A brief history of Disclosure Regulations
Disclosure regulations are necessary if investors are to have a clear line of sight on how companies manage ESG standards. But truly effective regulations are only now coming into view - signalling widespread change.
The Materiality Standard
In years past, disclosure requirements (that we would today associate with ESG) were limited to very specific pieces of information such as company GHG emissions¹ or the commercial utilisation of conflict minerals². Aside from specific cases such as these, the regulatory triggers for disclosure were interpreted flexibly on the basis of loosely defined and nebulous principles such as 'materiality' and 'decision-usefulness'.
Essentially, the requirement for disclosure hinged on whether the publication (or omission) of the data in question was predicted to tip the balance of investor decision-making. This approach was riddled with problems. Whilst it is fairly trivial to list general investment criteria, the finer tipping points of investor decision-making are notoriously inscrutable. In fact, the very existence of the market is predicated on the fact that investors assign value in materially different ways. Were this not the case, hopeful buyers would never find a counterparty willing to sell, and vice-versa.
Notwithstanding these problems, the use of 'materiality' as a touchstone for company disclosures was common to multiple jurisdictions. In the US, SEC Guidance (2010) required that firms disclose climate-related risks only if financially material (i.e. information which, if omitted, would significantly alter the 'total mix' of data available to investors).³ Regulations in the UK⁴ and in the EU⁵, defined materiality in similar terms, focusing on how a given disclosure might feasibly impact the decision-making of 'shareholders' (more recently generalised to 'users'⁶).
Comparability & Decision-usefulness
The fact that 'materiality' could be interpreted flexibly, meant that the scope and content of disclosed data varied considerably between firms. From an investor perspective, this made comparative evaluation difficult. Investors need credible & comparable data to price risk, and fairly assess competing opportunities. Given the focus on 'decision-usefulness', it is ironic that early regulations failed to address this central point.
The SEC has admitted this openly. Commissioner Allison Lee recently observed:
"the broad, principles-based materiality standard has not produced sufficient disclosure to ensure that investors are getting the information they need - that is, disclosures that are consistent, reliable, and comparable." ⁷
4 Paths to Better Disclosure
1 - Consider a range of time-horizons The time-horizon of an investment has a strong bearing as to which risk factors are considered performance-critical, and is therefore highly relevant to the disclosure process. Disclosures could be made more useful by differentiating short, medium and long-term risk scenarios (as exemplified within the TCFD framework for disclosure of climate-related risks). This approach ensures an adequate degree of overlap with most investment horizons and helps preserve comparability between datasets.
2 - Pin down ESG preferences where possible Investors often have specific ESG preferences or priorities which can be grouped and categorised fairly easily. Disclosures could be made more useful by addressing each of the main categories as standard elements of the disclosure process. Until 2020 there was no requirement for financial intermediaries to actively enquire about client ESG preferences at all - effectively muting a key trigger-point for disclosure and reducing the mix of data supplied to the market. Amendments to MiFID II & IDD now require financial intermediaries to specifically enquire about client ESG preferences alongside standard suitability questions. Additionally, the new Shareholder Rights Directive (SRD II) requires institutional intermediaries & asset managers to disclose the identity of end shareholders to issuing firms - improving engagement and enabling far-reaching visibility of shareholder preferences.
3 - Incorporate non-financial impacts The EU Non-Financial Reporting Directive (2014/95/EU) establishes ‘double-materiality’ reporting standards; requiring inclusion of non-financial environmental, social and societal impacts and providing a counterbalance to the singular focus on financial materiality.
4 - Maximise transparency & credibility Effective from 2019, the EU Low Carbon Benchmarks Regulation (2019/2089/EU) requires benchmark administrators to fully disclose the methodology used to measure and evaluate ESG risk factors. This will improve uniformity of and confidence in the use of ESG performance indices - providing investors with improved ability to compare benchmark scores in an informed manner. Additionally, the new EU Disclosure Regulation (2019/2088/EU) establishes “do no significant harm” (DNSH) criteria which disqualifies firms from scoring highly on measures of sustainability if they are also perpetuating significant environmental or social harms. This is supported by the upcoming EU Taxonomy Regulation (expected to come into force near the end of 2021) - which will enhance existing protections against misclassification.
FOOTNOTES & LINKS
¹ See Companies Act 2006 (Strategic Report and Directors' Report) Regulations 2013, which requires UK 'Quoted Companies' to publish annual GHG Emissions (Scope 1 & 2). In the US context, see EPA (Greenhouse Gases Rule) 40 CFR Part 98, which mandates disclosure of GHG emissions > 25,000 Tonnes CO2e/year (both direct emissions & potential emissions from supplied products if they were to be oxidised).
³ Materiality defined as per the SEC's Selective Disclosure and Insider Trading Rule (https://www.sec.gov/rules/final/33-7881.htm), based in turn on the US Supreme Court definition provided in TSC Industries, Inc. v. Northway, Inc (1976)
⁴ See s5 of FRC Guidance on the Strategic Report. (https://www.frc.org.uk/getattachment/fb05dd7b-c76c-424e-9daf-4293c9fa2d6a/Guidance-on-the-Strategic-Report-31-7-18.pdf)
⁵ The EU Accounting Directive (2013/34) Article 2 (16) defines materiality as: "information where its omission or misstatement could reasonably be expected to influence decisions that users make on the basis of the financial statements." (https://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:02013L0034-20141211&from=EN)
⁶ FRC Guidance, previously cited 'shareholder' decisions, but now references the more general 'user' (https://www.frc.org.uk/getattachment/4713123b-919c-4ed6-a7a4-869aa9a668f4/Audit-Quality-Thematic-Review-Materiality-(December-2017).pdf) to mirror the terminology used in the EU Accounting Directive (2013/34).
⁷ See comments from SEC Commissioner Allison Lee on 30 Jan 2020 https://www.sec.gov/news/public-statement/lee-mda-2020-01-30