The United States and the Need for ESG Legislation: Building on the Successes of the European Union

Abstract

In response to the worsening effects of climate change and subsequent lack of effective command-and control regulation, attention has been increasingly turned to market-based environmental solutions. Market-based solutions align environmental and financial goals, while traditional policies prioritize one at the expense of the other. One of the most notable solutions to arise from this shift towards alignment is the concept of Environmental, Social, and Governance (ESG), particularly in investing and corporate ratings. The ESG framework is most commonly used by investors and fund managers to develop an accurate assessment of a company’s risk and opportunity management.

Integration of this strategy into financial decisions on a global scale has been met with widely varying levels of success, specifically the United States (US) and European Union (EU). The former has struggled to effectively employ ESG investing as a solution, primarily due to its deeply polarized political landscape. Across the Atlantic, the EU continues to make strides towards its integration into their economy in the form of new legislation and related task forces.

This essay seeks to analyze the current legal landscape surrounding ESG in the US, utilizing current legislation in the EU as a point of juxtaposition. Further, it argues for the development of a comprehensive federal regulatory framework that will attempt to consolidate a fragmented political sphere and allow the investment sector to effectively utilize ESG as a risk management tool. This will be accomplished in four parts. Part I will outline the use of ESG in a financial context. Part II will serve as a summary of enacted and pending laws in the US. Part III will explore the state of ESG legislation in the EU. Part IV will provide a comparative analysis of policy approach by both governing bodies and a normative perspective on future action needed from the US.

I. Origins and Functions of ESG

In 2004, ESG made its first official appearance in the financial sector following the United Nations report “Who Cares Wins.”¹ Kofi Annan, the Secretary-General at the time, emphasized the potential of ESG to effect positive change in the publication, providing related guidance for varying stakeholders. From there, it has skyrocketed in global relevance as an investment tool.

It is essentially designed to serve as an evaluative framework that assesses a company or fund’s risk and opportunity management in three general contexts: Environment, Social, and Governance. The first dimension, Environment, considers the impact their operations have on the physical environment. This impact is determined using factors such as pollution, greenhouse gas emissions, biodiversity loss, and regulation compliance. Social assesses a company’s relationship with society as a whole by focusing on three core aspects: interactions with the public, the political sphere, and its workforce. Governance is the last dimension and evaluates an organization’s leadership using factors such as the compensation and demographic makeup of its executive board.

At first glance, non-financial factors such as emissions or land pollution does not seem to have an impact on financial returns. However, these factors are indicative of a company’s vulnerability to the worsening consequences of global warming. Extreme weather events in the form of floods or hurricanes upend supply chains and damage investor returns. Their increased severity and frequency only exacerbate the loss to shareholder value. Corporate ratings agencies and other financial firms are not the only actors utilizing this framework. Consumers are also increasingly cognizant of non-financial factors when making purchasing decisions due to heightened awareness of issues such as climate change and unethical labor practices.

II. ESG Legislation in the United States

American integration of ESG has been primarily spearheaded by large private institutions such as BlackRock and Mainstreet. At this time sustainability and ESG reporting is not legally required. However, voluntary disclosure serves as an opportunity for companies to bolster their reputation in the eyes of a public concerned about corporate sustainability. On the legislative front, the Securities and Exchange Commission (SEC) has a variety of policies awaiting approval or implementation. One policy is the NASDAQ Board Diversity Requirement, requiring all companies on the NASDAQ stock market to disclose demographic information on their executive board. They must also have two diverse directors, in terms of gender, ethnicity, or LGBTQ+ status, or an explanation as to why they do not.² One of the most substantial pieces of ESG legislation to arise in the preceding years is the Enhancement and Standardization of Climate-Related Disclosures for Investors and was finalized in March of this year. Under this regulation, companies would be required to disclose their Scope 1 and 2 emissions. Scope 1 emissions account for those released directly by a company’s operations, while Scope 2 encompasses emissions generated as a result of energy use. For the first time, Scope 3 emissions would also have to be reported, which are all indirect emissions in a company’s value chain.³ Scope 3 emissions include supplies bought, employee commutes, and business-related travel. Another regulation is the Federal Supplier Climate Risks and Resilience Rule proposed in 2022. Under this rule federal contractors receiving over $50 million in annual contracts must disclose their greenhouse gas emissions and climate-related risks.⁴

The strong connection ESG has to contested issues such as climate change and labor rights places it at the center of the nation’s bipartisan war. The political divide in the US prevents a cohesive legislative approach and instead creates one characterized by conflicting state regulations. While liberal states like California, New York, and Maine are advancing integration of ESG into their respective economies, conservative states are enacting severe anti-ESG legislation.⁵ Why such a strong opposition for a tool designed to maximize investor returns? The Republican party claims that ESG is a method to judge companies not on their risk management, but their adherence to what they deem as left-wing values. Governor Greg Abbott of Texas signed a law in 2022 banning business with companies that boycott fossil fuels, while Florida Governor Ron DeSantis has proposed regulation to ban ESG consideration from state pension investments.⁶

III. ESG Legislation in the European Union

Although the US has begun to enact federal ESG legislation through regulations proposed by the SEC, the rate of bill approval and implementation is much slower relative to the EU. Europe has released four major sustainability reporting regulations. The 2020 EU Taxonomy for Sustainable Activities is a comprehensive list of economic activities classified as environmentally sustainable for companies and investors. Some of these activities include projects that would further the objectives outlined in the regulation such as climate change adaptation and biodiversity restoration. It also sets four conditions that must be satisfied to receive this classification: it must contribute to a set environmental objective, it must not significantly harm any of the objectives, it must comply with the safeguards outlined in the regulation, and it must comply with technical screening criteria set by the European Commission.⁷ The second, titled the Corporate Sustainability Reporting Directive (CSRD), was approved in 2022. This regulation seeks to increase the consistency and frequency of corporate sustainability reporting and makes the EU the first to mandate ESG disclosure in accordance with the European Sustainability Reporting Standards.⁸ The Sustainable Finance Disclosure Regulation (SFDR), organizes financial funds under three categories: Articles 6, 8, and 9. Article 6 integrates ESG-related risks into economic decisions and is the baseline classification for all products. Products labeled Article 8 “promote” environmental and social goals. Article 9 is the most stringent of the three and is reserved for products with a core sustainable investment objective.⁹ Fund managers are also required to disclose their strategies for addressing issues such as sustainability risks and principal adverse impacts. The pending implementation of the Corporate Sustainability Due Diligence Directive (CSDDD) in 2023 addresses ESG concerns within corporate supply chains. The law mandates a higher level of due sustainability and human rights related-diligence for procurement practices. Companies must also address and seek to mitigate potential negative impacts in supply chains.¹⁰ The EU’s structured and ambitious approach to ESG integration is underscored by these policies, allowing for rapid implementation as they bind all member states to the collective standard.

Even with unanimous support of member states in the EU, their progress at ESG integration has been limited by frequent cases of greenwashing. Most of these cases have been on the heels of the implementation of the SFDR. The criteria that distinguishes Article 6, 8, and 9 funds are ambiguous and subjective, allowing for misinterpretations and subsequent variation in products’ ESG ratings within categories that are meant to be largely uniform. Article 8 funds are subject to the highest level of discrepancy as they are defined by their ‘promotion’ of environmental and social goals. Financial firms issue SFDR labels at their discretion; this responsibility paired with a lack of clear EU guidelines results in individualized definitions as to which products fall under Article 8. This variation has even caused the investment sector to use an entirely different classification of fund sustainability ranging from ‘light’ to ‘dark’ green.¹¹

The inconsistency in the application of the SFDR becomes apparent when comparing two Article 8 funds: the Allianz Global Water fund and the L&G UK Equity UCITS Exchange Traded Fund. The former uplifts companies and projects seeking to improve global water usage. The L&G UK Equity UCITS Exchange invests in “sin stocks,” which are defined as companies operating in industries such as tobacco and oil.¹² To an investor, the two funds appear to be even in terms of sustainability as they both ‘promote ESG qualities.’¹³ The dozens of ESG ratings systems used to assess financial products only worsen the issues of greenwashing. Corporations labeled with the more sustainable Article 8 or 9 title might receive a lower Article 6 label from indexes with more stringent requirements. Funds undeserving of a sustainable classification are able to assess themselves among different ratings systems until they find one that gives them the best score. Stakeholders have trouble accurately comparing financial products with a system originally meant to provide a clear assessment of potential risks and opportunities.

IV. Comparative Analysis and Looking Ahead

The EU’s and US’s difference in legislative approach can be attributed to the presence, or lack thereof, of sweeping legislation that mandates federal climate action. The European Climate Law serves as their formal commitment to achieving a goal of climate neutrality by 2050 originally outlined in the 2020 European Green Deal. Legislators are subsequently uninhibited by policy lag and able to generate effective ESG legislation for all member states. The US, on the other hand, does not have a binding climate law. The 2022 Inflation Reduction Act is the closest alternative, attempting to shift the nation towards a clean energy economy by subsidizing domestic solar and wind production. However, the law is not compulsory, instead offering grants and tax credits to companies and consumers. The private sector must then take the lead on ESG integration. Without a national climate bill, states are then able to determine their own laws regarding integration.¹⁴ This has led to a fractured approach constrained by anti-ESG legislation in Republican states.

The US is in a unique position where it is able to develop ESG legislation that can draw on the strengths of the EU as well as effectively circumvent its shortcomings. To do this, the nation must work to achieve two goals: the implementation of a binding climate law and the international standardization of ESG metrics. The impact of progressive policy is diluted by the fragmented American political landscape. A formal commitment to climate action would permit the effective development of legislation geared towards meeting set goals, whether that entails emissions caps or mandatory sustainability reporting. This will create a centralized, systematic approach to ESG integration without facing pushback from states such as Florida or Texas.

Greenwashing experienced by the EU can be avoided by the creation of international, universal ESG metrics. There are a multitude of indexes currently in use: the S&P 500, the MSCI World SRI, and Moody’s are among a few of them. Different indexes mean different ratings criteria, and subsequently different levels of stringency for what is considered to be well-rated. Companies can take advantage of this by simply finding an index that gives them the best rating. This creates confusion and distrust among investors as well as the public, who will have to constantly worry about potential greenwashing. Nations must collaborate to develop a strict, universal standard that will allow funds and corporations to be accurately compared to one another. Furthermore, an international standard will benefit companies operating in multiple countries.

Environmental, social, and governance investing has the potential to align both financial and environmental goals in an economy where they were traditionally perceived to be at odds with one another. It serves as motivation for corporations and financial firms to make genuine efforts towards internal improvements as well as investments into projects seeking to mitigate climate change. However, this potential cannot be realized given the current state of legislation and extreme bipartisanship in the United States. Significant changes must be made in the form of a sweeping environmental bill and a set of universal ESG metrics in order to propel the nation and rest of the world towards a more sustainable future.

About the Author

Alex Vihlen is a senior at Northeastern University majoring in Economics and Philosophy with minors in Chinese and Law & Public Policy. He serves as Editor-in-Chief of the Northeastern University Undergraduate Law Review, where he oversees the publication’s editorial process and the development of its print and digital editions, and has also previously served as Executive Editor, Managing Editor, and Staff Writer. As a Staff Writer, Alex co-wrote a note titled Navigating the AI Topography: Establishing an AI Specialty Court for Judicial Efficacy that argued for the creation of an Article I specialty court to adjudicate AI-related litigation.

Alex’s legal interests include financial-sector regulation, transactional law, corporate governance, and the intersection of economics and legal theory. He previously completed a legal co-op with the Private Investments Legal team at Wellington Management, as well as with the Legal team at Amundi Asset Management.

Outside of his academic work, you can catch Alex running or at the gym, exploring new coffee shops in Boston, and hanging out with his cat, a British Longhair named Benny.

The United States and the Need for ESG Legislation: Building on the Successes of the European Union

Abstract

I. Origins and Functions of ESG

II. ESG Legislation in the United States

III. ESG Legislation in the European Union

IV. Comparative Analysis and Looking Ahead

About the Author

Notes from the Author

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