Topics:   Compliance,ESG,Investor Relations,Legislative & Regulatory,Risk Management

Topics:   Compliance,ESG,Investor Relations,Legislative & Regulatory,Risk Management

October 21, 2019

ESG Risks Trickle Into Financial Filings

October 21, 2019

Investors in 2019 have increasingly turned their attention to environmental, social, and governance (ESG) topics, and are demanding more information on how companies are thinking about the potential long-term risk and opportunities related to specific environmental and social factors. As companies prepare for the 2020 proxy season and engage with shareholders, directors should understand the current state of ESG risk reporting in public filings.

Standards setters such as the Sustainability Accounting Standards Board and the Taskforce on Climate-Related Financial Disclosures provide frameworks to disclose ESG risks that could have a financial impact. Despite, or perhaps due to, the myriad standards and suggested disclosure frameworks, companies struggle to identify the most relevant risks to disclose, and where in their reporting to disclose them. In 2019, 66 percent of companies in the Russell 3000 Index discussed ESG risk but approaches varied widely.

To help directors and their management teams understand the current landscape of ESG risk disclosure, NACD mined MyLogIQ – Multidimensional Public Company Intelligence’s data to identify trends in 10-K filings, specifically in the risk-factors section and in management’s discussion and analysis of financial condition and results of operations (MD&A). While companies may describe risks anywhere in their 10-K filings, they must list all major ones in the risk-factors section. Previously, risks were listed in the MD&A, a practice that continues in some companies.

Our study compared disclosures by industry, using MyLogIQ’s classification for eight sectors. Almost all energy and mining companies discussed ESG risk in their 10-K, with the lowest amount of ESG risk disclosure in the entertainment, media, and communications industry at a still relatively high 41 percent of companies.

A review of how three key ESG risks—climate change risk, human capital management risk, and water scarcity risk—are being disclosed follows:

Climate Change Risk

Thirty percent of Russell 3000 companies discussed climate change as a risk in their 10-K statement, with only 3 percent of companies discussing climate change risk in the MD&A section. Predictably, the energy and mining sector had the most disclosure on climate change risk. Retail and consumer sector companies, which are not thought of traditionally for being exposed to climate change risk, also had a high rate of disclosure, citing damage to their supply chain and access to raw materials as risks.

Disclosures for every sector focused on the risk of regulatory and market responses to climate change, including legislative regulation of air emissions, caps, and carbon taxes. Other companies were more detailed in their discussion of climate change risk as it relates to their specific operations, such as Monster Beverage Co.’s 10-K, which states that, “In addition, public expectations for reductions in greenhouse gas emissions could result in increased energy, transportation and raw material costs, and may require us to make additional investments in facilities and equipment. As a result, the effects of climate change could have a long-term adverse impact on our business and results of operations.”

The high volume of disclosure in this category could be driven by 2010 amendments to Regulation S-K, one of two key regulations governing public company disclosures. Regulation S-K, adopted in 1977, affects nonfinancial disclosures. Under the 2010 amendments to Regulation S-K, the US Securities and Exchange Commission (SEC) requires that “registrants whose businesses may be vulnerable to severe weather or climate related events should consider disclosing material risks of, or consequences from, such events in their publicly filed disclosure documents.”

While there have been no recent changes to mandatory climate change disclosure, in 2019 thus far there have been 52 legislative bills put forth on climate that could impact mandatory disclosure in the future. Directors across industries would do well to heed the trends in climate disclosures and task their company’s government relations departments with watching and reporting on any legislative developments that might impact the company’s disclosures in 2020 and beyond.

Human Capital Management

The Human Capital Management Coalition defines human capital management as encompassing “a broad range of corporate practices related to the management of employees, including, but not limited to, hiring and retention, employee engagement, training, compensation, fair labor practices, health and safety, responsible contracting, ethics, desired company culture, and diversity, both with respect to a company’s direct employees and to the employees of vendors throughout the company’s supply chain.” This disclosure category is particularly relevant for companies moving into 2020 given the August 8, 2019, proposed amendments by the SEC to Regulation S-K.

The proposed amendments include a requirement to disclose human capital measures that management focuses on in 10-K filings, if those measures are material to the business. The SEC cites in their potential amendments a 2017 rulemaking petition from a group of 25 institutional investors, representing $2.8 trillion in assets, which called for mandatory disclosure on human capital management performance, policies, and practices. In 2019, just 8 percent of the Russell 3000 disclosed a risk for human capital management with the highest prevalence of disclosure at technology companies. (It is worth noting that this is reflective of the exact phrase, “human capital management,” not elements of the term such as retention, talent, and so on.)  

Water Scarcity

Water scarcity and water crises are top global risks, according to the World Economic Forum. A recent Ceres report discusses water risk in more detail, stating, “Many [asset] managers reported capturing information such as the percentage of corporate facilities in high water risk areas, and how water- or waste-intensive a company or product is overall.” Many investors are looking for more information on the risks to a company’s operations from water scarcity, but only a few companies are disclosing. Just 32 percent of Russell 3000 companies discussed water risk or water scarcity risk in their 10-K disclosure. Eighty-seven percent of these disclosures were found in the risk-factors section, with 13 percent found in the MD&A.

Disclosures for this risk range from the inclusion of water shortages a laundry list of other risks to detailed discussions of the potential implications of a water crisis on their operations. For example, Golden Entertainment discloses that “Our properties use significant amounts of water, electricity, natural gas and other forms of energy. Our Nevada properties in particular are located in a desert where water is scarce and the hot temperatures require heavy use of air conditioning. While we have not experienced any shortages of energy or water in the past, we cannot guarantee you that we will not in the future. . . . We expect that potable water in Nevada, where the majority of our facilities are located, will become an increasingly scarce commodity at an increasing price.”

As we enter 2020 proxy season, investor expectations of ESG risk disclosure is unlikely to wane. Directors can prepare their management teams to demonstrate effective oversight to investors and stakeholders by asking them the questions listed below.

Questions Directors Should Ask Management

  • Has our company identified the most salient environmental, social, and governance (ESG) risks to our business operations?
  • If the company has identified risks, are they incorporated into our broader enterprise risk management system?
  • Are our disclosure practices around key ESG risks in line with those of our industry and proxy peers?
  • What questions are shareholders, regulators, employees, customers, or other stakeholders asking about long-term strategy and the potential impact of ESG risks on corporate performance?