Recently the U.S. Securities and Exchange Commission (SEC) published a proposal in the Federal Register that aims to improve disclosures of certain investment advisers regarding Environmental, Social, and Governance (ESG) investment practices.
“When I think about (ESG investing), I’m reminded of walking down the aisle of a grocery store and seeing a product like fat-free milk,” says Gary Gensler, Chair of the SEC. “What does ‘fat-free’ mean? Well, in that case, you can see objective figures, like grams of fat, which are detailed on the nutrition label…When it comes to ESG investing, though, there’s currently a huge range of what asset managers might disclose or mean by their claims.”
The SEC is hoping that this proposal, which requires ESG-related disclosures in fund prospectuses and annual reports, will promote “consistent, comparable, and reliable information” for interested parties.
Those affected include registered investment companies and advisers, business development companies, and certain unregistered advisers.
Although this ruling involves disclosure of ESG factors, the amount of disclosure is determined by how central ESG factors are to a fund’s strategy.
These factors are presented in a layered disclosure framework, which, the agency hopes, will increase the amount of disclosure provided. For example, open-end funds would provide an overview of their ESG strategy in the summary section of the prospectus, and would provide more details about the strategy in the statutory prospectus.
The SEC is not defining ESG. Instead, it is identifying three types of funds: Integration, ESG-Focused, and Impact Funds, each addressed below.
All of these funds would require disclosure of: 1) how they incorporate ESG factors into their investment selection processes, and 2) how they incorporate ESG factors in their investment strategies.
Integration Funds
An Integration Fund would “…summarize in a few sentences how the fund incorporates ESG factors into its investment selection process.” A company may disclose that it invests in companies consistent with its objective of risk-adjusted return, for example, or that it considers ESG factors alongside financial, industry-related, and macroeconomic factors.
Also, for the first time, SEC will require disclosure of greenhouse gas (GHG) emissions data in certain circumstances. Investors have long asked for GHG emissions to be presented in a way that they can analyze, and in a form that prevents companies from exaggerating or overstating the extent to which GHG emissions play in a fund’s strategy.
Integration Funds will require such emissions to be spelled out in the fund’s statutory or in a closed-end fund’s prospectus. The agency is not proposing more extensive disclosure requirements in the summary prospectus.
ESG-Focused Fund
The SEC also wants to address ESG-Focused Funds, or funds that focus on ESG factors when either selecting investments or when engaging with the companies in which they invest.
Such a fund would provide specific disclosure about how it focuses on ESG factors in its investment process.
This includes funds that track an ESG-focused index or that apply a screen to include or exclude investments in particular industries based on ESG factors.
The agency is also proposing to require an ESG-Focused Fund that considers environmental factors as part of its investment strategy to disclose the carbon footprint and the weighted average carbon intensity of the fund’s portfolio. These metrics will be aligned with the recommendations from the TCFD and Partnership for Carbon Accounting Financials (PCAF) frameworks and based on emission data defined by the GHG Protocol framework.
These disclosures will have a specific format, presented in the same way and same location in every prospectus.
Impact Fund
A subset of ESG-Focused Funds, an Impact Fund seeks to achieve a specific ESG impact. An example would be a fund that invests with the goal of seeking current income while also furthering the fund’s disclosed goal of financing the construction of affordable housing units.
Or perhaps, a fund that invests with the goal of seeking to advance the availability of clean water by investing in industrial water treatment and conservation portfolio companies.
Although not related specifically to ESG investing, the Proposal also would amend Form N-CEN to require index funds to provide certain identifying information about the index tracked. This includes: the type of ESG strategy it employs such as integration, focused, or impact; the ESG factors it considers, whether E, S, and/or G; and the method it uses to implement its ESG strategy.
It’s clear that ESG reporting is as essential as a company’s financial reporting.
ESG will need to receive the same scrutiny and level of review from the CFO or legal counsel of a company as any published financial report.
Also, there needs to be a tighter link between the financial group and the sustainability group within a company. No longer can the two be separated.
