A disclosure regulation in the United States affecting firms selling investment products that are labeled as ESG funds
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The ESG Disclosure for Funds Regulation, also known as the “Enhanced Disclosures by Certain Investment Advisers and Investment Companies about Environmental, Social, and Governance Investment Practice,” was presented by the US Securities and Exchange Commission (SEC) on May 25, 2022.
At its core, the ESG Disclosure for Funds Regulations require funds to provide an overview of their ESG strategy and how the fund incorporates ESG factors in its investment decisions.
This disclosure regulation is expected to increase transparency by investment firms and the comparability of their investment products.
It most directly impacts funds labeled as ESG integration, ESG-focused, and impact investment funds.
This regulation is expected to reduce greenwashing in the markets.
What Funds are Included in the ESG Disclosure for Funds Regulation?
The SEC defines three types of ESG fund categories: integration, ESG-focused, and impact investment funds. The objective here is to ensure the fund’s name and category reflect the investment thesis and strategy. The SEC criteria for fund type include the following:
ESG integration funds incorporate ESG factors alongside traditional financial factors, yet ESG factors are not indicative of the fund’s investment thesis or decision-making.
ESG-focused funds use ESG factors as a significant investment consideration (e.g., negative screening techniques like not investing in oil and gas). In this category, the name of the fund is also suggestive of the focus, and it typically includes ESG (or something like it) in the name. The fund also has a clear ESG strategy reflected in its sales literature and includes which ESG factors inform the fund’s management and decision-making.
ESG impact funds are a subset of ESG-focused funds; these are funds that seek to deliver a particular ESG impact, such as clean water, reduced emissions, etc. (i.e., a double bottom line).
Why is the ESG Disclosure for Funds Regulation Important?
The SEC has flagged the importance for the financial services sector, and financial markets in general, to have consistent and comparable disclosures surrounding asset managers’ ESG strategies and the associated performance of those funds. Why? So they can better understand the data behind fund claims and so the investment community can choose investments accordingly.
This regulation is designed to address the following key concerns in the marketplace:
Decrease greenwashing: By requiring financial entities to disclose their ESG investment strategy, these regulations are driving the transparency needed to eliminate greenwashing (which refers to false claims or misrepresentations about actual ESG actions or performance).
Ensure comparability: These regulations ensure that all funds are disclosing the same types of information so investors are able to make apples-to-apples comparisons on each fund’s theses, investment criteria, and associated performance.
Innovation to meet sustainable transition needs: ESG is here to stay. Setting these regulations forces financial institutions to further develop and refine their ESG strategies to ensure they are managing both the risks and opportunities of a rapidly changing world, as well as making a contribution to a more sustainable and resilient global economy.
Who do ESG Disclosure Regulations Affect? (and Why?)
These regulations target mainly ESG funds, ESG advisory services, investment companies, specific index funds, mutual funds, and asset managers. This should be a critical legal concern and reputation risk to manage for these entities.
ESG strategies can be applied in various ways. This allows for diverse investment methods but also creates confusion and lack of consistency in the ESG information funds disclose. Inconsistencies and a lack of comparability present a significant risk for anyone looking to invest in ESG funds. For example, investment advisers considering ESG factors need to be able to compare different ESG bonds as they position their portfolios and advise their clients.
Therefore, investment companies, mutual funds, asset managers, and portfolio managers will need to be prepared to validate the names of their funds and demonstrate compliance with these new rules.
Some other examples:
ESG advisors must be prepared to advise their clients on how they are meeting each type of fund’s demands and help them align their business strategy with the fund type most relevant to each client.
Portfolio managers must be prepared to validate the names and characteristics of their funds and demonstrate that the name accurately represents the fund type. For example, funds claiming to achieve a specific ESG impact would be required to describe the clear impact(s) they seek to achieve and summarize their progress towards achieving those impacts.
Actively managed funds often have not implemented a rules-based approach to portfolio construction (with respect to ESG factors). Almost all large, actively managed funds state that ESG factors may inform investment decisions, either in the fund’s prospectus or in the asset manager’s sales literature; this is expected to change.
Key Considerations for Achieving and Maintaining Compliance
This SEC regulation provides the market with much-needed clarity on how funds incorporate ESG factors into their investment activities. Although these regulations are directed at investment companies and mutual funds, other companies will be impacted as well. For example, companies will need to provide investors with information about their emission reduction efforts if their cap table includes investments from ESG-focused funds.
Therefore, in terms of compliance, there are some things to consider:
Does the company/firm have a clear ESG investment strategy? Does this strategy align with other ESG frameworks or guidelines, such as the UN SDGs? If so, the connection between the fund name, investment strategy, and framework they’re aligning with must be coherent, cohesive, and explicit.
Companies looking to raise capital may wish to consider which type(s) of fund(s) would be relevant for them.
Third-party assurances regarding ESG information presented by companies of all sizes are likely to become more commonplace.
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