This past year has brought about a seemingly endless stream of ESG regulations. As the year is coming to a close, it is helpful to review the most notable of these emergent regulations and place them in an appropriate context. After all, years of advocacy and activism, particularly from the Impact-oriented crowd, often result in even minor legislative developments being portrayed as being far more consequential than they really are.
Tweaks to fuel standards or clarifying edits to data collection frameworks can often make headlines in ESG-oriented publications but result in few meaningful changes to operations and development objectives for those actually in the market. It’s not that these aren’t important, but rather that they can be taken in stride and aren’t typically disruptive or transformative. Instead of reviewing every novel ESG regulatory development, in this note, we have identified six of the most consequential developments to emerge this year and included one additional development we consider to be the sleeper hit of 2023. We explore:
- The ISSB Inaugural Standards
- The Future of the SFDR
- The Introduction of the EU-ESRS
- The (Still) Delayed SEC Climate Disclosure Regulation
- The UK FCA’s new Financial Product Labeling Scheme
- California’s Charge in Scope 3 Corporate Emissions Reporting
- Sleeper Hit: The Growing Influence of the EU-CSDDD from 2022
Throughout 2023, it is apparent that the EU has led the pace in advancing ESG disclosure and reporting regulations, often with implications stretching beyond their geographic boundaries. Although not quite as assertively, the USA and UK continue to advance sufficient regulations in this space so as to remain relevant while the remainder of market-based nations appear to generally follow the lead of these three or of leading international governance agencies such as the International Financial Reporting Standards (IFRS).
ISSB Launches Inaugural Standards
The International Sustainability Standards Board (ISSB) came together under the auspices of the International Financial Reporting Standards (IFRS) in 2021 with the goal of establishing a global foundation to harmonize sustainability reporting. The ISSB standards build on the work of the Climate Disclosure Standards Board (CDSB), the Value Reporting Foundation’s Integrated Reporting Framework and industry-based SASB standards, the World Economic Forum’s Stakeholder Capitalism Metrics, and generally harmonize with the GRI.
In 2023, the ISSB released its first two standards–IFRS S1 & IFRS S2–setting the foundation for how companies should report sustainability information and the broad-level metrics that are generally anticipated to be material to nearly all reporting parties, with industry-specific standards expected to emerge in 2024.
Key Implications:
- Most importantly, IFRS 1 enshrines the concept of financial materiality in ESG and Sustainability reporting. There had been discussion that ISSB’s new standards should promote a double materiality perspective, wherein a company is encouraged to report on issues that impact the business as well as on issues impacted by the business. Double materiality is typically promoted by those more interested in Stakeholder Capitalism, whereas financial materiality is typically promoted by those more interested in fiduciary duty. The IFRS S1 makes it clear that ESG reporting is underpinned by an interest in financial materiality, and as the leading reporting standard being adopted around the world, this choice by the ISSB is consequential in the continued development of the ESG landscape.
- Beyond enshrining financial materiality as a priority concern, IFRS 1 & IFRS 2 don’t bring any novel requirements or metrics for most companies that have previously prepared Sustainability or ESG reports. These really are intended to help set a clear and accessible foundation for companies to begin reporting, as well as to harmonize the landscape for companies that have been reporting. This is a welcome development that is not expected to place an undue or onerous burden on any reporting entity.
Looking Forward:
- The ISSB applies mostly to portfolio companies rather than to PE firms themselves, and even then, mostly to portfolio firms who are anticipating a return to public markets, as ESG reporting by privately-held companies remains a predominantly voluntary undertaking. When companies decide to initiate ESG reporting, the first question is always, “what framework should we follow?”, and now the answer would be that most inaugural reporting entities could be well served by turning to the ISSB standards as these integrate many previously disparate frameworks and harmonize with other more stakeholder-oriented frameworks such as the GRI–No other framework currently ticks as many boxes as does the ISSB framework with a single report.
Read More
SFDR Proves Itself
The Sustainable Finance Disclosure Regulation (SFDR) is not new, having largely come into effect in 2021, however 2023 represents the first year in which most reporting parties prepared their inaugural disclosures under this legislation.
The SFDR, and accompanying disclosure requirements around Principle Adverse Impacts (PAI), are a set of EU regulations imposing mandatory ESG disclosure obligations for asset managers and financial market participants. Reporting entities are required to disclose how ESG factors are integrated at both an entity and product level, whether or not they have an express ESG or Sustainability focus. Although developed as an EU regulation, many asset managers throughout the world have found themselves pushed to disclose under the SFDR framework due to their dealings with financial partners and intermediaries within the EU.
Key Implications:
- Many asset managers, including PE firms we work with directly, prepared their inaugural SFDR disclosures in 2023, with the general conclusion being that the added disclosure requirements were perhaps frustrating but overall not exceedingly burdensome. Many claimed that even in the absence of the SFDR, the pressure to collect and report ESG-oriented metrics was already growing.
- Many asset owners were able to review SFDR disclosures for the first time in 2023 to inform their asset allocation strategies. Of the asset owners we spoke with around this point, the conclusion was generally that the disclosures introduced an element of standardization to their due diligence process but did not introduce any novel insights nor result in any changes to their intended asset allocation strategies at this time. In general terms, the SFDR disclosures by asset managers were appreciated but not critical.
- These two above points combine to suggest that the SFDR reporting requirements may stabilize as they are now and not escalate with as much zeal as legislators had originally indicated. During development, careful consideration went into ensuring the disclosure requirements would produce useful information while not burdening reporting entities to the point of being anti-competitive, and it seems a relatively appropriate balance was struck, yet to require even more disclosure without the promise of producing more useful information may just push the entire framework too far.
Looking Forward:
- The SFDR applies most directly to PE firms, and only indirectly thereby to portfolio companies. It would appear that the SFDR reporting requirements are here to stay, however we do not anticipate meaningful changes in the near-term. For those firms which produced their inaugural disclosures, you may be well-served by reviewing what worked well and codifying this to make continued compliance with the SFDR requirements as efficient as possible.
Read More
The EU-ESRS Finally Emerge
The EU Corporate Sustainability Reporting Directive (CSRD) had already been affirmed, requiring companies under scope to report on sustainability impacts, opportunities, and risks in compliance with EU reporting standards. The ESRS have now been developed, and are being affirmed, to spell out exactly what those ‘EU reporting standards’ are. ESRS 1 and ESRS 2 are the general disclosure standards, with more industry-specific standards anticipated to be developed over the coming years.
As companies have time to review and understand the ESRS requirements, most will find that they are an exercise in compliance rather than a dramatic advance in operational sustainability. To be clear, the ESRS are not setting any sustainability objectives or mandating any particular ESG-oriented performance, rather they are standardizing how corporate sustainability information should be disclosed.
Side Note: The CSRD applies to EU listed or large firms for financial years starting on or after January 1st, 2024 (to report in 2025), and for non-EU firms exceeding specified EU-based revenue thresholds for financial years starting on or after January 1st, 2028 (to report in 2029).
Key Implications:
- The most immediate impact of the ESRS will be felt in the scheduling of ESG and Sustainability reporting. The new regulations require that the sustainability report be published at the same time as financial statements. This comes as an attempt to move sustainability information onto a level playing field with financial information and may be the most consequential element of the ESRS. Many companies will be required to adjust their data monitoring and collection protocols to meet this new schedule.
- The ESRS will require that any forward-looking action plans or targets be accompanied by more granular disclosures relating to timelines, strategies, and performance. The ESRS does not mandate any particular performance targets or objectives, but rather mandates more transparency in how these are evaluated and disclosed should a company choose to have such. It remains to be seen, but we anticipate this element of the ESRS could have an outsized effect in incentivizing companies to avoid targets and action plans and instead shift their sustainability disclosures to be more so evaluations of past performance rather than commitments to future goals.
- Third-party assurance of the sustainability disclosures will be required. Up until now, all ESG and Sustainability reports providing any level of assurance–and there aren’t very many that do–have done so voluntarily. Most companies will find that limited assurance–the degree which is required within the ESRS framework–is not difficult to establish as long data collection protocols are developed knowing that such assurance will be sought. This need not be a substantial cost.
Looking Forward:
- The EU-ESRS, under the umbrella of the EU-CSRD, applies mostly to larger portfolio companies which are based in the EU or which meet an employment and revenue threshold from EU operations. The most difficult element in complying with the ESRS will be in adjusting the schedule of sustainability-oriented disclosures to match that of annual financial reporting. Any portfolio company to which the EU-ESRS applies would be well-served to immediately begin exploring how they can adjust their data collection processes so as to be able to comply with the new disclosure schedules in the near-future.
Read More
SEC’s Climate Disclosure Sword of Damocles
The SEC’s proposed climate disclosure rule has been making waves since 2022…yet still seems stuck in a holding pattern. As originally proposed, companies would be required to disclose Scope 1 and Scope 2 emissions, and potentially Scope 3 emissions if these were material to the company or included in a company’s emissions reduction strategy. After a lengthy public consultation phase, the SEC has repeatedly delayed affirming the regulation and it is no longer clear exactly when it intends to do so. Even so, however, anticipation of the SEC’s climate disclosure regulation, paired to the legislative influence of the other regulations discussed in this note, seems to be sufficient to coax most publicly-traded companies to engage in, or prepare for, GHG emissions reporting in some manner.
Ostensibly, the proposed rule has been delayed in order to further consider the inclusion of a Scope 3 reporting mandate and the general cost of compliance such a rule would place on reporting entities. Although these considerations are important, they are insufficient to explain this lengthy delay. Many other regulations, as discussed in this note, as well as broader market forces and interests, now require companies to report their GHG emissions, including Scope 3 emissions, and the SEC’s proposed requirements could even be considered tame in comparison
More realistically, the delay can be explained by the promise many political actors have made to challenge the SEC’s authority in affirming such regulations should the latter actually do so–and this challenge would inevitably extend to numerous other areas the SEC has sought to regulate. In short, the ESG discussion had become so highly partisan that even one more step toward what is largely perceived as ESG regulations could be enough to undermine much of the SEC itself. Expansion of SEC oversight to include corporate climate emissions will bring into question the actual mandate of the SEC. The lengthy delay in affirming the carbon disclosure regulation makes sense when we understand that it is about so much more than just carbon emissions.
Key Implications:
- From a corporate perspective, a critical threshold of companies now voluntarily report, or report under a different regulatory mandate, their carbon emissions that, should the SEC affirm its carbon disclosure regulation, we do not anticipate significant developments in this space. The SEC would effectively be affirming common practice. From a political perspective, however, the battle over SEC jurisprudence remains a different story.
- One interesting consequence, however, remains the applicability of the EU-CSRD reporting requirements. The EU reporting standards, which require GHG emissions reporting, apply not only to EU-based firms, but also to American firms with a threshold level of operations, employment, and/or revenue in or derived from the EU. The EU-CSRD is more onerous than the proposed SEC climate disclosure regulations, however it has left open the opportunity to exempt American firms to whom the reporting directives apply should the SEC instead affirm its own carbon emissions reporting standards. It’s a fine balance, but the SEC regulation, if affirmed, could introduce a novel requirement for some firms while lessening the compliance burden of extra-jurisdictional requirements for other firms.
Looking Forward:
- The SEC’s climate disclosure rule would only apply to publicly-traded firms but would nonetheless also serve as a template for many other firms who are voluntarily disclosing their GHG emissions or who are compelled to do so by key customers. Any company initiating GHG emissions reporting now would be well-served to reference the GHG Protocol, which the SEC climate disclosure rule references quite extensively, and to also plan on including an initial consideration of Scope 3 emissions. The SEC climate disclosure rule may not yet be affirmed, but this is the direction it is heading.
Read More
New Labels Introduced by the UK FCA
The Financial Conduct Authority (FCA), which is the regulator for financial services firms and financial markets in the UK, released its new Sustainability Disclosure Requirements (SDR) for asset managers. This new requirement joins those in the EU and the USA, such as the SFDR and the enhanced SEC ‘Name Rule’, which seek to eliminate greenwashing risk.
The new FCA rule requires that all communications by FCA-authorized firms about the environmental or social elements of products and services ensure that claims are “consistent with the sustainability profile of the product or service”. In an attempt to help firms interpret the concept of ‘consistency’, and to assist consumers differentiate among the growing universe of sustainability-oriented financial products and services, the FCA has introduced four new labels for investment products, including: Sustainability Focus, Sustainability Improvers, Sustainability Impact, and Sustainability Mixed Goals.
These four labels really boil down to only two options: 1) A financial priority with an interest in sustainability or 2) A sustainable priority through financial channels. The Focus, Improvers, and Mixed Goals labels conform to the former while the Impact label conforms to the latter. Finally, products can integrate ESG as they see fit and not need to try to be everything to everybody all the time.
Key Implications:
- The new FCA rule concerning greenwashing is not critical to private equity firms and their portfolio companies. Even so, this rule does lay some ground-work which private equity firms and portfolio companies can benefit from over time. The labels presented in this rule mark a clear delineation between investments which integrate ESG data in the decision-making process and investments which optimize for impact. The delineation allows actors to engage in ESG without being required to engage in Impact. This is a significant step as the politicization of ESG in the USA is largely fueled by a confounding of ESG with Impact.
Looking Forward:
- This regulation applies to financial services firms offering products to public markets and is not anticipated to be applicable to most PE firms or their portfolio companies. It is useful, however, to help both PE firms and portfolio companies contextualize their ESG or Sustainability reporting and efforts. It is a taxonomy put forth by a global leading regulatory authority allowing entities to distinguish ESG from Impact–a distinction that markets have sorely needed.
Read More
California SB253 & 261 Break the Seal on Scope 3 Emissions Reporting
The California State Senate and State Assembly approved two climate disclosure bills in 2023, SB 253 and SB 261. This new legislation is a significant step forward for climate related disclosures in the USA and exceeds what the SEC had proposed in its draft climate disclosure legislation which still remains under review. The new California legislation is anticipated to apply to over 5,000 public and private companies.
SB 253, the Climate Corporation Data Accountability Act, applies to companies with annual revenue exceeding $1 Billion and doing business in California and will require that they publicly disclose Scope 1, 2 and 3 GHG emissions. SB 261, the Climate-Related Financial Risk Act, applies to companies with annual revenue exceeding $500 Million and doing business in California and will require them to publicly report climate-related financial risks pursuant to the Task Force on Climate-Related FInancial Disclosures (TCFD).
Key Implications:
- Most notably, California has included the reporting of Scope 3 GHG emissions. This is the first major legislation to do so in such a comprehensive manner. The SEC’s proposed legislation only included a qualified interpretation of who would need to report Scope 3 emissions, and even the more stringent EU-CSRD did not include as comprehensive an interpretation of Scope 3 reporting obligations as California’s legislation. California has raised the bar on GHG emissions reporting and is making it easier for other jurisdictions, whether national or state, to follow-suite. Companies getting into GHG reporting now would be well advised to build Scope 3 data tracking into their plans now.
- Although state-based, California has a very generous interpretation of what ‘doing business in California’ means, and a few companies may be surprised to find that it applies to them. See here for a breakdown of what ‘doing business in California’ actually means. (https://www.ftb.ca.gov/file/business/doing-business-in-california.html)
Looking Forward:
- This combination of state regulations applies directly to portfolio companies rather than to PE firms themselves. Any portfolio company which is considered to be ‘doing business in California’ and with annual revenues of $500 million or more would be well-served by familiarizing themselves with the TCFD framework for reporting climate-related financial risks. And for those portfolio companies with annual revenues of $1 billion or more, it would also be beneficial to include a consideration of the GHG Protocol framework for carbon emissions reporting, including Scopes 1, 2, and 3.
Read More
The Sleeper Hit of 2023: The EU-CSDDD
The EU Corporate Sustainability Due Diligence Directive (EU-CSDDD) was introduced in 2022 but is one of the most actionable pieces of legislation we helped portfolio companies address in 2023. The objective of this directive is to “promote sustainable and responsible corporate behaviour and to anchor human rights and environmental considerations in companies’ operations and corporate governance”, and applies to all large EU companies and non-EU companies with a threshold of employment and revenue within the EU.
Most importantly, the EU-CSDDD requires large companies to demonstrate enhanced monitoring and accountability across their supply chains. In 2023, this ‘enhanced monitoring’ largely took the form of requiring vendors and suppliers to report GHG emissions and provide a Business Code of Conduct. The actual degree of monitoring and accountability taking place remains questionable, but the EU-CSDDD has certainly added to the compliance requirements of smaller firms across the world.
A number of portfolio companies sought our assistance in 2023 in preparing a GHG emissions statement or advising on a Code of Conduct, and the number one reason reported to us for doing so was because a key customer was requesting it. The influence of the EU-CSDDD was never directly mentioned, but upon review, all of these key customers the portfolio companies were complying to fell under the mandate of the EU-CSDDD
Key Implications:
- The EU-CSDDD is the most consequential ESG reporting legislation to emerge of late. Although perhaps not the original intention of the legislation, EU-CSDDD requirements are being pushed down supply chains and adding sustainability and human rights elements to the vendor approval process of many procurement departments.
- We have helped many portfolio companies prepare general GHG emissions statements in compliance with customer requests. More interesting, however, is that, as of late, we have been helping portfolio companies prepare GHG emissions statements or programs that are required to conform to third-party frameworks, such as the CDP and SBTi. It seems that larger companies to whom the EU-CSDDD applies have realized that they can outsource much of their supply chain due diligence costs if they align their requirements with third-party frameworks.
- Many portfolio companies do not necessarily stand to benefit from releasing a public Annual ESG or Sustainability Report, but nearly all portfolio companies would likely stand to benefit from having much of this data and information internally available for when customer requests arise.
Looking Forward:
- At this pace, it is not unreasonable to anticipate that nearly all portfolio companies with EU-based or EU-exposed enterprise clients will be fielding requests for carbon emissions and human rights metrics within the next 18-24 months. Companies with such exposure could be well-served by initiating an internal GHG emissions assessment process and reviewing, or developing, a comprehensive Business Code of Conduct with a comprehensive consideration of human rights–these need not be publicly disclosed, but should be readily available for when they are requested.
Read More
Although not every single ESG regulation or pronouncement was quite as consequential as many would have us believe, 2023 was nonetheless a big year for this space. We appreciate your trust in us and we will continue to monitor new developments throughout 2024.
