As widely reported, the newly confirmed Chair of the Securities and Exchange Commission (SEC or Commission), Gary Gensler, is expected to put forth proposals around disclosure of environmental, social and governance (ESG) factors, beginning with climate risk disclosure. While the US is in the early stages of its ESG journey, the EU is much further along.

The EU’s being a first mover on ESG will have impacts far beyond its Member nations. No one understands this better than Chairman Gensler. In the wake of the 2008 financial crisis, as the Chair of the Commodity Futures Trading Commission (CFTC), Gensler led the way globally in implementing swaps market reforms. His proposals sometimes angered his foreign counterparts—most notably, the EU[1]—for their extraterritorial applications, but the US swaps reforms became a benchmark for other countries to compare their own reforms against.

Today, the shoe is on the other foot. The EU is leading the way on ESG disclosure and going one step further in explicitly seeking to redirect capital to “green” or “sustainable” investments to achieve the EU’s climate policy objectives. The effect of the EU’s approach is that not only could it serve as a roadmap for other regulators, but it could become the default approach for companies and money managers with a global footprint. This is commonly known as the “Brussels effect” and can also be seen in the wide adoption of the EU’s General Data Protection Regulation (GDPR), among other regulations.

To meet the objectives of the European Green Deal, the EU is developing three regulations focused on sustainability disclosure – the Non-Financial Reporting Directive (NFRD), the Sustainable Finance Disclosure Regulation (SFDR), and the EU Taxonomy. The EU has already ratified and implemented several reporting obligations for money managers and issuers. It is now on the precipice of implementing a taxonomy intended to help standardize climate disclosures in the EU. The EU’s framework of disclosure rules are complementary of each other, with the taxonomy defining the elements of what is considered “green” or “sustainable,” while NFRD imposes corporate ESG disclosure requirements, and SFRD mandates how financial actors should use that information.

Challenges for US Based Entities with EU Operations

The EU’s rules apply not just to European firms, but to all market participants and financial advisors marketing in the EU. According to Morningstar, the disclosure rules will “affect trillions of dollars in assets for fund companies that actively market funds in the EU,” including 55 U.S. firms.[2] The implications for US money managers with a presence in both the US and EU is that EU rules may become the default way that they analyze and report the “greenness” of their investments. In effect, as with the US swaps rules, the EU approach could become a regulatory floor of sorts.

However, a US company’s wholesale adoption of the EU’s rules across their business may face obstacles. The US requirements could diverge or even conflict with the EU’s approach. An ongoing point of contention between the EU and US is when they are willing to defer to the other’s regulatory regimes. These conflicts have played out with regulations impacting exchanges, clearinghouses and other parts of the market. It could take several years for the US and EU to reach an agreement whether their respective ESG disclosure regimes are equivalent and worthy of deference. There are efforts already underway, however, from The International Financial Reporting Standards Foundation (IFRSF) and others to help drive harmonization in reporting standards.[3]

How Chairman Gensler Might Approach ESG in the US

It remains to be seen if or how this impacts Gensler’s approach at the SEC. While an SEC advisory committee previously urged the SEC to take a “parsimonious approach” to ESG disclosure “focus[ed] on a limited number of material metrics, tailored by industry,”[4] such an approach would be a departure from the EU’s approach. It could also arguably be considered out of step with how Gensler approached implementing the CFTC’s swaps reforms, where he implemented a robust swaps reporting regime.

Gensler has several regulatory tools that he will likely use to advance an ESG disclosure agenda: interpretative Commission and staff guidance; speeches; enforcement cases; and rules expanding the SEC’s disclosure requirements for ESG topics.

At the CFTC, Gensler relied heavily on rulemaking, setting very aggressive timelines for proposing and finalizing rulemakings. That could be indicative of the approach he may take on ESG given that these policies are a high priority. There are two important caveats to note, though. Rulemakings take time and Gensler lacks the explicit Congressional mandate that he had under Dodd-Frank. Without new authority, the SEC will operate within its existing authority which could affect both the pace and approach they take.

Relying on interpretative guidance, comment letters, speeches, and other tools, the SEC can begin to shape the ESG policy landscape more quickly.[5] However, using these tools to get around a formal rulemaking process can make them more vulnerable to a challenge in court. Gensler also knows about this all too well from his CFTC tenure where the CFTC’s guidance on the cross-border application of its swap dealer rules was challenged in court. [6]

As Acting SEC Chair, Alison Lee used some of these tools to lay the groundwork for the SEC to act on climate disclosures,[7] and Gensler has said publicly that he expects to put forth a rule proposal sometime in the summer. [8] Whatever path Gensler pursues, the level of harmonization with the EU and other jurisdictions will be worth considering as companies assess how to weigh-in on and approach new ESG rules.

Additional Acronym Background: NFRD, SFDR, EU Taxonomy

NFRD.  Since 2018, the EU’s Non-Financial Reporting Directive (NFRD)[9] requires listed companies, banks, and insurance companies with more than 500 employees to include a non-financial statement as part of their annual reporting duties. NFRD requires companies to disclose impact, development and overall performance relating to the following non-financial issues: environment, human rights, diversity on boards, anti-corruption and bribery, and social and employee aspects. The European Commission recently adopted a proposal—the Corporate Sustainability Reporting Directive (CSRD)—that would amend the existing reporting requirements of the NFRD by extending sustainability reporting requirements to all listed companies.[10] The disclosure requirements would apply to about 50,000 companies, compared to the 11,000 that are subject to the NFRD rules today.[11]

SFDR.  The EU’s recently implemented[12] Sustainable Finance Disclosure Regulation (SFDR)[13] mandates that asset managers,[14] financial advisers, and insurance providers disclose how they incorporate sustainability into the services they provide. Among other things, SFDR requires reporting entities to conduct a “double materiality” assessment, by assessing how sustainability risks could negatively impact their financial returns and how their investments could adversely impact society, such as environmental and social factors.[15] SFDR requires high-level disclosures (known as “Level 1” requirements) that are supplemented by regulatory technical standards (“SFDR RTS” or “SFDR Level 2”) that provide more specific regulatory requirements and guidance.

Sustainable Finance Taxonomy.  Another key component of the EU’s ESG disclosure regime is the Taxonomy Regulation that sets out a classification system that investors and business may use to assess the “sustainability” of certain economic activity.[16] The Taxonomy Regulation references six economic objectives[17] and defines what makes an economic activity “sustainable”.  Under the Taxonomy Regulation, an activity is sustainable if it makes a “substantial contribution” to at least one of the following environmental objectives:

o   climate change mitigation;

o   climate change adaptation;

o   sustainable use and protection of water and marine resources;

o   transition to a circular economy;

o   pollution prevention and control; and

o   protection and restoration of biodiversity and ecosystems.

and does “no significant harm” to any of the other six environmental objectives,

o   Comply with minimum social and governance standards, and

o   Meet the Technical Screening Criteria (TSC) adopted under the regulation.

[1] See e.g., Jamila Trindle and Tom Fairless, U.S. Rules on Swaps Face a Barrier Abroad, WSJ (June 9, 2013), available at https://www.wsj.com/articles/SB10001424127887324904004578535313407286392.

[2] Jean Eaglesham and Anna Hirtenstein, New ESG Disclosure Rules From Europe Challenge U.S. Fund Managers, Morningstar (Mar 22, 2021), available at  https://www.morningstar.com/news/dow-jones/202103222243/new-esg-disclosure-rules-from-europe-challenge-us-fund-managers

[3] https://www.ifrs.org.

[4] U.S. Securities and Exchange Commission Asset Management Advisory Committee, Potential Recommendations of ESG Subcommittee (December 1, 2020), available at https://www.sec.gov/files/potential-recommendations-of-the-esg-subcommittee-12012020.pdF.

[5] The SEC’s Acting Director of the SEC’s Division of Corporation Finance, John Coates, made comments on March 11th about adapting existing rules and standards, indicating that the SEC may be considering this approach:

Going forward, I believe SEC policy on ESG disclosures will need to be both adaptive and innovative. We can and should continue to adapt existing rules and standards to the realities of climate risk, for example, and the fact that investors increasingly are asking for ESG information to help them make informed investment and voting decisions. We will also need to be open to and supportive of innovation – in both institutions and policies on the content, format and process for developing ESG disclosures.

John Coates, ESG Disclosure – Keeping Pace with Developments Affecting Investors, Public Companies and the Capital Markets (March 11, 2021), available at https://www.sec.gov/news/public-statement/coates-esg-disclosure-keeping-pace-031121.

[6] See Sec. Indus. & Fin. Mkts. Ass’n., et al., v. CFTC, 13-CV-1916 slip op. (D.D.C. Sept. 14, 2014).

[7] See Public Statement by Acting Chair Allison Herrin Lee, Public Input Welcome on Climate Change Disclosures (March 15, 2021), available at https://www.sec.gov/news/public-statement/lee-climate-change-disclosures.

[8] See Speech by Acting Chair Allison Herrin Lee, A Climate for Change: Meeting Investor Demand for Climate and ESG Information at the SEC (March 15, 2021), available at https://www.sec.gov/news/speech/lee-climate-change.

[9] EU Directive 2014/95/EU.

[10] EC Corporate sustainability reporting, available at https://ec.europa.eu/info/business-economy-euro/company-reporting-and-auditing/company-reporting/corporate-sustainability-reporting_en.

[11] Id.

[12] Came into force in March 10, 2021.

[13] Regulation 2019/2088/EU.

[14] SFDR requires asset managers to make entity level and product level disclosures. For additional guidance, see Michelle Moran,  Navigating the European ESG Disclosure Regime in a Post-Brexit World (April 6, 2021), available at https://www.natlawreview.com/article/navigating-european-esg-disclosure-regime-post-brexit-world.

[15]  BloombergNEF, The relationships between SFDR, NFRD and EU Taxonomy (March 31, 2021), avail
able at https://www.bloomberg.com/professional/blog/the-relationships-between-sfdr-nfrd-and-eu-taxonomy/.

[16] EU taxonomy for sustainable activities, available at https://ec.europa.eu/info/business-economy-euro/banking-and-finance/sustainable-finance/eu-taxonomy-sustainable-activities_en.

[17] (1) Climate change mitigation, (2) climate change adaptation, (3) the sustainable use and protection of water and marine resources, (4) the transition to a circular economy (5) pollution prevention and control, and (6) the protection and restoration of biodiversity and ecosystems.