Institutional Impact | September 1, 2022

My summer fun: Parsing the proposals to regulate ESG

Imogen Rose-Smith
ImpactAlpha Editor

Imogen Rose-Smith

Editor’s note: ImpactAlpha contributing editor Imogen Rose-Smith, a longtime senior writer for Institutional Investor, contributes a bi-weekly column on the policies, practices and strategies of the largest asset allocators, including pensions, foundations, and endowments. As Imogen says, she’s “tracking what investors do, not just what they say.”

ImpactAlpha, Sept. 1 – Summer is almost over, and I’m still having a really tough time caring about the Securities and Exchange Commission’s proposed ESG regulations.

It’s not that I do not think that regulation is important, or that getting the right regulation matters. I just don’t think that in this current climate any federal regulation around ESG or related issues, such as impact investing, is going to be that, well, impactful. 

After all, President DeSantis is just going to roll it all back (or, shudder, President Trump 2, possible criminal indictments notwithstanding). 

I’m not trying to be defeatist. But the discussion around sustainable investment in the U.S. has become so politically polarized that it is hard to see the Biden White House make any ESG regulation stick. 

Anything the SEC does is likely to be challenged and, eventually, gutted by the Supreme Court. Or just rolled back by the next Republican administration. 

We are in the usual situation in which other jurisdictions, specifically the European Union, are taking the lead. In the U.S. the most significant legislative action on sustainable investment is happening on a local level, and that is going in the wrong direction. 

Even many U.S. institutional and impact investors seem unsure about where they stand on cornerstone ESG and impact policies amid the politicization of what should be a straightforward conversation. Once again, the forces against sustainable investment have brought a bazooka to a knife fight, and started firing. 

I was recently speaking to an investment officer of a corporate pension plan who said that the plan could not pursue ESG strategies because of ERISA, the 1974 Employees Retirement and Investment Securities Act, which outlines the fiduciary responsibilities of corporate pension plans and is overseen by the Department of Labor. 

This despite the fact that the Biden administration has made it clear ERISA fiduciaries can, and possibly even should, make ESG investments. So, yeah, not feeling super jazzed. 

Fat-free milk

Here’s where things stand:

In May, the SEC proposed a rule change under the Investment Advisers Act of 1940 and the Investment Company Act of 1940 requiring registered investment advisors to provide additional disclosure about their ESG and impact investment practices. As is standard, the Commission opened a comment period, and the comments rolled in. 

The meat of the 300-plus page proposal is that SEC-registered ESG and impact investment funds would have to disclose their processes. Disclosure would vary among “integration funds,” “ESG-focused funds,” and “impact funds.” Specifically:

  • Integration Funds. Funds that integrate ESG factors alongside non-ESG factors in investment decisions would be required to describe how ESG factors are incorporated into their investment process.
  • ESG-Focused Funds. Funds for which ESG factors are a significant or main consideration would be required to provide detailed disclosure, including a standardized ESG strategy overview table.
  • Impact Funds. A subset of ESG-Focused Funds that seek to achieve a particular ESG impact would be required to disclose how it measures progress on its objective.

And climate-focused funds should disclose their greenhouse gas emissions. 

The case for better ESG regulation and guidance is clear. All investors, institutional and retail, should better educate themselves about what ESG and impact investing actually is. Money managers (cough – BlackRock – cough) should be discouraged from charging higher fees for products just because they are labeled ESG. More and standardized disclosure can help with that. 

SEC Chair Gary Gensler said it is “Important that investors have consistent and comparable disclosures about asset managers’ ESG strategies so they can understand what data underlies funds’ claims and choose the right investments for them.” 

Gensler said he is reminded of seeing fat-free milk in the grocery store. “What does ‘fat-free’ mean?” he asked. “Well, in that case, you can see objective figures, like grams of fat, which are detailed on the nutrition label.” Funds, he said, also need to share objective metrics around what makes their funds fat-free, er, ESG. 

Over-regulation of what is and is not impact or ESG can stifle innovation and encourage box-checking. The result may be more, not less, greenwashing. It will also be easier for the very large asset managers to comply than smaller funds that may, in fact, be more values-aligned.  

“Overly prescriptive or unclear disclosure requirements could disincentivize further ESG integration and consideration by adding liability and costs,” Principles of Responsible Investment warned in its comment to the SEC, “especially if those added costs lead to higher fees on ‘ESG funds’ compared to other funds.” 

The PRI said that such prescriptions would “require managers to conform their considerations and uses of ESG to those of the Commission.” It said “creation of categories that do not match market practice could add to confusion for both managers and investors.”

Some comment letters suggested the SEC drop the “Integration Funds” category and limit the reporting requirements to pure ESG and impact funds only. Others worried about throwing the impact investment baby in with the ESG bathwater.

The discussion is part of normal policymaking. But this highly politicized environment is not normal. It’s hard to see common sense – let alone good policy — prevailing. 

The U.S. Supreme Court has decided the Environmental Protection Agency doesn’t have the authority to protect the environment. It’s pretty easy to see this same SCOTUS ruling that the SEC does not have regulatory authority over, say, climate change. In any event, it seems likely a Republican administration would seek to undo a lot of this hard work.  

I guess I can see the argument that it’s still worth trying to get the policy right. But it’s hard to muster much enthusiasm. 

Been here, done that

As is well known in impact investing circles, the Obama administration supported an effort, spearheaded by members of the impact investment community, to have the Department of Labor set out new guidance for how ERISA fiduciaries should view ESG factors when making investment decisions. 

The push and pull was between the Chamber of Commerce, which did not like the idea of pension officials getting involved in how businesses operate, and those in the impact investing and ESG communities, as well as organized labor and other stakeholders, who felt it was important to consider so-called non-financial factors in investment decision making. 

As part of some work for the Robert F Kennedy Human Rights foundation, I attended some of the meetings with then-Labor Secretary Tom Perez. We were asking for new guidance to replace guidance that had come out at the end of the George W. Bush administration that was perceived as having a “chilling effect” on the industry. The Bush-era guidance had replaced the original Clinton-era guidance on ERISA fiduciaries and socially responsible investment that was more favorable to ESG. 

The original 1998 opinion was requested by the socially responsible investment firm Calvert Investment group. Calvert stayed out of the subsequent efforts to have the DOL issue new opinions. They and others felt like the original option still stood.

In retrospect, they might have been right. It’s possible that all the meddling with ERISA was a mistake. What seemed to be common sense – that increasingly the consideration of ESG factors is part of all investing – became a tedious back and forth which seemed to prioritize political expediency. 

Eventually the DOL passed new guidance that was more ESG friendly. But the whole process left me sour on Perez, who came across as a careerist hack (voters may have agreed: Perez this year lost the Democratic primary for governor of Maryland). Democrats thought they had all the time in the world. Because the new President Clinton would come in and fix everything.

Spoiler alert: Donald Trump won the 2016 election. The new administration went out of their way to pursue an anti-ESG agenda, capped by a rule change designed to be toxic to ESG and sustainable investing. Biden froze the rules before they could be implemented, and his administration then issued its own.

You can see why an ERISA fiduciary might be confused – and why I have little faith in ESG guidance outlasting any administration. 

Europeans at the gate

As the U.S. descended into a fiery pit of political hell, the rest of the world moved on. ESG regulation coming out of Europe and the U.K. reflects the kind of consensus that is possible in places that, mostly (ex-Hungary), believe in things like climate change and democracy, with electorates that shy away from political officials openly dabbling in a bit of light treason.

The U.K.’s Financial Conduct Authority laid out an ESG strategy, with a focus on transparency and trust. 

The European Union is even further along in its ESG regulatory process. Alongside the EU’s Sustainable Finance Disclosure Regulation, or SFDR, the European ESG taxonomy adopted in 2020, sets out a conceptual framework and vocabulary for understanding sustainable investing and ESG. They also require investment managers to explain what they are doing with regards to ESG, regardless of whether they are ESG investors or not. Article 8, or “green light” funds include some level of ESG integration; Article 9 funds more fully embrace ESG. 

Commentators in the U.S. are encouraging the SEC and others to work with the U.K. and Europe to ensure a global regulatory ESG framework. The PRI, for example, urged the SEC “to build a harmonized global system of investor and product disclosure.” 

European and UK standards already are leaking into the U.S. market, because most money managers want to sell globally. The frameworks don’t, and likely won’t, perfectly align in a world where the U.S. is not fully committed to ESG, but over the long term these other frameworks will prevail. 

The weaponization of ESG

Now come lawmakers in red states in the U.S. who are weaponizing ESG as part of a populist anti-Wall Street anti-civil liberties agenda. 

These states are passing anti-ESG laws that are specifically directed at protecting the fossil fuel industry but are expected to be expanded to areas such as abortion and LBGTQ rights. 

“Treasurers in nearly half the United States have been coordinating tactics and talking points, meeting in private and cheering each other in public as part of a well-funded campaign to protect the fossil fuel companies that bolster their local economies,” The New York Times has reported

The divestment language in these bills is modeled on previous divestment campaigns. In the past, however, there has always been a fiduciary-duty loophole to these divestment laws (including most fossil-fuel divestment initiatives): public plans need not divest if doing so would violate their fiduciary duty. Barring most major banks sure sounds like a violation of fiduciary duty. 

The laws also say that state agencies can’t enter into contracts with entities that threaten the fossil fuel industry. These contracting provisions will make it hard for targeted states to raise money in the muni markets. This is a toxic political stew that is putting a huge amount of pressure on government workers in these states, and is likely to get worse before it gets better.

The other day I was talking to a sustainable investment veteran in a swing state. She has campaigners on her doorstep saying, “We’ve got to get those ESG people out of office.” A few years ago, right-wing political operatives would not have known how to spell E-S-G. Now it’s part of the play book. 

Florida Gov. Ron DeSantis, widely expected to run for president, advanced his own war on ESG the day after his state’s mid-term primary.  DeSantis – think Trump without the treason – announced that the State Board of Administration, which oversees the state’s $228 billion pension plan, had approved his proposal to ban the consideration of  “social, political or ideological interests” in investment decisions. 

Culture wars is too bland a phrase to capture what is going on here.

Risk, adjusted

Maybe the solution lies not in policy at all, but in investing. 

The opposition to ESG is coming from a place of fear. Fear in the minds of regular citizens in places like Texas and West Virginia that their livelihood and their way of life is being threatened and changed. Fear on the part of large corporations and lobbyists that their gravy train will be cut off. And fear on the part of us who were lucky enough to be born white and middle class that we might have to give up some of that privilege. 

Economies are changing. Investment capital can play a role, not in protecting old and dying industries, but by investing in new business and innovations, including in places like Kansas, Texas, Oklahoma, Pennsylvania, Utah and Ohio.

The most interesting ESG activity coming out of Washington is not the proposed ESG rules, but rather the legislation and incentives encouraging investment in infrastructure and the renewable economy. This can drive real change and create opportunities. Especially if the impact investment community holds the finance industry’s feet to the fire and demands positive social outcomes. 

Banks and asset managers are already highly regulated entities. They will adapt. 

A big danger of ESG regulation is that it is overly prescriptive and too-narrowly defines what an ESG investment can be, particularly when it comes to the climate crises. One man’s fossil fuel investment is another woman’s energy transition opportunity. Under certain circumstances an energy transition fund might want to buy a coal power plant. Will the SEC call that ESG? Maybe not.

And I still believe that good ideas will out. So, if certain strategies come with attractive risk-adjusted returns and speed the clean energy transition, it may not matter that they cannot call themselves “green.” 

In fact, when it comes to doing business with Florida, Texas and West Virginia, that might be all to the good. 

Imogen Rose-Smith is a contributing editor at ImpactAlpha. A longtime senior writer for Institutional Investor, she was most recently a fellow in the Office of the Chief Investment Officer of the University of California.

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