Tougher standards on ESG, enhanced regulation, increases risk of litigation: MLT Aikins lawyer

As the global mindset regarding environmental, social, and corporate governance (ESG) shifts towards a stricter line on holding corporations to their stated net-zero goals, the risk of litigation increases, says Conor Chell, Head of the ESG Practice Group at MLT Aikins LLP.

“If ESG strategies are not developed or implemented property,” Chell says, “there may be potential exposure to significant legal risk,” especially as mandatory disclosure is coming to many countries – Canada included.

For example, in the latest federal budget, the government outlined its plan to require federally regulated financial institutions to begin reporting climate-related financial risks under the Task Force on Climate-Related Financial Disclosures (TCFD) framework.

Banks and other financial institutions will have to collect climate risks and emissions data from their clients, forcing companies with which they do business to make climate-related disclosures to access financing and other financial services.

Chell says that if such mandatory ESG disclosure does not meet the compulsory disclosure requirements or is misleading, companies and organizations may face investigations, enforcement, and litigation.

Governments, institutional investors, other stakeholders, and the public expect greater transparency and visibility from corporations on ESG, Chell says. “They want more than nice-sounding words in a Corporate Social Responsibility report.”

Chell, who will be one of the speakers at Canadian Lawyer’s ESG Summit on Oct. 12, says the ESG expectations of these players, in large part, are 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, often criticized for being unreliable and potentially biased.

This lack of quality data 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.

Although ESG standard setters and rating firms have increased in recent years, the number of ESG rating agencies has not improved the reliability of ESG ratings. Researchers at MIT’s Sloan School of Management recently studied six top ESG rating firms and concluded that ratings from different providers disagree substantially.

Read more: CDP raises concerns about fragmented ESG ratings regulations

The result is a “general lack of trust” in ESG reporting rating on ESG matters. A report from the sustainability reporting standards organization Global Reporting Initiative found that approximately half of those surveyed globally do not trust sustainability reporting. PwC reported in 2016 that while 100 percent of the corporations surveyed had confidence in the information they provided, fewer than one-third of investors shared that confidence.

Part of the problem, Chell says, is that most companies have complete discretion over which ESG standard or framework they follow. This discretion extends to what issues they report on and include in their ESG reports.

Consumers often find sustainability reports confusing and difficult to interpret. In addition, third parties only validate a minority of reports, which means much of the data reported are potentially misleading and incomplete. Additionally, corporations are not reporting on material issues, and net-zero goals are often criticized for being unachievable and lacking in credibility.

Chell points to the KPMG Survey of Sustainable Reporting, which 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.

As mandatory ESG disclosure looms in Canada’s future, these issues will create a significant risk for litigation and arbitration for corporations, and misleading or incomplete ESG reporting could “result in significant legal and financial” penalties.

Chell notes that developments in Europe provide an example of the potential for risk. On May 26, 2021, the Hague District Court ordered Royal Dutch Shell to reduce its worldwide carbon emissions by 45 percent 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.

He says he expects ESG-related investor litigation and arbitration to grow worldwide. The coming years will also 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.”

Numerous jurisdictions, including the EU, the U.K. and the U.S., have either legislated mandatory ESG disclosure requirements or are rapidly moving in that direction. In Canada, mandatory ESG disclosure is imminent.

Indeed, beginning this year, the federal Office of the Superintendent of Financial Institutions (OSFI) will consult with banks and insurers on developing climate disclosure guidelines regarding ESG disclosure, aiming to gradually phase in reporting requirements for financial institutions beginning in 2024.

In the April budget, the government also announced plans to require federally regulated pensions to disclose the ESG considerations they use in their portfolio construction. However, there were no specific details on how or when the government would roll out that requirement.

And while the OSFI guidelines will for now focus on reporting requirements for financial institutions and pension funds, they are expected to have an impact throughout the Canadian economy, regardless of the industry or sector, given the role that regulated banks, and financial institutions play.

Not only will companies face potential litigation, but Chell says they may also “face severe financial and market repercussions” if their sustainability claims are not verifiable. For instance, last February, influential data provider Morningstar Inc. 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.