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A First Look At The SEC’s New ESG Funds Disclosure Rule
A First Look At The SEC’s New ESG Funds Disclosure Rule
Shivaram Rajgopal
By Shivaram Rajgopal
Jun 13 2022 · 11 min read

Illuminem Voices
Environmental Sustainability · ESG

Close on the heels of the climate disclosures for companies, the SEC has issued a much-needed proposal on standardizing ESG disclosures for ESG funds. I believe greenwashing is rampant in ESG funds as I have documented in academic papers with colleagues and in Forbes columns before. The DWS greenwashing scandal is potentially just the tip of the iceberg.

The new ESG funds rule is a 350 odd page document. I just finished reading most of the salient requirements. I realize that the SEC has also issued a rule on naming of funds. I will address that rule in another column.

In essence, the ESG fund disclosure rule proposes the following changes:

Types of funds

  • The SEC defines three types of ESG funds: integration, ESG-focused and impact investing. These labels have well defined parameters.
  • ESG integration is defined as funds that consider one or more ESG factors alongside other non-ESG factors in decision making.
  • ESG-focused strategies rely on one or more ESG factors by using them as a significant or a main consideration in selecting investments.
  • In this sub-category, the strategy may involve (i) exclusionary screens for tobacco, guns etc.; (ii) inclusionary screens such for investing in pro-DEI companies; (iii) tracking an ESG index; (iv) an attempt to achieve a specific impact; (v) proxy voting for ESG issues; (vi) engagement with issuers; or (vii) other actions.
  • An Impact Fund seeks to achieve a specific ESG impact.

Overview of strategy and ESG use in investments

  • Funds are required to provide an overview of their ESG strategy, how the fund incorporates ESG factors in its investment decision (screens, percentage in terms of net asset value to which the screen is applied, why the screen applies to less than 100% of the portfolio, reliance on internal methodology, third party data or a combination of both, reliance on third party frameworks such as U.N. SDG principles and name of the index the fund tracks and how that index uses ESG factors).
  • An impact fund must also disclose how the fund measures progress towards the specific impact, including KPIs (key performance indicators), the time horizon the fund uses to check for progress, and most important, and the relationship between the impact the fund is seeking to achieve and financial return.

How the fund votes its proxies or engages with companies

The fund must describe briefly how it engages with firms or votes its proxies on ESG issues. This may be a clever way of detecting “proxy washing” given recent evidence that ESG funds do not even vote in favor of ESG proposals in shareholder meetings.

Detailed guidance on a few KPIs

  • Disclose the percentage of ESG voting matters during the reporting period.
  • With ESG engagement, the fund should disclose the number or percentage of issuers with which the find held ESG engagement meetings and total number of ESG engagement meetings. On page 82, the SEC goes to the extent of saying “employees (should) memorialize the discussion of ESG issues, for example, by creating and preserving meeting agendas and contemporaneous notes of engagements relating to ESG issues to assure accurate reporting on the number of engagements.” Good strike against “engagement washing.”
  • ESG focused funds that consider environmental factors have to disclose (i) carbon footprints; and (ii) weighted average carbon intensity (WACI).
  • Carbon footprint is defined as [(current value of the portfolio holding of say Apple Inc./Apple’s enterprise value) * Apple’s scope 1 and 2 emissions is total GHG emissions]/current portfolio’s NAV. Note the absence of scope 3 emissions here.
  • WACI is defined as (current value of Apple’s holding/current NAV) * (Apple’s scope 1 and 2 emissions)/Apple’s total revenue).
  • Scope 3 emissions need to be disclosed separately, if available or estimable in a reasonable manner. I wish the SEC would ask funds to disclose the margin of error they expect in these KPIs, especially if funds rely on third party vendors estimates of scope 3 emissions.

Index funds

The SEC requires all index funds, regardless of whether the fund tracks an ESG-related index, to report identifying information about the index. This is potentially important as investors increasingly buy baskets of stocks, or indexes, as opposed to individual stocks. I often joke with students that the king/queen of Wall Street today is the index maker. If an index maker decides Tesla is in the S&P 500, its value is probably assured to double or more. But there is virtually no regulatory oversight of how an index is constructed. Perhaps, collecting data is a first step in that direction.

A few reactions to the new ESG funds disclosure rule:

1. No SEC definition of ESG

I am glad that the SEC does not define ESG. That is an evolving term and its best to leave the definition to the individual fund. The European Sustainable Finance Disclosure Regulation (SFDR), on the other hand, defines a sustainability investment as

“an investment in an economic activity that contributes to an environmental objective, as measured, for example, by key resource efficiency indicators on the use of energy, renewable energy, raw materials, water and land, on the production of waste, and greenhouse gas emissions, or on its impact on biodiversity and the circular economy, or an investment in an economic activity that contributes to a social objective, in particular an investment that contributes to tackling inequality or that fosters social cohesion, social integration and labour relations, or an investment in human capital or economically or socially disadvantaged communities, provided that such investments do not significantly harm any of those objectives and that the investee companies follow good governance practices, in particular with respect to sound management structures, employee relations, remuneration of staff and tax compliance”

The EU green taxonomy establishes six environmental objectives: (i) climate change mitigation; (ii) climate change adaptation; (iii) the sustainable use and protection of water and marine resources; (iv) the transition to a circular economy; (v) pollution prevention and control; and (vi) the protection and restoration of biodiversity and ecosystems. Hence, a green investment presumably has to address one of these six objectives.

This is classic “principles” versus “rules” debate and for a change, we, in the U.S., have opted to be regulate principles and leave the details to individual funds. Of course, the hope is that enforcement can take care of slippages or creative use of principles.

I personally find the EU approach a bit too restrictive for several reasons. First, brown assets or sin stocks are effectively disbarred from this definition. The definition of what is a sin stock is worryingly inconsistent. If tobacco is not a sustainable investment, why are cannabis not barred? Why is nuclear power and natural gas barred? How do we decarbonize without relying on nuclear power? Second, SFDR and the Green taxonomy appear to penalize investments in brown firms where the asset manager may be engaged in constructive dialogue. Third, what does “do not significantly harm any of those objectives” mean in practice?

Before you think these are wonky discussions, I get reminded time and again by my investment banking friends that a lot of serious money follows SFDR and EU green taxonomy-based classifications. Hence, sectors that are not in favor will, on the margin, lose access to some capital.

2. Don’t we need this for all funds?

I have written before about the fluidity of labels in the world of funds in general. For instance, what exactly does a fund focused on “quality” do? What is a “value” fund? What is a “growth” fund? Many investors now rely on a private vendor, Morningstar, to assign these labels to funds. Who is Morningstar accountable to? Is there enough competition in such classification services? I cannot help but imagine that most fund investors would like to know what “quality” factors, for instance, were considered by fund management and how did the fund manager differentiate across these factors? As an investor, I want to know, for instance, if the fund manager engages with management or votes against say dividend payments for an aspirational “growth” stock such as IBM that might have underinvested in the future?

3. What might the pricing implications of these three classifications be?

After the dust settles, one has to wonder how funds will sort themselves into these three categories (integrated, focused and impact). Will most simply choose the category with the least onerous disclosure requirement (integrated, for instance)? Will we see enough impact funds given the relatively specific disclosures needed to track impact? Will such a sorting affect the pricing of the stock or debt instruments that these funds hold?

I suspect asset managers will come up with their own internally defined standards, benchmarks and thresholds to decide which of the three categories to pick. Will self-selection into the three categories and subjective applications of these definitions lead to even less comparability than before? Are the distinctions between the three types of funds sharp enough to affect pricing in capital markets? How will investors respond to these new rules? Will they push asset managers to deliver more impact funds than the weaker integration funds? These questions are worthy of research and debate in the coming years.

4. Can funds still hide under vague disclosures?

Despite these attempts to regulate disclosures, I worry that funds can get away with vague noises about factoring in ESG into their investment decisions. I suspect including words such as “low carbon” or “ESG” or “sustainable” might be enough for the first category of so-called ESG integration funds. I suspect these disclosures are not required to be audited or assured. The SEC will have to carry a big enforcement stick to make these disclosures credible and to truly clean up greenwashing.

5. Isn’t G universal?

One of the consequences of leaving ESG undefined is the worry that every fund manager likely takes “G” into account before investing in a company. Does that make every fund an ESG fund?

6. Has the SEC overemphasized E?

I understand emissions are relatively easy to measure for an environmentally focused fund but has the SEC overemphasized emissions at the cost of other environmental or even social and governance metrics. The contrast with the EU is stark though. Lack of data is a significant concern for the so-called PAI (principal adverse impact) indicators that the EU is asking for such as those related to the fund’s and hence the portfolio company’s share of energy consumption from renewable and non-renewable sources, activities negatively affecting biodiversity, water and water emissions, violations and compliance with human/labor rights initiatives, and gender pay gaps. Perhaps the SEC has struck the right balance in pushing for KPIs that are collectible rather than ask for aspirational metrics that will inevitably attract criticism from commentators opposed to mandatory disclosure.

7. No carbon offsets allowed

On page 98, the SEC states that “the proposed rules do not permit a fund to reduce the GHG (greenhouse gas) emissions associated with a portfolio company as a result of the company’s use of purchased or generated carbon offsets.” This is obviously a good move designed to curb greenwashing. In our review of carbon pledges of oil and gas firms, we routinely found firms relying on offsets at least to promise a path to net zero. Will the fund manager have to sort through the emissions reports of every firm she holds to undo the impact of offsets? Perhaps third-party data vendors will start collecting which firm relies on offsets to report net emissions.

8. Will focus on current GHG divert capital away from future GHG reduction?

Many sectors are GHG heavy today such as oil, cement and steel. But, many of these companies are working furiously towards a greener future. On top of that many of the components that these industries make facilitate energy transition such as the use of steel in say wind turbines. Will the focus on GHG divert capital, on the margin, away from these transitional sectors?

9. A technical quibble about value weighting GHG portfolio measures

One of the dangers of value-weighting GHG measures for the portfolio is the volatility in the prices of sin stocks. Imagine an ESG fund that holds oil stocks. Let’s say that oil, and hence, the underlying oil stocks, treble in value over a year but the overall portfolio is unchanged. The value-weighted emissions from oil stocks will hence look much bigger than they might have relative to last year although the emissions per se or the environmental impact of the company has not changed.

10. Asking for investor preferences

Here is one European innovation that I find intriguing. MIFID II requires that asset managers ask investors about their risk tolerance, financial objectives and sustainability preferences. This is perhaps one of the few regulatory attempts to discover what the real investor actually wants when she buys funds. You could always argue that the very act of buying the fund tells us what the investor cares about, but I am not so sure. How many go merely by the label of the fund rather than fully investigate whether the fund fully satisfies their risk tolerance or preferences? The SEC might want to consider a similar idea.

So, that is my first look at the SEC’s new ESG fund disclosures supplemented by comparisons to the European SFDR, RTS and MIFID II requirements. These requirements are a welcome first step in policing exaggerated marketing claims about ESG and in providing consistent, comparable disclosures that diligent investors can actually rely on. Comments welcome, as always.

This article is also published by Forbes. Energy Voices is a democratic space presenting the thoughts and opinions of leading Energy & Sustainability writers, their opinions do not necessarily represent those of illuminem.

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Shivaram Rajgopal
About the author

Shiva Rajgopal is the Kester and Byrnes Professor at Columbia Business School. He works on sustainability and financial reporting questions and is deeply interested in bringing academic work to bear on practical and policy issues.

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