iThe new year brings many continuing environmental, social and governance (ESG) challenges for companies, some from a different perspective than in years past, and sees a variety of new thorny ESG issues emerging. Read on for a bite-sized, non-exclusive list of some of the ESG issues likely to vex various stakeholders and garner a fair share of public attention in 2023.
What is ESG?
The more it is talked about, the less clear the term “ESG” is. It has become whatever stakeholders (including regulators) want it to be. Or, like the timeless phrasing of Lewis Carroll in Through the Looking Glass:
“‘When I use a word,’ Humpty Dumpty said in rather a scornful tone, ‘it means just what I choose it to mean — neither more nor less.’
‘The question is,’ said Alice, ‘whether you can make words mean so many different things.’
‘The question is,’ said Humpty Dumpty, ‘which is to be master — that’s all.’”
The absence of anything approaching a consensus definition of the term ESG has led advocates and critics to talk past each other and has put ESG at the center of some of the more contentious contemporary debates about societal values and legal rights. Is this the year to take a step back and have a larger discussion of what ESG should mean, and whether it should be broken down into smaller more digestible (and implementable) pieces?
The Lack of Clear Standards to Measure ESG
While there is a huge volume of ESG-related data available to be harvested, there are no common standards or consistent methodologies for collecting verifiable and reliable data, measuring performance, or comparing performance within or across sectors. These differences have led to confusion and disagreement, and the growing number of disparate approaches to ESG has also muddled the accuracy of disclosures and complicated the ESG definitional issues noted above. It is far from clear what one particular ESG score tells us as compared to another; and until there is agreement on consistency, transparency and the rigor required, companies will continue to gravitate toward the ranking frameworks that put them in the best light.
There is a movement afoot to align ESG ratings and establish a global standard for ESG disclosures via the International Sustainability Standards Board, but that effort still has a way to go, and some have questioned whether the standards being considered for consolidation are themselves adequate.
In the meantime, the U.S. and EU are taking a closer look at ESG ratings and raters. The European Commission (EC) has engaged in a targeted consultation on the functioning of the ESG ratings market in the EU and on the consideration of ESG factors in credit ratings. The EC’s Summary Report published in August 2022 related that a majority of respondents did not think the ESG ratings market is functioning well and supported a legislative intervention to improve transparency on ESG rating providers’ methodology and the reliability and comparability of ratings. Respondents also thought it important to clarify the objectives of and what is meant by and captured by ratings. Shortly thereafter, in September 2022, the ranking member of the U.S. Senate Banking Committee asked a dozen ratings firms to provide information regarding their practices on calculating companies’ ESG scores.
As a result of these initiatives, the long-simmering ESG ratings issues heated up considerably in 2022 and are expected to boil over and become an ESG focal point for all stakeholders in 2023.
Greenwashing Claims Come into Their Own as a Growth Industry
Greenwashing, like ESG, has suffered from an ever-expanding definition. The term “greenwashing” was coined in 1986 by Jay Westerveld, who used it to describe hotels’ admonitions to reuse towels to save water – which he concluded were all about cost-savings secured by misleading patrons that they were protecting the environment. While greenwashing initially focused on misleading environmental claims, with the growth of ESG, it has expanded to include claims based on social and governance misrepresentations and overstatements. This has given rise to regulatory enforcement by the Federal Trade Commission (FTC) and Securities and Exchange Commission (SEC) and a robust and creative private greenwashing litigation engine.
In the coming year, this growth is likely to be fed by ongoing regulatory initiatives in the EU, UK and U.S. In mid-November 2022, the three European Supervisory Authorities for the EU issued a call for evidence on potential greenwashing practices in the entire EU financial sector, including banking, insurance and financial markets. Responses were due by Jan. 10, 2023, and final reports are expected in May 2024.
In the UK, the Competition & Markets Authority (CMA) issued its Green Claims Code in September 2021, and in early 2022, the CMA commenced a compliance review of environmental claims made in various sectors. The Financial Conduct Authority also published its proposed rules for the Sustainability Disclosure Regime in October 2022 aimed at greenwashing of investment products. After a consultation period that ends later this month, they will likely be finalized and published later this year.
The U.S. has also prioritized the prevention of greenwashing. After forming a task force in March 2021 to proactively identify misstatements in ESG disclosures by public companies and investment managers, in March 2022, the SEC proposed its Climate Rules. In May 2022, the SEC issued the proposed Names Rule and ESG Disclosure Rule targeting greenwashing in the naming and purpose of claimed ESG funds. During this period, the SEC also settled a number of enforcement actions against investment advisers and asset managers for allegedly misleading ESG claims and failure to follow internal ESG policies. Most recently, in December 2022, the FTC announced that it is seeking public comment on potential updates and changes to the Green Guides. Notably, the commission is asking the public to comment on whether it should initiate a rulemaking under the FTC Act related to deceptive or unfair environmental claims.
Although not surprising, an unfortunate byproduct of this growing greenwashing regulation and litigation has been “green-hushing.” In an effort to preempt greenwashing claims, an increasing number of companies are avoiding reporting on or are minimizing the details they provide regarding progress toward their climate targets and their eco accomplishments, according to recent reports.
With regulators and consumers clamoring for cleaner corporate practices, perhaps the better approach for all concerned – and the one most likely to actually reduce greenwashing claims – would be conscientious transparency. As then SEC Commissioner Allison Herren Lee said with insightful clarity in It’s Not Easy Being Green: Bringing Transparency and Accountability to Sustainable Investing: “In other words: say what you mean and mean what you say.”
ESG Investment Meets Anti-ESG
ESG investing has been on a tear in recent years. These investments are driven, at least in part, by the public appeal of companies that support ESG and sustainability values and the belief that companies that give priority to ESG and sustainability considerations will outperform companies that do not. The growth of ESG investing gave rise to greenwashing concerns about ESG investment products and those risks, in turn, helped trigger the recent spate of ESG disclosure regulations. Nonetheless, and notwithstanding the current economic headwinds, it is anticipated that ESG investments – focusing on energy transition and environmental sustainability – will continue to grow in coming years, fueled by the European Green Deal and associated sustainable finance initiatives in the EU and by the Inflation Reduction Act and Greenhouse Gas Reduction Fund in the U.S.
Irresistible as the ESG investment force may appear to be, it has run directly into the anti-ESG immovable object. This anti-ESG backlash has been driven largely by concerns from the political right that ESG investing improperly gives short shrift to financial objectives in favor of policy, climate, and social goals. Republican-leaning states led the charge in 2021 and 2022, with more than 20 approving or proposing legislation, regulations or policies barring the states from using ESG criteria in their investment decisions or investing in ESG funds, or barring them from doing business with investment advisers that purportedly “discriminate” against certain industries (e.g., fossil fuel companies or gun manufacturers).
Just one of many recent examples: In December 2022, Florida divested $2 billion from BlackRock for focusing on ESG rather than higher investment returns; and then followed up on Jan. 17, 2023, by formalizing policy and guideline revisions that bar Florida's money managers from considering ESG factors when investing the state’s funds. These state prohibitions on considering ESG criteria in making decisions regarding investment of state pension funds appear to be at odds with the final rule recently issued by DOL allowing ERISA plan fiduciaries to consider climate change and other ESG factors characteristics when they choose investments, and some of these conflicts will likely be the subject of litigation.
On a parallel path, both federal and state legislators on the right have also raised concerns that financial and other industries’ collaboration on ESG initiatives could violate antitrust laws. On Nov. 3, 2022, five Republican senators issued letters to 50 law firms stating that they have “a duty to fully inform clients of the risks they incur by participating in climate cartels and other ill-advised ESG schemes,” and that “[o]ver the coming months and years, Congress will increasingly use its oversight powers to scrutinize the institutionalized antitrust violations being committed in the name of ESG.”
More recently, on Dec. 6, 2022, the incoming chair of the House Judiciary Committee, joined by several other committee Republicans, launched an investigation into whether major climate groups in the forefront of the ESG movement are violating antitrust laws. These actions contrast sharply with those recently taken in both the UK and EU, in furtherance of their respective overarching sustainability policies, to reduce the application of antitrust laws when competitors coordinate ESG efforts.
The polarized politics separating ESG advocates from ESG doubters in the U.S. assure that the debate on these issues is not going away any time soon. To the contrary, in the wake of the 2022 midterm elections, the rhetoric is likely to continue at a fever pitch, and we are all in for a bumpy ride.
Supply Chains in the U.S. and Abroad Are the New ESG Frontier
The trickle-down effect of ESG on supply chains that has been one of the more stealthy ESG issues in recent years is likely to become a flood in 2023 and beyond. While most companies that have prioritized ESG have given some attention to greening their supply chains, regulatory developments around the globe in just the past year have put a bright spotlight on ESG due diligence requirements for supply chains.
The German Supply Chain Due Diligence Act, effective Jan. 1, 2023, requires larger companies operating in Germany to start implementing a supplier risk management system in 2023 that includes human rights and environmental due diligence. Requirements for supply chain environmental and/or social due diligence are also in place in France, the Netherlands, Norway and Japan. Human rights protections have been promulgated separately in the UK and Australia, with Canada likely to enact a similar law this year.
More far-ranging, in February 2022, the EC proposed a Corporate Sustainability Due Diligence Directive (CSDD) that would apply to the same EU and non-EU companies as the Corporate Sustainability Reporting Directive (CSRD). The CSDD due diligence requirements would extend to those companies’ value chains and require “identifying, preventing, mitigating and accounting for their adverse human rights, and environmental impacts, and having adequate governance, management systems and measures in place to this end.” The CSDD was formally recommended for approval in December 2022, the European Parliament is expected to approve it in May this year, and it would go into effect in the EU in 2024.
In addition to potentially being subject to the EU’s CSRD and CSDD, U.S. companies covered by the SEC’s proposed Climate Rule would be required to report Scope 3 greenhouse gas emissions – those generated by customers and throughout their supply chain – if they are material to company performance or the company has made commitments to reducing them. If promulgated, these reporting requirements could subject a huge number of private entities to ESG scrutiny.
Given the potential cost and level of effort required to assess and monitor supply chain ESG risk, performance and compliance, this topic has moved front and center from the fringes and will likely be part of ESG discussions worldwide in 2023.
This handful of complex issues is just the tip of the iceberg peeking out of the crowded ESG waters and a harbinger that 2023 is likely to be the most tumultuous year yet for ESG.
