Global Developments in ESG Disclosures May Have a Significant Impact on U.S. Companies
Kroll provides an overview of regulatory initiatives with a significant potential impact on the data that U.S. companies need to collect and disclose on ESG.
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Climate, and more broadly, environmental, social and governance (ESG)-related issues are increasingly prominent considerations for investors and regulators. Various studies have tried to quantify the magnitude of capital investments made in ESG and sustainability-related themes. For perspective, the proportion of sustainable investing assets relative to total assets under management (AUM) increased from 27.9% in 2016 to 35.9% in 2020, according to a study from the Global Sustainable Investment Alliance.1
However, many questions have arisen on what qualifies an initiative or an investment to be labeled as climate, ESG or sustainability focused. Accusations of “greenwashing” have increased significantly.2 Russia’s war on Ukraine in February 2022 exacerbated some of the concerns regarding what constitutes an ESG-focused investment. Part of the issue is the lack of consistency and standardization of what these terms mean. In addition, the voluntary nature of reporting means that many companies and funds selectively disclose information that portray them in a more favorable light. As a result, the recent proliferation of ESG- and climate-focused investment products has led to a global regulatory shift towards requiring companies, investment funds and advisors to report on climate and other ESG issues.
We provide a brief overview of three major regulatory initiatives with a significant potential impact on the data that U.S. companies need to collect and disclose on ESG in the near future. These regulatory developments may have ramifications on how investors incorporate the effects of ESG in the valuation of these businesses. U.S. companies should be aware of proposals in various stages of development by the following bodies:
- European Union (EU)
- International Sustainability Standards Board (ISSB)
- U.S. Securities and Exchange Commission (SEC)
Some of these proposals are expected to become effective in 2023, with data collection required in FY 2024. Changes in laws and regulations, as well as in investor and consumer preferences are expected to have economic effects that may impact valuations.
Multinationals with operations in jurisdictions covered by the above rules and meeting certain criteria may be affected by the new requirements, regardless of where they are domiciled. Notably, materiality is defined and assessed differently among the above proposals for the purpose of providing disclosures, which will be an added challenge for companies impacted by multiple regulatory requirements.
EU Regulations and Disclosure Proposals
EU law requires all large companies (public and private) and all listed companies (with some exceptions) to disclose information about risks and opportunities they face arising from social and environmental issues and the impacts of their activities on people and the environment. The EU’s Corporate Sustainability Reporting Directive (CSRD) entered into force on January 5, 2023. EU member states will have 18 months from this date to implement the CSRD provisions into their respective national laws. The CSRD was first proposed in April 2021 as part of the EU’s European Green Deal and the Sustainable Finance Agenda. The objective was to revamp and expand the information that was already required to be reported since 2017 under the EU’s existing Non-Financial Reporting Directive (NFRD).3
According to the European Commission, a broader set of companies will now be required to report on sustainability, which they estimate will affect approximately 50,000 companies (relative to 11,700 under the NFRD).4 Importantly, non-EU companies that have a large presence in the EU (as defined by the CSRD) will be affected by these requirements. U.S. and other multinational companies may have to address additional requirements at the consolidated level, in addition to having to comply at the local subsidiary level.
Companies subject to the CSRD will have to report in accordance with the European Sustainability Reporting Standards (ESRS), which are being developed by the European Financial Reporting Advisory Group (EFRAG). The European Commission expects to adopt the first set of standards by mid-2023. Reporting requirements will be phased in over time. The first set of companies under the scope will have to apply the standards in fiscal year 2024, with reports published in 2025.
ISSB Disclosure Standards Proposals
The ISSB was created in November 2021, following widespread support for its creation during the United Nations Climate Conference (COP27) in Glasgow. As a result, the IFRS Foundation now oversees two global standard setting boards: (1) the IASB, responsible for international financial reporting standard (IFRS) and (2) the ISSB, tasked with setting IFRS Sustainability Disclosure Standards.
ISSB’s objective is to deliver a comprehensive global baseline of sustainability-related (climate and other ESG) disclosure standards that provide investors and other capital market participants with information about companies’ sustainability-related risks and opportunities, thereby allowing more informed investment decisions. The ISSB intends to develop both thematic and industry-based requirements. In 2022, the IFRS Foundation integrated other independent organizations that had been previously producing voluntary climate, or more broadly ESG and sustainability disclosure standards: (1) the Climate Disclosure Standards Board (CDSB) and (2) the Value Reporting Foundation (VRF). The VRF itself was comprised of (1) the Sustainability Accounting Standards Board (SASB) and (2) the International Integrated Reporting Council (IIRC). The VRF’s SASB Standards served as a key starting point for the development of the IFRS Sustainability Disclosure Standards, while the Integrated Reporting Framework is providing the connectivity between financial statements and sustainability-related financial disclosures.
The ISSB published proposed standards on General Requirements for Disclosure of Sustainability-related Financial Information (draft IFRS S1) and Climate-related Disclosures (draft IFRS S2), receiving more than 1,400 comment letters from all over the world and from a wide range of stakeholders. The ISSB is currently considering this feedback and making refinements to the proposals, so that it can start issuing standards this year. The first two standards are expected to be issued towards the end of Q2 2023. In its latest board meeting, the ISSB decided that both standards will become effective starting in January 2024. This means that an entity would report its first sustainability-related disclosures in 2025.
The ISSB is working with a number of jurisdictions to ensure the IFRS Sustainability Disclosure Standards can be adopted and applied effectively around the world. The application of the standards, either voluntary or mandatory, will be predicated on individual jurisdictions’ willingness to incorporate them into national laws. Even if the U.S. does not adopt these standards domestically, U.S. companies with operations abroad will still have to see to disclosure requirements in jurisdictions where the standards become mandatory.
SEC Climate and Other Proposals
In 2022, the SEC proposed for public comment, “The Enhancement and Standardization of Climate-Related Disclosures for Investors,” amending rules that would require registrants to provide certain climate-related information in their registration statements (e.g., S-1, S-4) and annual reports (e.g.,10-K, 20-F). The SEC is concerned that the existing disclosures of climate-related risks do not adequately protect investors. While this proposal is limited to climate issues, the SEC has indicated it plans further rulemaking in the area of human capital management disclosures, with a proposal expected in 2023.
The proposed disclosure rules on climate would require information about a registrant’s:
- Governance of climate-related risks and risk management processes.
- Climate-related risks and their actual or likely material impacts on the registrant’s business and consolidated financial statements over the short-, medium- and long-term. For the identified risks, a registrant needs to disclose how these risks have or are likely to affect its strategy, business model and outlook.
- Impact of climate-related events and transition activities on individual line items of the consolidated financial statements, which would include certain climate-related financial metrics and disclosures in a footnote to the audited financial statements.
- Greenhouse gas (GHG) emissions. For certain filers, a subset of GHG emissions would be subject to assurance.5
- Information about climate-related targets and goals, and the transition plan, if any.
The SEC believes that these proposed rules would provide registrants with a more standardized framework to communicate their assessments of climate-related risks and the measures they are taking to address those risks. The SEC also believes that enhanced climate disclosure requirements could increase confidence in capital markets and help promote efficient valuation of securities and capital formation. Some of the proposed disclosures are similar to those that many companies already provide based on broadly accepted disclosure frameworks, such as the Task Force on Climate-Related Financial Disclosures (TCFD) and the Greenhouse Gas Protocol.
By the end of the proposal’s comment period, the SEC had received more than 11,000 comment letters—a significantly higher volume than it typically receives—from a broad range of constituents, both in favor and against various aspects of the proposal. According to the SEC’s Fall 2022 Unified Agenda of Regulatory and Deregulatory Actions released on January 4, 2023, the SEC expects to issue the final rules sometime in April 2023.6
The proposed rules would be phased in for all companies, with the compliance date dependent upon the status of the company (e.g., large accelerated filer) and the content of the item of disclosure. As originally proposed, the earliest impact of the new rules would begin to be felt and seen in 2023-2024. However, given that the final rulemaking has been pushed out by several months, the timeline for compliance could also be extended.
Multinationals with operations in jurisdictions covered by the EU, ISSB, and SEC rules, and meeting certain criteria may be affected by the new requirements, regardless of where they are domiciled.
Preliminary Valuation Observations
U.S. companies may be potentially subject to more than one disclosure regime. As of now, the EU’s CSRD appears to require more specific disclosures than the ISSB and SEC proposals. Companies will have to deal with complex data collection systems to fit multiple disclosure requirements and evaluate the impact of various climate and sustainability risks and opportunities on their operations. Because some of the disclosure requirements will be subject to attestation, there will be more quantitative and qualitative information that investors will be able to rely upon for making decisions. In addition, a broader comparability among the definitions used for climate and ESG issues will help investors compare ESG initiatives by different companies within the same industry. At this point, it is premature to conclude on the specific aspects of the various proposals that may be used directly by finance professionals in gauging the impact of ESG on the valuation of companies. Our observations will evolve, as the various proposals are finalized, and standards are adopted. However, certain aspects merit consideration:
- The focus on climate and climate reporting (and more broadly, ESG) may affect the information, inputs and assumptions that go into valuations. In general, this is observed today where, for example, the impact of a natural disaster or a significant exposure thereto would be considered in a valuation or an impairment test. However, a concerted effort by companies and common requirements to identify climate-related risks and opportunities will bring such considerations forward consistently and will be subject to further evaluation.
- Proposed requirements to consider and disclose climate risks over the short-, medium- and long-term could presumably be reflected in the prospective financial information (PFI) prepared by management, when significant. This would require more extensive discussions to ascertain the degree that such risks have been captured in the projections and the associated probability of occurrence.
- We would expect a greater focus from auditors and regulators on impairment indicators and triggering events that are related to climate and other ESG events and their impact on fair value measurements.
- Estimates and assumptions that may require disclosure could include those related to the PFI used in impairment calculations, estimated loss contingencies and fair value measurement of certain assets, as it relates to climate issues and transition activities. Thus, auditors may become more focused on such estimates and assumptions.
- An essential recommendation of the TCFD framework (and the various proposals or regulations that follow the TCFD guidance) is to undertake climate-related scenario analyses to assess companies’ resilience to climate change. However, until recently, the actual application of climate change scenario analysis has been limited. According to a 2022 TCFD report, the climate-related scenario disclosure is the least reported of the recommended disclosures, although an increasing number of companies are addressing it (from 6% of companies in 2019 to 16% in 2021).7 From an SEC perspective, at this time, it is unclear how quickly companies will embrace the use of climate-related scenario analyses (unless they become mandatory) and whether disclosures will be expanded to address the impact on asset values, in addition to the impact on various financial statement metrics. However, both the CSRD (based on EFRAG’s proposed ESRS) and the ISSB would require companies to use scenario analysis in some form to assess their climate resilience. To the extent a U.S. company is subject to either the CSRD or the ISSB, it would have to develop a system to conduct climate-related scenario analyses to meet the associated disclosure requirements.
- Other valuation considerations may include assessment of the impact on the discount rate, to the extent this can be supported. At this juncture, there is no definitive evidence that climate and ESG risks are a form of systematic risk that should be directly incorporated into discount rates when valuing an individual company. However, academics and practitioners continue to work in this area and more developments are expected in the future.
1.“Global Sustainable Investment Review 2020", released in July 2021. Available here: http://www.gsi-alliance.org/wp-content/uploads/2021/08/GSIR-20201.pdf.
2.Greenwashing is the act of a company or an investment fund/advisor claiming to be environmentally conscious (or more broadly, ESG-focused) for marketing purposes but in practice not making any substantial sustainability efforts.
3.“Sustainable economy: Parliament adopts new reporting rules for multinationals”, European Parliament Press Release, November 11, 2022. https://www.europarl.europa.eu/news/en/press-room/20221107IPR49611/sustainable-economy-parliament-adopts-new-reporting-rules-for-multinationals. The final CSRD adopted text is available here: https://www.europarl.europa.eu/doceo/document/TA-9-2022-0380_EN.pdf.
4.The European Commission is the EU’s executive arm. For a summary on the EU’s corporate sustainability reporting activities, visit: https://finance.ec.europa.eu/capital-markets-union-and-financial-markets/company-reporting-and-auditing/company-reporting/corporate-sustainability-reporting_en.
5.The proposed rules would not require an attestation service provider to be a registered public accounting firm.
6.The SEC's regulatory agenda is released semi-annually. The SEC updates the list of rulemakings it plans to consider in the near future vs. the long term.
7.Based on an AI (artificial intelligence) review of reports from over 1,400 public companies from five geographic regions over a three-year period (fiscal years 2019, 2020 and 2021). Source: “2022 Status Report: Task Force on Climate-related Financial Disclosures”, Financial Stability Board, 13 October 2022. Available here: https://assets.bbhub.io/company/sites/60/2022/10/2022-TCFD-Status-Report.pdf.
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