Environmental, Social, and Governance Disclosures for Public Companies
Environmental, social, and governance (ESG) issues have become increasingly important to many stakeholders, including asset managers, institutional shareholders, and activist investors. Additionally, regulators in the United States and across the glove have been developing mandatory disclosure rules related to ESG for public companies, funds, and asset managers, with a particular focus on climate change. In March 2022, the U.S. Securities and Exchange Commission (SEC) proposed new rules that would require public companies to disclosure detailed information about climate-related risk, financial impact, and related corporate governance matters (Climate Disclosure Proposal).
Item 101 of Regulation S-K requires a company to describe its business and that of its subsidiaries. It requires companies to disclosure the materials impact that compliance with government regulations - including environmental regulations - may have on the company’s capital expenditures, earnings, and competitive position. The SEC’s 2010 Climate Guidance clarifies that this provision includes the impact of any government regulations related to climate change. The 2010 Climate Guidance also directs companies to consider, and disclosure when material, the impact of international climate accords, such as the 2015 Paris Accord, which aims to limit global warming to 1.5 degrees Celsius. When assessing the impact of compliance with government regulations, companies must consider “estimated capital expenditures for environmental control facilities for the current fiscal year and any other material subsequent period.” Depending on the project, capital expenditures related to climate change, such as expenditures to reduce greenhouse gas emissions, could be disclosed under Item 101 as “expenditures for environmental control facilities.”
Item 103 of Regulation S-K also requires disclosure of “any materials legal proceedings” to which the company or any of its subsidiaries is a party. Ordinary routine litigation incidental to the business need not be disclosed. Item 103 calls for disclosure related to administrative or judicial proceedings arising under any federal, state, or local provisions “enacted or adopted regulating the discharge of materials into the environment or primarily for the purpose of protecting the environment.” The 2010 Climate Guidance suggests that laws and regulations related to climate change could be considered as “regulating the discharge of materials into the environment or primarily for the purpose of protecting the environment.” Thus, litigation or enforcement action under such laws and regulations could trigger disclosure under Item 103 if one of the triggering conditions is satisfied.
Item 105 of Regulation S-K requires companies to discuss the “material factors that make an investment in the registrant or offering speculative or risky.” The rile directs companies to explain how each risk affects the company or the securities being offered. In the 2010 Climate Guidance, the SEC notes that significant physical effects of climate change, such as severe weather events, sea level rise, and water availability and quality, can present material risks to a company’s operations and results, both directly and indirectly. The 2010 Climate Guidance instructs companies whose businesses may be vulnerable to severe weather or climate related events to consider disclosing material risks of, or consequences from, such events in their publicly filed disclosure documents. Risks associated with the potential transition to a lower carbon economy, or transition risks, could trigger risk factor disclosure under Item 105 if those risks are material to the company. “Transition risk” includes actual or potential negative impacts on a company’s financial condition, business operations, or value chains attributable to regulatory, technological, and market changes to address the migration of, or adaptation to, climate-related risks.
Item 303 of Regulation S-K requires disclosure known as Management’s Discussion n and Analysis of Financial Condition and Results of Operations (MD&A). The objective of Item 303 is to provide material information relevant to an assessment of a company’s financial condition and results of operations, including an evaluation of the amounts and certainty of cash flows from operations and from outside sources. Disclosure under Item 303 focuses on material events and uncertainties known to management that are reasonably likely to cause reported financial information not to be indicative of future operating results or of future financial condition. Various events or uncertainties related to climate change could trigger a disclosure obligation under Item 303. A company must assess whether climate change legislation or regulation is reasonably likely to have a material impact on its financial condition or results of operation, requiring MD&A disclosure. Pending litigation or regulation would be considered a known uncertainty requiring an analysis of the likelihood such legislation or regulation will be enacted, as well as whether the impact of such measures is material. Similarly, a company that is reasonably likely to be affected by international climate accords should consider the possible impact in evaluating their MD&A disclosure obligations. Transition risks arising from business trends and changing consumer preferences related to climate change, such as decreased demand for goods that product significant greenhouse gas emissions, could trigger a disclosure obligation under Item 303 if they are reasonably likely to have a material impact on the company. Any materials commitments for capital expenditures related to climate change also would be disclosed under Item 303, which requires a description of the company’s material capital resources.
Human capital management refers to how an organization recruits, engages with, empowers, and ultimately retains its people. Human capital management covers a range of topics, including compensation and benefits, corporate culture and values, talent development, diversity, equity, and inclusion, and employee health and safety. Human capital management has emerged as a key ESG factor and is widely recognized as a potential source of both financial and repetitional risk for organizations or all sizes. As stakeholders have become more interested in understanding how an organization engages with its workforce, many companies have expanded their voluntary reporting on human capital management, as well as responding to disclosure requirements in their SEC filings.
In 2020, the SEC adopted a new requirement for companies to disclose information about human capital management initiatives in their SEC filings. The SEC observed that “human capital may represent an important resource and driver of performance for certain companies,” and the rule changes were intended to refocus companies’ human capital disclosures. Historically, among other information about the business, Item 101 called for disclosure of the number of persons employed by the company. Following the SEC’s 2020 amendments, Item 101 now includes a broader, principles-based requirement relating to disclosure of human capital resources. In addition to the number of employees, companies must describe their human capital resources and any human capital measures or objectives that the company focuses on in managing their business. Such measures, depending on the nature of the business and the workforce, could include those that address the development, attraction and retention of employees. Companies are required to provide human capital disclosure only to the extent such information is material to an understanding of the company’s business taken as a whole, and in practice there is a great deal of variation in the type and amount of information that companies disclose under this requirement.
The SEC has stated that each company’s human capital disclosure must be “tailored to its unique business, workforce, and facts and circumstances.” For that reason, Item 101 does not include prescriptive narrative or numeric disclosure requirements, recognizing that the exact measures and objectives used in human capital management may evolve over time. However, to the extent that a metric or measure, such as the number of part-time employees, full-time employees, independent contractors and contingent workers, or employee turnover, is material to an understanding of the company’s business, the information must be disclosed.
Similar to climate-related risks, the principles-based mandate of Item 105 could trigger an obligation to disclose human capital risk factors, depending on the materiality of such risks to a particular company. Many companies include such disclosure, generally focusing on talent recruitment and retention issues. A company’s failure to attract and retain key personnel or workers with necessary technical skills could present a material risk to the company’s operations, strategy, and financial performance. Some companies may also experience material risks related to labor relations, such as the risk of work stoppages that could adversely affect operations and financial performance.
Core elements of corporate governance structures include a corporation’s purpose, the role and makeup of the board of directors, shareholder rights, and how corporate performance is measured. Two long-standing SEC disclosure requirements addressing board composition and board oversight of risk are particularly relevant to ESG considerations. First, Item 407 of Regulation S-K provides extensive disclosure requirements related to corporate governance, including a provision on board diversity. Specifically, Item 407 requires a company to disclose the process that the board’s nominating committee uses for identifying and evaluating director nominees and whether the nominating committee (or the board) considers diversity as part of that process. In addition, if the board or the nominating committee has a diversity policy for identifying director nominees, the company must disclose how the policy is implemented and how effectiveness is assessed. The SEC’s rule does not require companies to disclose information about diversity across the full board of directors or for individual directors or nominees. Many companies, however, voluntarily provide self-identified gender, race, and ethnicity information for each board member and nominee in their annual proxy statements.
Item 407 also requires companies to disclose the board’s role in risk oversight of the company. In describing the extent of the board’s role in risk oversight, a company should consider how the board administers its oversight function and the effect this has on the board’s leadership structure.
The SEC has formed a task force within the Division of Enforcement to “proactively identify ESG-related disclosure and investment.” This action makes clear that the SEC expects companies to address relevant ESG disclosures in their SEC filings.