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Posted over 2 years ago

Sustainability Disclosures: New Regulations Expected

What is Sustainability?

Sustainable development can be defined in a number of different ways, though the most common is “development that meets the needs of the present without compromising the ability of future generations to meet their own needs”. Sustainability is then generally expanded upon by addressing a series of three categories of issues, namely Environmental, Social, and Governance (abbreviated ESG for short).

Environmental sustainability refers primarily to addressing issues around climate change through increased energy efficiency and the reduction, if not the outright elimination of carbon emissions that are responsible for climate change. Social sustainability addresses issues such as diversity, equity, and inclusion, as well as employee engagement, fair labor practices, and personal health and safety. Governance in turn is about issues such as avoiding corporate corruption, executive compensation, and assuring protection for whistleblowers.

Voluntary Disclosure

Between ongoing concern for the environment, social movements and events, and public outrage about executive behavior, the sustainability movement and ESG principles have gained a lot of momentum in recent years.

Consumers and investors alike are beginning to expect companies to step up and make changes. Would-be customers may boycott a company they feel has failed to act in a responsible manner, while more and more investment firms are considering ESG principles when they make recommendations to their clients. For example, a company that has a policy in place and a plan for reducing carbon emissions, hiring a more diverse workforce, and that promotes values and ethics among its executives and board members is more likely to be promoted to potential investors that one without such policies in place.

There are a number of different organizations currently out there offering ratings and certifications around corporate sustainability. For example, LEED is a well-known certification program that assesses companies across five categories including basic requirements, energy, water, waste, and the human experience. Based on the number of points collected, companies are then granted one of four levels of certification: LEED Certified, LEED Silver, LEED Gold, or LEED Platinum.

Fitwel and WELL are two additional certifications that have more of a focus on health. WELL also rates companies on a series of categories including air, water, nourishment, light, movement, sound, mind, and community.

Different organizations may prioritize different aspects of sustainability, but the common theme is that companies voluntarily seek out these certifications as a way of being able to confirm that they’ve made a commitment to sustainability.

That being said, there are also involuntary data aggregators. These are companies such as Morgan Stanley Capital International, Institutional Shareholder Services, Bloomberg ESG, and Refinitiv that look at publicly available information and provide a rating of a company’s sustainability efforts. These aggregators rate publicly traded companies and will look at their websites, sustainability reports published by the companies, and public filings in making their ratings. In some cases, these ratings directly rate to buy/sell recommendations.

SEC Regulation

The Securities and Exchange Commission regulates and oversees securities, including publicly traded companies. Put another way, public companies have to abide by the regulations of the SEC. The job of the SEC is to protect investors. We often think of the SEC when it comes to major cases involving insider trading, Ponzi schemes, or stock price manipulation.

As part of their commitment to protecting the public, the US Supreme Court allows the SEC to require informational disclosures by companies that a reasonable investor would deem material in their decision about whether or not to invest. This means that the jurisdiction of the SEC goes beyond criminal activities and can relate to just about anything that a typical investor would consider important.

In April 2021, the SEC warned that ESG principles will soon be more heavily scrutinized than they’ve been in the past. This warning encouraged public companies to voluntarily adhere to ESG standards, such as by getting in line with the standards set out by some of the various certifications described above.

For some time, consultants and other professionals have warned companies to get on track and be prepared; but not knowing the details of what the SEC would require has been a challenge. Then on March 21, 2022 the SEC proposed a set of new climate change disclosure requirements. The proposed rules draw heavily from the framework developed by the Task Force for Climate Related Financial Disclosures, and would apply to both domestic and foreign entities that file periodic reports or are registered with the SEC. This means that the regulations would not be limited to just public companies.

Registrants would need to provide information on climate-related strategies, risk management, metrics, and goals. They would need to measure and disclose greenhouse gas emissions. There would also be a requirement to add a line-item to financial statements relating to their climate change behaviors. Furthermore, larger entities would also need to report specifically on Scope 1 and Scope 2 emissions (carbon emissions generated by their own production of energy and those generated by energy purchased off-site, such as from a local power company).

At this point, the measure is a proposal and is open for public comment. The final version is yet to be determined and so the details are subject to change. While it was expected that the environmental aspect would be emphasized, it remains to be seen what kind of social and governance regulations may also be instituted.

Design vs Performance

When it comes to the different rating agencies and certifications, there’s one other important distinction that needs to be made when it comes to real property. Buildings can be certified in the design stage or post-construction.

This means that a building can be rated as being highly energy efficient or as having excellent air quality indoors even before the building is constructed. Value engineering and other changes are common, and design plans frequently change.

As a result, there is a move towards auditing buildings post-construction to address this concern. It makes sense that a building’s greenhouse gas emissions for example could be different once office tenants or an industrial manufacturer moves in, as compared to the expected emissions anticipated during the building’s design phase.

In some cases, certifications and ratings may be separated out such that for instance carbon emissions generated by tenants are not lumped in with those that are directly attributable to the building’s owner. It’s not hard to imagine a well-intentioned building owner whose emissions are high because of the actions of their tenants.

The point is that not all rating systems or certifications are equal. Some are more thorough than others. Some are easier to obtain, while others are more stringent. Some may focus primarily on the environment, while others may favor social and/or governance related issues. Some are voluntary and others are mandatory. Finally, some may audit actual performance measured by a third-party reviewer, while others simply involve self-assessments and measured intentions. To a large extent, the public is on its own trying to sort all of this out. Be careful not to be misled by a company touting its efforts or bragging about a certification that may not actually be as meaningful as they’d like you to believe.



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