Adapted from the 2022 "State of Green Business," published earlier this year by GreenBiz Group. Download the report here.
In March 2021, then-acting chair of the U.S. Securities and Exchange Commission Allison Herren Lee set the stage for the next act in sustainable finance and investing.
"Human capital, human rights, climate change — these issues are fundamental to our markets, and investors want to and can help drive sustainable solutions on these issues," she told an audience at the Center for American Progress. "We see that unmistakably in shifts in capital toward ESG investing … [W]e understand these issues are key to investors — and therefore key to our core mission."
Around the world, ESG’s explosion is echoing in markets and the media, and has thus become a matter of serious concern for regulators — not to mention companies and investors.
Just how immense has this shift been? PwC found last fall that 49 percent of investors globally would divest from companies that aren’t taking sufficient action on ESG issues, and 79 percent identified a firm’s management of ESG risks and opportunities as an important factor in investment decision-making. In June, more than 550 organizations had responded to the SEC’s request for comment on climate disclosure. Just a few months later, about $1 in $3 managed globally was invested with some form of ESG strategy — more than $35 trillion in total.
The G7, composed of the world's largest advanced economies, is clear in its support of mandatory climate disclosure.
Getting the ESG bandwagon rolling
Today, the ESG bandwagon is rolling at top speed, and the SEC is determined to gently pump the brakes to minimize potential injuries to investors jumping aboard. In the U.S., the SEC has responded to soaring investor demand for ESG information with what it’s calling an "all-agency approach." Across the pond, the EU's Sustainable Finance Disclosure Regulation (SFDR) is mandating ESG disclosure for asset managers across the 27-nation bloc, although regulators in Europe are uncovering unsupported ESG claims, and watchdogs such as the International Organization of Securities are already moving beyond SFDR to take direct action. Countries across Asia are ushering in a paradigm shift in ESG for the region, with numerous countries' regulators mandating funds’ ESG disclosure in the coming one to three years.
So, what is ahead for ESG regulation?
In a word, change. Roughly 75 percent of the comment letters submitted to the SEC by June were in support of mandatory climate disclosure, though there are notable ideological and practical disagreements over the appropriate substance of the rules. These rifts will certainly influence what shape regulations take in the coming years, most notably with respect to how or whether social — the "S" pillar of ESG — criteria will be recognized as material investment factors. Many social factors lack the pragmatism inherent in the measurability of environmental and governance issues, but as the currency of the "S" continues to grow so, too, will pressure to meaningfully incorporate these factors into regulation.
For added context in the U.S., the SEC has not formally updated its guidance on disclosures for environmental issues in more than a decade. That guidance relied on the established materiality standard, whereby information is material if there is a substantial likelihood that a "reasonable investor" would view a "particular fact" as significantly altering the information available. Ample particular facts point to a changing climate’s effect on financial markets, and ever-growing agreement on the veracity of those facts.
2021 saw what could serve as one of the most significant changes in corporate reporting since the 1930s: the formation of the International Sustainability Standards Board (ISSB), an organization meant to deliver a comprehensive global baseline of sustainability-related disclosure standards that provide investors and other capital market participants.
The ISSB is meant to encourage the voluntary uptake of the standards globally. But "global standards, like global trade, are a myth," according to Jean Rogers, founder of the Sustainability Accounting Standards Board and now global head of ESG at Blackstone, a major alternative investment management firm. She says that the key opportunity for the ISSB will be to align global markets around an approach to sustainability standards-setting and core principles, while allowing for jurisdictional differences in implementation.
The challenge: standardizing and harmonizing
And if standardization was the clarion call for the ESG space in the past decade, looking forward it will be harmonization. As such, Europe’s SFDR sets harmonized rules for market participants as it regards transparency on the furnishing of sustainability-related information for financial products. Under the European Union’s regulatory regime, asset managers and owners will, for the first time, need to tell investors where ESG risks lie in their fund portfolios. If they don’t take sustainability risks into consideration, they will have to explain why.
SFDR imposes mandatory ESG disclosure on asset managers with the aim of preventing greenwashing, as defined by the EU when a firm "gives a false impression of their environmental impact or benefits." Similar progress in the United States has been widely celebrated, but Larry Fink, founder and CEO of BlackRock, has sounded the alarm for what he sees as the "biggest arbitrage in our lifetime": the transferring of dirty assets to privately held firms, thereby giving the impression of decarbonizing but actually transferring dirty assets to firms with less disclosure.
With pressure for ESG disclosure focused on public equity markets, awareness is growing that dirty assets are sliding into the darkness of privately held companies — a concerning trend. Promisingly, IHS Markit, a data provider, found that 87 percent of private-equity investment managers surveyed pointed to regulation and political pressure for why they are taking account of ESG factors for investments; over half said pending regulation was the primary reason.
Now: How can the ESG space (re)build trust?
Financial regulations are meant to foster trust, ensure stability and protect investors. But trust across the globe is in short supply, evidenced by Edelman’s 2021 "Trust Barometer Special Report: Institutional Investors." Of the 700 institutional investors surveyed — financial analysts, chief investment officers and portfolio managers across global geographies — 86 percent said companies frequently exaggerate their ESG progress in disclosures, and 72 percent said they don’t believe companies will meet their ESG commitments. Nearly all — 94 percent — said they expect a rise in litigation due to companies not delivering on ESG pledges. Lawyers are starting to see real green in fighting greenwash.
The Wild West of ESG will shrink as regulations in North America, Europe and Asia take hold in the coming years. Friction will continue, particularly in the United States, where SEC Commissioner Hester M. Peirce has bitingly framed ESG advocacy as "labeling based on incomplete information, public shaming, and shunning wrapped in moral rhetoric, preached with cold-hearted, self-righteous oblivion to the consequences." But as ESG continues its remarkable ascent among investors, the ESG bandwagon is almost certain to imperil some on board without sufficient guardrails. According to SEC Chair Gary Gensler, "Investors have told us what they want. It’s now time for the Commission to take the baton."
Key players to watch
Financial Industry Regulatory Authority — is the largest independent regulator for all securities firms doing business in the United States. It has made the case for increased government regulation of ESG disclosure.
Glasgow Financial Alliance for Net Zero — has committed $130 trillion among 450 financial firms across 45 countries to fund investments aimed at achieving net zero greenhouse gas emissions.
International Sustainability Standards Board — a new global standards setting body is producing a global baseline of sustainability standards that provide investors with information about companies’ sustainability-related risks and opportunities.
PwC — the global professional services giant is directing $12 billion toward creating 100,000 net new jobs in ESG by 2026.
SEC’s Climate and ESG Task Force — a new initiative in the Division of Enforcement will oversee a division-wide effort to proactively identify ESG-related misconduct for U.S. markets.