Should Private Companies Embrace ESG Disclosure Practices?
There are business and financial advantages for private companies that adopt ESG reporting strategies.
ESG disclosure, as mandated by the Federal Reserve Board or the SEC, is a matter of compliance for public companies. In general, private companies are not subject to federal regulations. Yet, the spillover effects of federal regulations onto the private sector carry material and strategic consequences for certain private companies. For boards to make optimal decisions regarding ESG strategy, including the optimal disclosure strategy, these spillover consequences need to be understood.
Private entities are regulated by states in which they are incorporated or in which they operate. Most states follow general principles of the Commercial Code of the State of Delaware (CCSD), since many American businesses are incorporated in Delaware. The “North Star” for the CCSD is value creation for a corporation. Specifically, the CCSD lacks ESG-specific disclosure requirements. Therefore, no laws will be broken if a private company that is subject to CCSD or similar state codes does not take action on ESG issues while the board is focused on value creation.
In 2022, the SEC proposed guidance regarding ESG disclosure for public institutions. Final rulings that define regulatory requirements to standardize public companies’ disclosure on climate, cyber governance risk, human capital and board diversity are expected later this year. Public and private companies should review their strategies against expected SEC rulings to avoid potential regulatory risk surprises.
Business considerations for disclosure or nondisclosure
Publicly listed companies need to comply with SEC and Federal Reserve ESG reporting guidelines, but private companies have options on how to react to regulatory developments. Business sectors, product and service types in conjunction with client types, growth strategy, culture and location of operation are just a few variables related to decision-making. Each option will carry certain business consequences depending on the company's unique ecosystem. Being a part of a public company value chain is the most important factor that will catalyze the decision on ESG strategy for domestic companies. Private companies with E.U. and U.K. operations may have legal disclosure obligations in these jurisdictions.
See below for scenarios that touch on business considerations for the decision regarding optimal ESG strategy for a private company.
Five business cases for consideration to adopt ESG strategy
Scenario 1: Scope I, II and III GHG reporting in the value chain
The SEC´s risk disclosure guidelines give flexibility to listed companies to select which disclosure standards or platform they will follow. All recommended platforms use the Greenhouse Gas Protocol (GHG) emission framework, which organizes emissions into three types: scopes I, II and III. Scope I details the GHG emissions from an entity's own operations (offices, manufacturing spaces). Scope II refers to indirect emissions from purchased electricity, steam, heating and cooling. Scope III accounts for all other GHG emissions in the value chain, both upstream and downstream. Scope III, the most difficult to assess (and most debated by the SEC) consists of scope I and scope II for all of a company’s suppliers.
CDP (formerly known as the Carbon Disclosure Project) is one of the most frequently used disclosure standards. In 2021, over 13,000 organizations disclosed on the CDP platform scope I, II and III data. As such, CDP became a primary, go-to source for investors to obtain or request climate disclosure data from their portfolio companies.
If a private company has investors or lenders who belong to a group of over 680 financial institutions reporting on climate risk on the CDP platform, the portfolio private company may be asked to disclose certain ESG factors, such as GHG footprint, as a lender or an investor compiles its own data on a portfolio’s climate risk. If a private company applies for a loan or a line of credit from a large financial institution that is subject to Federal Reserve regulations, the cost of capital offered will be determined, among other risk factors, by climate risk, which is assessed based on a private company disclosure or a lack of such a disclosure.
If a private company is in a value chain of companies that have already made a commitment to climate goals, it most likely will be asked for a disclosure. For example, Unilever has publicly set a goal of being carbon-neutral by 2030 and it is regularly reporting on the progress toward that goal, gathering the data from its 60,000 vendors. In October 2019, Google and Amazon made ambitious commitments to renewable energy and carbon-neutrality goals. Tracking these goals requires scope III data, which, for Google, means over 1,000 vendors. Any of the approximately 150,000 private companies worldwide that are primary or secondary suppliers to Unilever, Alphabet or Amazon (excluding Amazon sellers) should expect requests for disclosure in line with SEC or E.U. CSRD recommended standards.
In 2022, approximately 10,400 companies received a CDP questionnaire originated by clients, investors or lenders who report scope III emissions on CDP. In these cases, disclosure requests came not from federal regulators, but from business partners or financial institutions that have been collecting data for their own disclosures of scope III emissions.
Private companies in the U.S. do not have legal obligations to respond to such requests. The choice of whether to respond is a business decision. It should be kept in mind that both actions — a response or lack thereof — are a matter of public disclosure on the CDP website. Lack of response may jeopardize business relationships with a client, as it will affect a third-party risk score and may impact brand value and increase repetitional risk of a private company. Conversely, providing disclosure upon request, however imperfect, may offer competitive advantages in vendor relationships by lowering third-party risks. It may increase a company's brand value and valuation, and build goodwill and trust in vendor relationships.
Scenario 2: International activities
In the past decade, and as recently as 2021, stakeholders and regulators in the U.S., the E.U., and the U.K. were seemingly moving in the same direction regarding ESG, with the U.K. leading the way and the E.U. codifying its standards by enacting two directives:
- The CSRD will become effective Jan. 1, 2024, with the first reports due in 2025.
- Sustainable Finance Disclosure Regulation (SFDR), which will require private market investors to disclose ESG metrics and performance, starts in June 2023.
Any public or private company with a net turnover in the E.U. of 150 million euros will be in the scope of this CSRD ruling. For such companies, E.U. lawmakers designated 2023 to assess and build data systems that will allow accurate and transparent reporting from 2024 onward. Scope III GHG reporting proposed by the SEC is similar to that adopted by the E.U. in the CSRD; therefore, an American subsidiary with a turnover below a threshold of 150 million euros that participates in a value chain of an E.U.-based large company may be required to disclose the data, either on a subsidiary level or the headquarters level.
The climate-related legislative agenda in the U.K. slowed down in 2021 because of government changes, yet it is expected that the U.K. will stay its course with its sustainability disclosures, which in some cases are further reaching than the CSRD. Companies listed on the London Stock Exchange must include climate-related disclosures (including scope III GHG emissions) on a “comply or explain'' basis from 2022 onward. Independently, all companies conducting business in the U.K. with a turnover of 36 million pounds are required to publish a slavery and human trafficking statement from 2015. A single-use plastic ban will be in effect in October 2023.
A private company operating in the E.U. or the U.K. needs to evaluate potential legal obligations under the newly enacted directives, the cost and time needed to collect data and, conversely, potential liabilities from noncompliance regarding ESG disclosures.
Scenario 3: Public company track
Serious consideration should be given to embracing ESG disclosures if a company is on an IPO or SPAC track within the next three to seven years. Various exchanges have adopted listing rules that may include disclosures of some ESG factors, such as climate risks, GHG emissions, diversity and inclusion, and cyber governance. Developing data-capture systems that will satisfy required listing qualifications takes time and expertise, so companies need to be ready before the IPO/SPAC due diligence process starts.
Scenario 4: Consumer brand sensitivity
The fashion, cosmetics and entertainment industries are examples of market pockets where many customers hold strong opinions about social issues. Purchasing behavior of such consumers is highly influenced by the “brand value” of products or services.
Today, both private and public businesses operate in a “transparent economy” where consumers are only a click away from expressing their views about a product or a company. Communication strategies that may impact brand value must be carefully crafted and monitored by large and small companies, independent of their formal standing on ESG. It is more and more common in a “client-sensitive business” to establish the position of CLO, or chief listening officer, to implement “consumer-first” strategies, with the goal of elevating consumer input through company ranks and expediting company reaction to sensitive issues, including those that can be classified as “S'' factors in ESG. Brands like Pizza Hut, Dunkin’, Apple and Disney pay high attention to consumer input.
Boards of private companies that service consumers with high S factor sensitivity need to carefully consider all strategies to attract and retain such customers, from product design, customer communication, transparency and reporting.
Scenario 5: Company culture and human capital considerations
Retaining, attracting and motivating talent is one of the top challenges for CEOs, even in the current labor market, where high-tech companies like Apple, Microsoft and Amazon are shaving off excess labor from the 2020 pandemic hiring spree.
Employees actively seek to work for companies that exemplify their own values and beliefs. As seen during the heights of the COVID pandemic, the “Great Resignation” gives evidence to the importance of employee/employer value alignment, or what happens when such alignment is either not there or not clearly communicated.
Management can energize the workforce and build a sense of belonging by clearly stating the company's beliefs and values. Not surprisingly, such vision and value statements have been adopted as an effective tool in human capital strategy. In doing so, management should be mindful of public market disclosure standards that distinguish aspirations and inspirations from factual statements. Adopting ESG disclosure standards may enhance discipline and accountability across all levels of a private company, which will help to avoid pitfalls of greenwashing or “green-wishing” by management.
Financial considerations of disclosure or nondisclosure
The decision to disclose or not to disclose ESG strategy will carry significant financial consequences. In fact, one of the most vocal critical arguments against disclosure is its cost.
In weighing the pros and cons associated with disclosure, one should keep in mind that adopting an ESG strategy, including disclosure practices, is a journey rather than a destination.
According to the SEC recommended standards, the cost of adopting ESG disclosure practices can be a materially significant factor, especially for a smaller entity. The cost will include:
- Developing ESG expertise. The various approaches include developing in-house expertise, building it gradually by bringing dedicated resources in-house or acquiring outside expertise from consultants. Each of these options has its own time and cost consequences. Developing in-house expertise will require more time than hiring outside experts for the preparation and production of the first report. However, as ESG reporting is expected to become standard annually, the decision has to be made as to how much expertise a company wants to retain and nurture in-house.
- Capturing ESG data. Companies may build their own data-capture systems or acquire a third-party system to capture ESG data alongside other business analytics. Developing a company's own data systems will require the expertise of what data points to capture and the time to build such a data-collection system. Outside vendors offer a variety of solutions. For example, utilities provide reports on scope I and scope II GHG emission data. Service providers offer their CRM products enhanced with modules that capture/estimate the scope III GHG emission data.
- Compiling the data for disclosure according to regulator specifications. Once a company has quality data, the next step is to compile data into one of the recommended disclosure formats. Any disclosure should also be monitored from the legal perspective.
Building a comprehensive ESG disclosure system can be overwhelming for a private company that operates on a tight budget and lacks deep ESG experience. Large companies, which over the years have developed many layers of ESG expertise, appreciate these challenges and frequently offer support and guidance to their value chain partners who embark on the ESG disclosure journey. They provide technical expertise and sometimes project management guidance. Some investors, who are subject to federal disclosures and are managing their portfolios through ESG lenses, are eager to actively work with the management of their portfolio companies to create the path toward disclosures. They realize that supporting development of data capture systems is a win-win proposition for both an asset manager and a portfolio company.
At this stage of ESG framework development, the goal for big public companies, investors, lenders and regulators is not to expect a perfect disclosure but rather to gradually develop an expertise and build a system for incrementally improved reporting. Private entities need to be ready to embrace such support, guidance and expertise, which requires an allocation of internal resources. Regulators appreciate that enterprises that are new to ESG reporting need time to develop necessary expertise and build data-capture systems. Such time allowance is built into the CSRD regulations, with year 2023 being designated to prepare for reporting for 2024, and the first reports due in 2025.
Private companies are not subject to ESG disclosures mandated by U.S. federal regulators. However, there are many business cases where private and public disclosures are interwoven. In addition, private companies need to understand the business consequences and legal liabilities of “disclose or not to disclose” decisions. At this point, ESG disclosures for private companies are voluntary. However, such voluntary disclosures should follow the guidelines set up by federal regulators, as these two systems are interrelated, especially in the value chains. This will help companies avoid intentional or unintentional greenwashing effects.
Wanda R. Lopuch, Ph.D., is chair of the governance, nominating & ESG committee of HEVO Inc.
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