to disclose as material.
As then chair of the SEC Jay Clayton noted, “Disclosure is at the heart of our country’s and the SEC’s approach to both capital formation and secondary liquidity. As stewards of this powerful, far reaching, dynamic and ever evolving system, a key responsibility of the SEC is to ensure that the mix of information companies provide to investors facilitates well-informed decision making. The concepts of materiality, comparability, flexibility, efficiency and responsibility (i.e., liability) are the linchpins of our approach.”[20] Capturing ESG under the current framework is certainly challenging for a number of reasons, and these reasons apply to both the U.S. and Canada. First, it is not clear that ESG information is material under the traditional definition of “materiality.” If regulators must go beyond traditional conceptions of materiality to capture ESG, then regulators face a corollary issue of whether it is consistent with the regulator’s policy mandate and whether they have the authority to implement such changes. Second, as noted above, even if ESG fell under traditional frameworks of materiality or the question of expanding materiality was moot, it is not clear how to formulate a consistent disclosure framework around it. There must be some metric to track and it is not clear that regulators are best positioned to pick the correct metric. Nevertheless, even if there is some degree of arbitrariness in the metric used to track ESG, it may ultimately be better than having no standard whatsoever. Third, as Cynthia Williams notes, “there seems to be a blind spot in place that either mistakenly assumes issuers already operate under an affirmative disclosure obligation when ESG information is material”[21] This last point is at the crux of the debate between a principles-based approach versus a rules-based approach. Williams critiques the principles-based approach in that it assumes ESG is already material and issuers already have an obligation to disclose ESG information. Williams has largely been proven correct in that the principles-based approach led to substandard ESG disclosure and issuers facing unclarity with ESG disclosure requirements. It is clear that the current disclosure regime is not self-regulating material ESG information effectively. Further regulatory guidance is needed.
How do U.S. and Canada securities disclosure regimes differ?
Thus far, I have set out some issues around ESG disclosure that is generally applicable to both Canada and the U.S. Let us now take a closer look at the nuances in each of the disclosure regimes. A brief and preliminary background on the disclosure regimes is necessary as the foundation for suggesting an ESG scheme. Additionally, understanding the differing approaches to ESG between the U.S. and Canada can illuminate lessons that one can learn from the other.
To start, Canadian securities laws do not have specific requirements for disclosing ESG, but some material aspects of disclosure may overlap with the purview of ESG. By way of background, despite some substantial attempts for a fully national body, the current securities regulation in Canada is not harmonized. That is, each of the provinces and territories regulate their capital markets: in the words of the Supreme Court of Canada (“SCC”), “It is open to the federal government and the provinces to exercise their respective powers over securities harmoniously, in the spirit of cooperative federalism.”[22] The SCC notes that federal bodies may work with each province to exercise their combined powers to collaboratively create a national cooperative capital markets regulatory system.[23] The harmonization is, in principle, possible. For now, there are partially harmonised securities national instruments as well as guiding national policies (approximately 130 national instruments, 11 multilateral instruments, and 800 local rules), and the Canadian Securities Administrators (“CSA”) provides some national cooperation. In 2020, Ontario’s Capital Markets Modernization Taskforce recommended to implement a single piece of legislation to apply across Canada.[24]
Let us take a closer look at the province of Ontario as a case study of a securities disclosure framework in Canada. Any public issuer must file a prospectus with the Ontario Securities Commission or rely on an enumerated exception. A prospectus must provide “full, true and plain disclosure of all material facts relating to the securities issued.”[25] Any new material changes must be disclosed in a press release and a corresponding “Material Change Report” must be filed on the System for Electronic Document Analysis and Retrieval (the equivalent system in the U.S. is the Electronic Data Gathering, Analysis, and Retrieval system).[26] The test for material information depends on what would be reasonably expected to have a significant effect on the market price of securities.[27] Therefore, a prospectus by a public issuer must include a description of risk factors in the issuer and its business; in other words, a company must give investors accessible, accurate, and timely information that may have a significant impact on the prices of securities.[28] Nevertheless, market practices have picked up on this and companies have often voluntarily disclosed information beyond what is legally required in order to attract new investors. This suggests that securities laws around ESG disclosures is not the proper incentive for companies; rather, the best incentive for enhanced ESG disclosure must track the market sentiments of shareholders and investors.
In the U.S., the Biden administration announced the appointment of a “Senior Policy Advisor for Climate and ESG” for the SEC, and a Climate and ESG Taskforce. Interestingly, the broad political issue of climate change is being implemented through capital markets regulation. This kind of politicization of securities laws is not uncommon. In May 2020, the SEC’s Investor Committee recommended that the SEC start updating reporting requirements to include ESG factors,[29] and, in December 2020,[30] the ESG Subcommittee proposed recommendations on the disclosure of ESG risks. The acting chair announced, in March 2021, a chance to comment on climate change disclosure.[31] The issues were around the disclosure of the internal governance of climate issues and risks, and whether disclosure standards should be comparable to financial disclosure. In March 2022, the SEC ratified its new climate-related disclosure framework.
Let us now shift to an overview of the disclosure regime in the U.S. By and large, the U.S. federal securities law provides transparency and disclosure intended to allow investors to make reasonably informed investment decisions. Required disclosures therefore function to provide adequate information to investors rather than influencing corporate conduct. But influencing corporate conduct is well within the authority of the SEC. The Securities Act of 1933 focuses on public offerings of securities and requires issuers to provide investors with full disclosure of material facts in their registration statement. [32] The Securities Exchange Act of 1934 adds periodic reporting requirements on publicly held companies, including annual reports on Form 10-K, quarterly reports on Form 10-Q, and interim reports on Form 8-K; moreover, further details of line-item disclosures are found in the SEC regulation S-K and S-X. [33] There are many similarities to the Canadian securities regime as Canada transplants many elements of U.S. securities law into its own regime.
Contrary to the Canadian regime, U.S. materiality depends on whether there is a “a substantial likelihood that a reasonable shareholder would consider [a misstatement or omission] important.” [34] It is a test of a reasonable investor and highly fact-driven by what a reasonable investor would consider significant. Notably, the test is not whether the reasonable investor would have acted differently or found the information of particular interest. The U.S. Supreme Court also made it clear that disclosure is not required simply because a fact is material.[35] There must be some disclosure requirement enumerated in securities law for a material omission or misstatement for a public company to be considered offside of disclosure obligations.
The policy aims of securities regulators are clear. In both Canada and the U.S., there are broad aims that are shared under the umbrella of investor protection, maintaining fair and efficient capital markets, and the facilitation capital formation. However, it is important to clarify how ESG disclosure is being justified and which umbrella(s) of policy it may fall under. Generally, the U.S. (and Canada) are also lagging behind the rest of the world in terms of climate disclosure. Overseas, the European union began a comprehensive mandatory ESG disclosure regime.[36] Still, it is important to appreciate that their capital markets have significant differences with the capital markets in North America. The “EU Taxonomy Climate Delegated Act” introduced disclosure obligations for companies based on expert criteria on contributors of climate change,[37] and the “Corporate Sustainability Reporting Directive” is supposed to act as a uniform reporting standard for sustainability disclosure. The European Union also aims at targeting fiduciary duties and corporate governance regulations to promote sustainability. European Union securities regulators have adopted a scheme of mandatory disclosure through the “Sustainable Finance Disclosure Regulation” and called for increased oversight of ESG ratings to directly combat green washing.[38] Others have pursued their own scheme of mandatory ESG disclosure, such as the United Kingdom[39] and New Zealand,[40] which have slightly longer timelines. Australia also has had some interesting developments, such as its June 2021 ASIC targeted surveillance of green washing.[41] Additionally, there have been several examples of litigation based on climate-risk disclosure, which can serve as an important lesson for other jurisdictions.[42] The U.S. and Canada can look to these oversea examples for guidance in developing their own ESG disclosure regime.
What are the policy aims of ESG disclosure?
With an overview of the securities disclosure regimes, we can now assess the policy aims which regulators are employing. It is important to understand the scopes of policy aims. A broad political-based policy aim might overlap with the specific policy aims of regulating capital markets, but these aims can conflict. There is certainly much overlap between policy aims and this can be a source of confusion. We might ask whether policy aims really overlap or promote one another, or if this is purely rhetoric and a guise to promote some other political agenda.
The current chair of the SEC, Gary Gensler, remarked that “investors with $ 130 trillion in assets have requested that companies disclose their climate risks.”[43] The primary justification that the SEC purports for the new climate disclosure is that most companies have already been preparing sustainability reports to meet a demand for this information, but the reports lacked rigor, controls, and oversight. The SEC is responding and providing guidance to the lack of reliability, consistency, and comparability. According the Williams, “This shift has occurred because institutional investors have realized the financial value of ESG data integration.”[44] The SEC claims to be responding to the demands of the market. Investors are recognizing the relevance of ESG data for long-term risk and integrating it into their investment analysis, and companies are responding to these investors and voluntarily disclosing ESG information to remain competitive. The SEC’s role in ESG is not unprecedented. Material information around environmental risks in particular were on the SEC’s radar since the 1970s, and further guidance was provided in 2010 on how existing disclosure requirements may include climate-related risks.[45]
The evidence indeed supports Gensler’s claim that there is a need for more ESG-related disclosure. The Investor Advisory Committee Relating to ESG disclosure came to five observations: first, investors need reliable ESG disclosure for informed investment decisions; second, public companies should provide material ESG disclosures; third, standardized ESG disclosures by the SEC would level the playing field; fourth, ESG standardization would encourage capital formation in the U.S. capital markets; and, fifth, mandating ESG disclosure should be principles-based rather than rules-based.[46] These recommendations are consistent with the authority and mandate of the SEC. There is certainly a problem with climate-related disclosure in the capital markets that needs regulatory intervention. The Sustainability Accounting Standards Board revealed that climate disclosure in the 10-Ks of the ten largest companies found that 27% do not identify climate risks and 40% have boilerplate disclosures; moreover, the material risks from climate change represented $27.5 trillion. [47] Thus far, the policy aims of the SEC with respect to ESG seem relatively straightforward.
A crucial question that arises is whether including ESG information as “material” under securities law would change the traditional conception of materiality. In the affirmative, materiality might be properly understood as a strict financial term that focuses on the value of the company, and this inevitably is reflected in information that is reasonably important for share price and the decision to purchase shares. Others, like Williams, have argued that the scope of information that reasonable investors require go beyond strictly financial information; more specifically, Williams understands social and political policy aims to be tied to the securities laws and Congress’s intention to have a broad understanding of disclosure.[48] She writes, “Congress had broader accountability goals in enacting the Securities Act and the Exchange Act, and even investor protection was not simply a financial construct going to the investment decision […] Congress saw fundamental public purposes in having well regulated financial markets, ascribing responsibility for the Great Depression to the Wall Street crash. Those purposes included empowering shareholders in their exercise of voting rights, improving the ‘morals’ of company directors, and promoting the well-being of the economy.”[49] This is an important insight because it is often thought that materiality only has to do with financial information. Williams explains that the concept of materiality and the ultimate authority or mandate of the SEC can include political or moral policy aims. If Williams is correct, materiality includes at least two dimensions: the traditional financial understanding of materiality as well as a political or moral understanding of materiality. These two concepts of materiality will be central to our discussion going forward.
To digress to Canadian law for a moment, there is a similar push to make corporations more sensitive to moral or political considerations. However, in Canada, the origins are not from securities law but from corporate law and fiduciary duties. By targeting the duties of directors, corporations can be more sensitive to a plurality of considerations in their disclosures. The SCC’s decisions in BCE Inc. v. 1976 Debentureholders[50] as well as Peoples Department Stores Inc. (Trustee of) v. Wise[51] marked a shift from a director’s duty to shareholder primacy to acting in the best interest of a plurality of stakeholders, such as employees, retirees, creditors, consumers, the government, the environment, and the long-term interests of the corporation. A duty of care held by directors and corporations could also extend to be owed to the environment and investors interested in information on the corporation’s stance on environmental issues. The disclosure of morality can be tied to ESG and one might argue that shareholders ought to know about the moral decisions of a company. This moral dimension might be initially introduced through ESG by its relationship to increasing the value of a firm and mitigating risks. Furthermore, directors may have a duty to disclose such information if it is relevant for investors and tied to the health of the corporation.
To return to the U.S., the 2022 climate disclosure rules are aimed at helping both investors and issuers.[52] The primary policy rationale is that investors would have more consistent and reliable information, and issuers would know exactly how and what is required information to disclose. To provide a brief overview, the climate disclosure rules aim at green house gas emissions of varying scopes. The green house gas emissions are a relatively stable and uncontested metric, and represents a good starting point for integrating ESG into the securities disclosure framework. Scope 1 are direct emissions from operations that are owned by registrants. Scope 2 are indirect emissions from the generation of acquired electricity, heat, steam, or cooling that is consumed by operations owned by the registrant. Scope 3 are all other indirect emissions that are upstream or downstream of the registrant’s value chain. Companies are required to disclose total annual Scope 1 and Scope 2 emissions, and must disclose Scope 3 emissions if they are material or a part of their reduction targets. Notably, Canadian issuers filing under the Multijurisdictional Disclosure System are not required to include these climate-related disclosures in their Form 40-F. We see that the scopes are differentiated by how much the green house gas emissions are within the control of the registrant and therefore reflects how onerous disclosure obligations would be.
There is certainly overlap between climate-related risks and traditional financial understandings of materiality, especially in terms of risk-adjusted returns. Mitigating climate-related risks can be financially prudent and tie into the above notion of financial materiality. However, it is not clear that the 2022 rules fit into financial understandings of materiality and it seems to go beyond the current materiality standard. At this point, we may need to appeal to notions of political or moral materiality. Green house gas emissions are more contingently connected to financial materiality and there is no strict necessary connection. One may argue that green house gas emissions may pose some risk of environmental litigation that may inform financial materiality, but a stronger argument is that green house gas emissions is information that serves the investors who are sensitive to making investments based on moral or political views. This is a clear broadening of materiality into the political and moral conceptions of materiality whereby green house gas emissions, even if not directly financially relevant, is considered material information for the reasonable investor.
Commissioner Hester Peirce has a number of counterarguments to the 2022 climate disclosure rules.[53] Some may dismiss her as a vocal minority, but it is important to take objections seriously and understand them in a charitable light. Peirce launched several distinct points, but there are select arguments to attend to for our purposes here. First, environmental disclosures are not material under the current framework and environmental disclosures are not material for investors. It is clear that Peirce is talking about financial materiality and understands this to be the only way to interpret the existing conception of materiality. Peirce is correct that the new disclosure rules would go beyond the traditional notions of materiality, but, as Williams forcefully argues, broadening materiality is well within the scope and authority of the SEC. Moreover, while some investors may find environmental disclosure immaterial just as some people may not particularly care about climate change, the empirical data shows that a vast number of market participants do care about environmental information. Ultimately, the reasonable investor would consider such information material for their investing decision. Second, Pierce argues that standardizing is not feasible and the putative increase in reliability is just as speculative as any other standard out there. Granted, rules can be nebulous when different models lead to different results, but this is an empirical question that has yet to be tested. Still, a uniform standard, even if imperfect, can be better than no standard whatsoever. Again, it would at least cut down on conflicting standards and bring some clarity for investors. The SEC’s current focus on green house gas emissions is better tested, but it remains to be seen as to whether other measures of ESG will be ratified in due course. Third, environmental disclosures are not directed at investors, rather they are intended for other stakeholders. This last point deserves a deeper analysis.
On first glance, the idea that environmental disclosures are not directed at investors may seem obviously untrue; as Gensler noted, investors representing trillions of dollars in the markets overwhelming say they want more clarity on environmental risks. However, to put Pierce’s argument in its strongest light, we should consider again the distinction between financial materiality and moral or political materiality. If investors are actually demanding climate-related risks for financially material purposes, then it would be spurious to devise a framework that is actually responsive to moral or political materiality. There are certainly overlaps between the two—for instance, disclosure of green house gas emissions by a company can be morally or politically material to an investor while also collaterally having the benefit of determining risk-adjusted returns and being integral to financial materiality. But the problem arises when these two kinds of materiality conflict, and purporting to offer financial materiality to investors under the guise of trying to promote political or moral ends is indeed problematic.
The point can be made sharper by considering regulatory burdens by environmental disclosures. Implementing this new scheme will certainly be costly for companies, especially with the costs of consultants, experts, and monitoring environmental risks. These costs will be priced into the company’s shares and the burden will ultimately fall on investors. Now, imagine an investor who only cares about financial materiality and does not care about the moral or political dimensions of environmental disclosure. If the disclosure regime is even partly motivated by moral or political conceptions of materiality, then this investor is paying an extra premium for something they do not care about. Even worse, they are being deceived by regulators who are claiming to offer this disclosure information for this investor’s financial benefit. Even in investing, for example, fiduciaries are not allowed to rely on ethical considerations in most circumstances unless such goals will financially advantage their beneficiaries. The problem is that this is an inefficiency in the market. To illustrate, regulators and firms may devote considerable resources to climate change disclosure yet this might have little or no impact on investor protection or capital formation. One might object that this is not an inefficiency as it is the cost of controlling climate change or reducing emissions. Yet this implies that climate change or reducing emissions is a part of securities law and the primary policy aim for capital markets regulators instead of, say, regulating the efficiency of markets or protecting investors. This counterargument can be put forth, but it is certainly contentious. It is not obvious how moral or political aims can be pushed under securities laws without also having some financial justification.
Even on the part of the SEC or other regulators, this rules-based regulatory approach is inefficient and requires high costs to enforce. The premium for moral or political aims is difficult to justify on its own, and it is clear that the SEC seeks to buttress its position with some form of financial justification. For example, commissioner Allison Lee repeatedly refers to the “systemic risk” of climate change and how “steering the capital that drives global economies need consistent, comparable, and reliable climate data in order to accurately price risk and efficiently allocate capital.”[54] It is possible to underlie any moral or political justification of environmental disclosure and its inefficiencies to the market with the threat of a systemic risk, like the Global Financial Crisis. But this needs to be an explicit policy choice. There are differing policy goals between financial materiality and moral or social materiality, and crossing these wires leads to inefficiencies for both goals. Finding thin financial justifications for policies that are actually motivated by morality or politics is not an appropriate posture for regulators. If combatting climate change is the goal, it may be more efficient to make explicit climate change policies instead of using capital markets to achieve these ends.
Should Canada follow the U.S. in ESG disclosure?
In Canada, the existing ESG disclosure framework is outlined in CSA Staff Notice 51-333 (Environmental Reporting Guidance)[55] and CSA Staff Notice 51-358 (Reporting Climate Change-related Risks).[56] There factors of materiality for climate disclosures are highly context sensitive and discretionary. The CSA noted there is no bright-line test for materiality, and both quantitative and qualitative factors are vaguely considered. The CSA adds that issuers should be advised that environmental disclosure is only required insofar as it relates to material risks. Beyond this, material information relating to ESG can be a part of a number of securities disclosure forms. Some material risks might be disclosed in an issuer’s Manage Discussion and Analysis, especially as it relates to consumer preferences, supply chain management, or carbon allowances. Material risks can also be a part of an issuer’s Annual Information Form, especially as environmental and social policies can affect operations and influence the price of securities. This gives companies a high amount of discretion and little guidance insofar as what is material enough to be disclosed.
The current ESG disclosure framework in Canada has been largely ineffective. Boards often only make vague representations about ESG. The CSA reported that, despites the guidance provided in NI 51-333, 22% of sampled issuers made no climate-related disclosure at all and 22% included only boilerplate disclosure.[57] The Ontario’s Capital Markets Modernization Task Force’s final report recommends a mandatory ESG disclosure for all non-investment fund issuers (the final report contains 74 recommendations and is the product of consulting with over 110 stakeholders and 130 comment letters). Moreover, Canada, through the Responsible Investment Association, is looking to lead the world’s charge for managing climate risks and reaffirm Canada’s place in the global capital markets through establishing the International Sustainability Standards Board in Canada.[58]
The CSA also proposed National Instrument 51-107: Disclosure of Climate-related Matters.[59] Under this instrument, reporting issuers would be required to disclose their governance around climate risks and opportunities in the management information circular (alternatively, this can be in the AIF or MD&A.). Specifically, the recommendation starts with the largest issuers (500 million in market capitalization) to comply within two years and smaller issuers (150 million in market capitalization) to comply within five years. The disclosure requirements would apply to all reporting issuers and entail governance, strategy and risk management; additionally, similar to the U.S., there would be varying scopes of green house emissions, except it is reported on a comply-or-explain basis. [60] Unlike the U.S., the Canadian approach is principle-based and does not prescribe granular rules with respect to climate-related disclosure obligations. The task force also called on the CSA to impose a harmonized standard of ESG across Canada.
The existing disclosure regime gives companies a high amount of discretion and little guidance insofar as what is material enough to be disclosed. As we shall see, this is problematic for ESG disclosure. However, the rationale behind the current framework addresses the variability in companies in terms of industry, size, and business type. On the other hand, too little guidance can have the effect of companies innocently failing to identify material risks. More explicit and clear regulation can also assist in offsetting information costs for companies; by providing guidance, companies do not need to waste resources in trying to discern the requirements for disclosure. Recall that the materiality threshold in Canada is based on a test of significant impact of market price and not what would affect a reasonable investor’s choice to purchase a security. There is a disconnect between what impacts market price and what impacts an investor’s decision. For example, an investor might want to know information about a company’s position on climate change, but this information might be irrelevant to market price and thus a company would have no obligation to disclose this information to the investor. The primarily rationale for the new changes is that disclosure is that climate-related disclosure, especially green house gas emission disclosure, is already widely accepted, but the current voluntary disclosure may not be enough for investors to make informed decisions. It might not be entirely accurate to paint this in terms of investor protection, but this kind of information is clearly very important to investors. If policy rationale is meeting investors’ demands, then we must separate investors wanting material financial information and investors wanting environmental justice aims.
It is important to keep in mind that Canadian capital markets are dominated by smaller companies; moreover, the dominant industries, such as oil or mineral extraction, already include climate disclosure since it is obviously material to their industry. A generally worry with stricter ESG disclosure policies is that it will add to costly over-disclosure that may obscure useful information.[61] Overcomplexity is definitely counterproductive for ESG, especially for relatively smaller markets like Canada. However, it remains that under-disclosure is currently the problem and tilting the scales slightly towards increased disclosure is necessary. The aim of investor protection should make disclosure as accessible as possible, yet information must first be adequately disclosed before we look at the problem of accessibility. Still, the worry is that stricter securities regulations may undercut Canada’s competitive edge on the international stage, and it may push more public companies to go private.
Unlike the U.S., Canada may in fact benefit from principle-based regulation; specifically, aiming at high-level rules rather than more detailed prescriptions can be an effective approach for reform.[62] Canada has less resources for regulation and rule-based regulation can be intensely resource heavy, and it is also costly for issuers. Rules that are designed by market participants rather than regulators would be more efficient and have stronger rates of compliance. This can accommodate for some of the differences in size between U.S. and Canadian capital markets. For Canada, principle-based regulation can be a natural fit for ESG reform rather than the rules-based approach to regulation.[63] It recognizes the variability in businesses in terms of size, sector or industry, and it is more cost-effective to enforce. We can look at the success of principle-based regulation through an outcomes-based approach. An onerous disclosure regime with prescriptive rules can be inefficient if market participants are already voluntarily disclosing with similar outcomes. Despite the minority of bad players, the majority will establish a norm of ESG disclosure and create a penalty of reputational risk. Regulator should certainly still act to protect consumers or protecting against market failure and systemic risks, but they should only implement prescriptive rules when there is clear evidence of harm.[64] This would assist in the growth of Canada’s capital markets and reduce limits of the speed or volume of transactions. Prescriptive regulations always lag a bit behind innovations and changes in the market, so it is important to have a more flexible approach to regulation.
Conclusion
Climate change is undoubtedly an existential threat and we should endorse every initiative towards combatting this threat. Critiques here against the new U.S. climate disclosure rules should not be understood as undermining the SEC’s attempt to address climate change. This is certainly a step in the right direction. However, the policy aims must be made explicit and clear, and the SEC seems to be taking an ambivalent posture. In any case, the new climate change disclosure is going to be litigated and it will be years before going into effect.
Securities regulators in Canada and the U.S. are struggling to integrate ESG into the traditional disclosure framework. The policy aims inform the core concept of materiality by either aiming at information that is financially material or information that is morally or politically material. Depending on which policy aims are pursued, there is a potential for inefficiencies in the capital markets. There are multiple policy aims at play and the SEC must strike the appropriate balance, but I have argued that it is important for securities regulators to distinguish policy aims in informing materiality standards. ESG is certainly here to stay, but the data and research around ESG is still in its nascency. Further research is needed to see the effects of the rules around greenhouse gas emissions on the capital markets. This represents an incremental step towards implementing ESG, but ESG encompasses much more than just green house gas emissions. It remains to be seen if capital markets regulators will seek to implement other, more ambitious elements of ESG.
[1] Ina Freeman, “The Meaning of Corporate Social Responsibility: The Vision of Four Nations” (2011) J Bus Ethics 100, 419–443.
[2] John H Langbein & Richard A Posner, “Social Investing and the Law of Trusts” (1980) 79:72 Mich L Rev.
[3] John Hale, “Sustainable Fund Flows in 2019 Smash Previous Records” (2020) online Morningstar: https://www.morningstar.com/articles/961765/sustainable-fund-flows-in-2019-smashprevious-records.
[4] Ecosystem Marketplace, “EM Global Carbon Hub” (2021) online: https://www.ecosystemmarketplace.com/carbon-markets/.
[5] Gordon L Clark, Andres Feiner, & Michael Viehs, “From the Stockholder to the Stakeholder: How Sustainability Can Drive Financial Outperformance” (2015), online: SSRN <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2508281>
[6] Michal Barzuza, Quinn Curtis & David H. Webber, “Shareholder Value(s): Index Fund ESG Activism and the New Millennial Corporate Governance” (2020) 93 S. CAL. L. REv. 1243, 1250.
[7] John C. Coffee Jr., “The Future of Disclosure: ESG, Common Ownership, and Systemic Risk” (2021) 2021:2 Colum Bus L Rev 602.
[8] Ibid at p 6.
[9] Larry Fink, 2022 Chairman’s Letter, online: BlackRock <https://www.blackrock.com/corporate/investor-relations/larry-fink-chairmans-letter >
[10] Bradford Cornell & Aswath Damodaran, “Valuing ESG: Doing Good or Sounding Good?” (2020) online: SSRN <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3557432>
[11] Ibid. Cornell and Damodaran note that increased value should be reflected through higher cash flows or a lower discount rate, but none of these are increase solely by ESG. Rather, they argue that there is a false correlation between profitability and the perceived “goodness” of ESG. They attribute the ESG and increased valuation correlation to the gamification of ESG by large companies.
[12] Gordon L Clark, Andres Feiner, & Michael Viehs, “From the Stockholder to the Stakeholder: How Sustainability Can Drive Financial Outperformance” (2015), online SSRN: <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2508281>
[13] Tamas Barko, Martijn Cremers, & Luc Renneboog, “Shareholder Engagement on Environmental, Social, and Governance Performance” (2021), J Bus Ethics (forthcoming).
[14] Dana Brakman Reiser & Anne Tucker, “Buyer Beware: Variation and Opacity in ESG and ESG Index Funds” (2020) 41:5 Cardozo L Rev 1921.
[15] Aaron A. Dhir, “Shadows and Light: Addressing Information Asymmetries through Enhanced Social Disclosure in Canadian Securities Law” (2009) 47:3 Can Bus LJ 435.
[16]Magali Delmas & Vanessa Cuerel Burbano. “The Drivers of Greenwashing” (2011) California Management Review 54: 1 64-87.
[17] Florian Berg, Julian F Kolbel, & Roberto Rigobon, “Aggregate Confusion: The Divergence of ESG Ratings” (2020), online SSRN: <https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3438533>
[18] Shearman & Sterling LLP, Corporate Governance and Executive Compensation 2021 (2021), online: <https://digital.shearman.com/i/1425392-corporate-governance-and-exec-compensation-2021/>
[19] Task Force on Climate-Related Financial Disclosures, About, online: <https://www.fsb-tcfd.org/about/>
[20] Jay Clayton, Meeting of the Investor Advisory Committee (Dec. 13, 2018), online: <https://www.sec.gov/news/public-statement/clayton-remarks-investor-advisory-committee-meeting-121318>
[21] Cynthia A. Williams & Donna M. Nagy, “ESG and Climate Change Blind Spots: Turning the Corner on SEC Disclosure” (2021) 99:7 Tex L Rev 1453 at 1455-1456 [Williams & Nagy].
[22] Reference Re Securities Act, 2011 SCC 66, at para 9.
[23] Reference re Pan-Canadian Securities Regulation, 2018 SCC 48.
[24] As of the end of 2021, it remains to be seen whether this recommendation will be realized.
[25] Securities Act, R.S.O. 1990, c. S.5, s. 56(1).
[26] Moreover, National Instrument 51-102 requires periodic disclosure of material information in its “Annual Information Form” (“AIF”), including risk factors influencing an investor’s decision to purchase securities; and, “Management Discussion and Analysis” (“MD&A”), including risks or uncertainty for the business’s future performance.
[27] Mary G. Condon, Anita I. Anand & Janis P. Sarra, Securities Law in Canada: Cases and Commentary (Toronto: Emond Montgomery, 2005).
[28] Moreover, National Instrument 51-102 requires periodic disclosure of material information in its Annual Information Form (including risk factors influencing an investor’s decision to purchase securities) and Management Discussion and Analysis (including risks or uncertainty for the business’s future performance).
[29] U.S. Securities and Exchange Commission, Recommendation of the SEC Investor Advisory Committee Relating to ESG Disclosure (2020), online: <https://www.sec.gov/spotlight/investor-advisory-committee-2012/esg-disclosure.pdf>
[30] U.S. Securities and Exchange Commission, Asset Management Advisory Committee Potential Recommendations of ESG Subcommittee (2020), online: <https://www.sec.gov/files/potential-recommendations-of-the-esg-subcommittee-12012020.pdf>
[31] U.S. Securities and Exchange Commission, Public Input Welcomed on Climate Change Disclosures (2021), online: <https://www.sec.gov/news/public-statement/lee-climate-change-disclosures>
[32] Thomas Lee Hazen, “Social Issues in the Spotlight: The Increasing Need to Improve Publicly-Held Companies’ CSR and ESG Disclosures” (2021) 23 U. Pa. J. Bus. L. 740.
[33] See Act of May 27, 1933, c. 38, Title I, §1, 48 Stat. 74, codified in 15 U.S.C. §§ 77a et seq; Act of June 6, 1934, c. 404, Title I, § 1, 48 Stat. 881, codified in 15 U.S.C. §§ 78a et seq.
[34] See TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976); Accord Matrixx Initiatives, Inc. v. Siracusano, 563 U.S. 27 (2011).
[35] Basic, Inc. v. Levinson, 485 U.S. 224, 239 n. 17 (1988).
[36] European Securities and Markets Authority, ESMA Calls for Legislative Action on ESG Ratings and Assment Tools (2021), online: <https://www.esma.europa.eu/press-news/esma-news/esma-calls-legislative-action-esg-ratings-and-assessment-tools>
[37] Robert G Eccles, “Mandatory Environmental, Social, and Governance Disclosure in the European Union” (2012) Harvard Business School Accounting & Management Unit Case No 111-120.
[38] European Securities and Markets Authority, ESMA Calls for Legislative Action on ESG Ratings and Assment Tools (2021), online: <https://www.esma.europa.eu/press-news/esma-news/esma-calls-legislative-action-esg-ratings-and-assessment-tools>
[39] HM Treasury, A Roadmap towards mandatory climate-related disclosures (2020), online: <https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/933783/FINAL_TCFD_ROADMAP.pdf>
[40] David Clark, Financial Sector (Climate-related Disclosures and Other Matters) Amendment Act 2021 (2021/39) (2021), online: <https://www.parliament.nz/en/pb/bills-and-laws/bills-proposed-laws/document/BILL_109905/financial-sector-climate-related-disclosures-and-other>
[41] Australian Securities & Investments Commission, 21-295MR ASIC and ATO engage with directors as part of ASIC’s Phoenix Surveillance Campaign (2021), online: <https://asic.gov.au/about-asic/news-centre/find-a-media-release/2021-releases/21-295mr-asic-and-ato-engage-with-directors-as-part-of-asic-s-phoenix-surveillance-campaign/>
[42] For example, in Mark McVeigh v Retail Employees Superannuation Pty Ltd (REST), McVeigh claimed that REST failed to disclose risks which prevented him from making an informed decision about the fund’s performance. This case was settled and REST undertook to adopt TCFD reporting recommendations. In Australian Centre for Corporate Responsibility v Santos Ltd, a shareholder advocacy group alleged misleading and deceptive conduct in Santos’s 2020 report claiming natural gas as a “clean fuel.” They also claimed that Santos’s plan to achieve net zero emissions by 2040 is misleading because it was based on undisclosed assumptions about carbon capturing.
[43] Gary Gensler, Statement on Proposed Mandatory Climate Risk Disclosures (March 21, 2022), online: <https://www.sec.gov/news/statement/gensler-climate-disclosure-20220321>
[44] Williams & Nagy, supra note 20.
[45] Ibid.
[46] U.S. Securities and Exchange Commission, Recommendation from the Investor-as-Owner Subcommittee of the SEC Investor Advisory Committee Relating to ESG Disclosure (May 14, 2020), online: <https://www.sec.gov/spotl ight/investor-advisory-committee-2012/recommendation-of-the-investor-as-owner-subcommittee-on-esg-disclosure.pdf?
[47] The Sustainability Accounting Standards Board, online: < https://www.sasb.org/ >
[48] Cynthia A. Williams, “The Securities and Exchange Commission and Corporate Social Transparency” (1999) 112 HARv. L. REV. 1197, 1237-38, 1245-46.
[49] Williams & Nagy, supra note 20.
[50] BCE Inc. v. 1976 Debentureholders, 2008 SCC 69.
[51] Peoples Department Stores Inc. (Trustee of) v. Wise, 2004 SCC 68.
[52] U.S. Securities and Exchange Commission, The Enhancement and Standardization of Climate-Related Disclosures for Investors (2022), online: <https://www.sec.gov/rules/proposed/2022/33-11042.pdf>
[53] U.S. Securities and Exchange Commission, Government in the Sunshine Act, Pub. L. 94-409 (2022), online: <https://www.sec.gov/files/33-11042-fact-sheet.pdf>
[54] Allison Herren Lee, Speech by Commissioner Lee on Action on Climate (2021), online: <https://corpgov.law.harvard.edu/2021/10/21/speech-by-commissioner-lee-on-action-on-climate/>
[55] Canadian Securities Administrators, Staff Notice 51-333 Environmental Reporting Guidance (October 2010), online: <https://www.osc.ca/sites/default/files/pdfs/irps/csa_20101027_51-333_environmental-reporting.pdf>
[56] Canadian Securities Administrators, Staff Notice 51-358 Reporting of Climate Change-Related Risks (August 2019), online: <https://www.osc.ca/en/securities-law/instruments-rules-policies/5/51-358/csa-staff-notice-51-358-reporting-climate-change-related-risks>
[57] Canadian Securities Administrators, Consultation Climate-related Disclosure Update and CSA Notice and Request for Comment Proposed National Instrument 51-107 Disclosure of Climate-related Matters (October 18, 2021), online: <https://www.osc.ca/sites/default/files/2021-10/csa_20211018_51-107_disclosure-update.pdf>
[58] Ontario Securities Commission, “Canadian securities regulators strongly support the establishment of the International Sustainability Standards Board in Canada” (2021) online: <https://www.osc.ca/en/news-events/news/canadian-securities-regulators-strongly-support-establishment-international-sustainability-standards>
[59] Canadian Securities Administrator, CSA Staff Notice 51-358 – Consultation Climate-related Disclosure Update and CSA Notice and Request for Comment Proposed National Instrument 51-107 Disclosure of Climate-related Matters (October 18, 2021).
[60] Scope 1 refers to direct GHG emissions, Scope 2 refers to indirect GHG emissions from purchased energy. and Scope 3 refers to indirect GHG emissions not covered by Scope 2.
[61] Virginia Harper Ho, “Disclosure Overload? Lessons for Risk Disclosure & ESG Reform from the Regulation S-K Concept Release” (2020) 65:1 Vill L Rev 67.
[62] Julia Black, Martyn Hopper, & Christa Band, “Making a success of principles-based regulation” (2007) 1:3 Law and financial markets review 191-206.
[63] Brigitte Burgemeestre, Joris Hulstijn, & Yao-Hua Tan, “Rule-based versus principle-based regulatory compliance” (2009) Legal Knowledge and Information Systems IOS Press 37-46.
[64] Richard E. Mendales, “Intensive Care for the Public Corporation: Securities Law, Corporate Governance, and the Reorganization Process” (2008) 91:4 Marq L Rev 979.
Philo-so-fun 