Authors: Conor Chell, Esha Saxena
There is a clear shift in the global mindset toward environmental, social and corporate governance (ESG) considerations and practices. Governments, institutional investors, stakeholders and the general public expect greater visibility and transparency from corporations around the world on their environmental and social risks.
Currently, this expectation is not being met. Sustainability reporting provided by corporations is often incomplete and, in some cases, misleading. The information shared is largely self-reported and unaudited. ESG rating agencies rely on this data to provide ESG ratings, which are often criticized for being unreliable and potentially biased. This has created a general lack of trust in ESG reporting and ratings among investors.
As mandatory ESG disclosure likely looms in the near future for Canada, these issues create a major risk of litigation and arbitration for Canadian corporations. Misleading or incomplete ESG reporting could result in significant legal and financial repercussions.
Problems with Sustainability Reporting and Net Zero Goals
There are many problems with sustainability reporting. Most companies have complete discretion over which ESG standard-setting body or framework they follow, what issues they decide to report on, and ultimately, what information to include in their sustainability reporting. Only a minority of reports are validated by third parties, which means much of the data being reported is potentially misleading and incomplete. Consumers often find sustainability reports confusing and difficult to interpret. Additionally, corporations are not reporting on material issues and net zero goals are often criticized for being unachievable and lacking in credibility.
The KPMG Survey of Sustainable Reporting suggests that corporate reporting on the UN Sustainable Development Goals focuses exclusively on the positive contributions companies made toward achieving the goals, and lacks transparency on corporations’ negative impacts. Investors are now expressing frustration over the lack of harmonized standards for non-financial reporting.
Although ESG standard setters and rating firms have proliferated in recent years, the growth in the number of ESG rating agencies has not improved the reliability of ESG ratings. Researchers at MIT’s Sloan School of Management recently conducted a study of six top ESG ratings firms and concluded that ratings from different providers disagree substantially. The information decision-makers receive from ESG rating agencies is relatively noisy and raters often seem unaware of what’s actually happening inside companies. PwC reported in 2016 that while 100% of the corporations it surveyed had confidence in the information they were providing, fewer than one-third of investors shared that confidence.
One major problem with ESG rating agencies is the lack of quality data, which means agencies rely on self-disclosures or obtain data from third-party sources that are not necessarily more reliable than the firms being rated. Company size, geography and industry sector may also create bias in these ratings.
Lack of Trust
Due to these reasons, both the public’s and institutional investors’ trust levels in sustainability reporting is falling rapidly.
A report from sustainability reporting standards organization the Global Reporting Initiative found that approximately half of people surveyed globally do not trust sustainability reporting. In certain jurisdictions, including the U.K., U.S., Australia, France, Germany and Argentina, the number of people who distrust sustainability reporting is greater than the number of people who do.
Creation of Risk
At the moment, ESG disclosure is not mandatory in Canada. However, numerous jurisdictions around the globe (e.g. the EU, U.K. and U.S.) have either legislated mandatory ESG disclosure requirements or are rapidly moving in that direction. In Canada, there are strong signals from government and regulators that mandatory ESG disclosure is imminent.
If mandatory ESG disclosure requirements are implemented, there will be potential exposure to significant legal risk if ESG strategies are not developed and implemented properly. For instance, if ESG disclosure (e.g. sustainability reports and net zero goals) does not meet the mandatory disclosure requirements or is misleading, companies and organizations may face investigations, enforcement and litigation initiated by governments, regulators, shareholders and other stakeholders.
Environment-related investor litigation and arbitration is on the rise across Europe. This is expected to grow on a massive scale across the world, including in Canada. On May 26, 2021, the Hague District Court ordered Royal Dutch Shell to reduce its worldwide carbon emissions by 45% by 2030. Across Europe, legislators are increasing their focus on ESG issues, aiming to steer companies’ attention toward the long-term sustainability of their businesses and their broader impacts on stakeholders. The coming years will see an expansion of international and domestic climate change and sustainability policy and regulation, which will lead to a corresponding increase in the number of related disputes globally.
Not only will companies face potential litigation, they may also face severe financial and market repercussions if their sustainability claims are not verifiable. In February 2022, Morningstar Inc., an influential data provider, removed more than 1,200 investment funds with a combined $1.4 trillion in assets from its European sustainable list after an extensive review of prospectuses and annual reports provided to investors uncovered ambiguous language.
How Can MLT Aikins Help?
Now more than ever, companies that do not have credible and transparent sustainability reporting and net zero plans risk losing access to capital – and becoming a potential target for litigation. Even companies in high-emitting sectors can still be viewed as an attractive investment by many institutional investors if they have credible sustainability reporting and net zero plans, as well as meaningful targets for reducing emissions. The lawyers in our ESG practice group have extensive experience advising clients in a broad range of industries on developing their ESG strategies. Contact us to learn how we can help.
Note: This article is of a general nature only and is not exhaustive of all possible legal rights or remedies. In addition, laws may change over time and should be interpreted only in the context of particular circumstances such that these materials are not intended to be relied upon or taken as legal advice or opinion. Readers should consult a legal professional for specific advice in any particular situation.