Policy Corner | July 7, 2022

The S.E.C.’s new rules (Part Two): Five features of the ESG proposal that warrant attention from investors

John Kostyack

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Guest Author

John Kostyack

I recently wrote about the transformational pair of proposed rules from the SEC that would, at long last, lend clarity and comparability to the ESG investing market. You can read my analysis of the two rulemakings – the Fund Names Rule Amendment and ESG Disclosure Rule – in an accompanying ImpactAlpha article.

A Looming Battle Over Investors’ Rights

The two proposals contain a number of features likely to be of enormous importance to investors concerned about greenwashing and other deceptions regarding ESG funds by asset managers. I discuss five below that deserve focused attention in technical comments due to be filed with the SEC by its August 16 deadline.  

Vindicating investors rights to pursue ESG objectives will require more than filing technical comments, as evidenced by the political attacks on ESG investing driven by fossil fuel interests. Contributing to a robust public record in support of the rules through comments, however, is a critical first step.

Five Key Features

1. Index Tracking. The enormous scale of the world’s largest asset managers – just 25 of the world’s 825 fund sponsors control 83% of the industry’s total assets – has been achieved in part due to their successful use of indexes and avoidance of the costs of active management. According to the Investment Company Institute, passively managed index funds now account for more ownership of the U.S. stock market than their actively managed counterparts. 

In the context of ESG funds, large asset managers have employed indexes, and the rating systems that determine which companies benefit from placement on indexes, in a manner that has generated significant controversy and confusion. As NYU professor Hans Taparia has suggested, the bar for qualifying for inclusion in ESG index funds has been set “abysmally low.” For example, ESG indexes often award high scores to fossil fuel companies despite their high transition risk and the severe damage they are causing to the planet’s habitability, on the premise that they are managing short-term financial risks. In a recent study of 30 of the world’s largest asset managers, Reclaim Finance finds that they remain heavily invested in fossil fuel development despite the fact that most have made net-zero emissions pledges; self-imposed restrictions on future fossil fuel investments are deceptively designed so that they do not cover passively managed assets.

To improve transparency regarding indexes, the SEC proposes in its ESG Disclosure Rule to require that all funds disclose the names of indexes they track, a brief description of the indexes and how the indexes utilize ESG factors in determining its constituents. For ESG-Focused Funds, the fund must disclose the index methodology for any index the fund tracks, including any criteria or methodologies for selecting or excluding components of the index that are based on ESG factors. Investors should comment on whether additional disclosure may be needed to increase investors’ ability to evaluate and compare ESG indexes.

2. Engagement. The question of whether asset managers have been candid about their engagement with portfolio companies is a major concern of ESG investors. Many asset managers rebuff calls from investors to divest from fossil fuel companies by claiming they are engaging with portfolio companies on strategies to reduce GHG emissions. But a host of analyses have shown that engagement efforts with fossil fuel companies have been largely ineffectual. This negative assessment is shared by Morningstar and investor Chris Hohn, who both recently warned that continued failures with engagement justify asset managers losing their jobs.

Recognizing that asset managers may be misleading investors about their engagement with portfolio companies, the Commission proposes in its ESG Disclosure Rule to require asset managers for which engagement with issuers is a significant means of implementing their ESG strategy to annually disclose progress on any key performance indicators of such engagement. The Commission also would require disclosure of the number or percentage of issuers with whom the fund held ESG engagement meetings during the reporting period related to one or more ESG issues and total number of ESG engagement meetings. The Commission offers a definition of engagement meetings to ensure that reporting captures only substantive discussions. 

Investors should carefully review the Commission’s language to identify areas for improvement. For example, the proposed rule arguably could be strengthened to ensure that asset managers identify the consequences, if any, of portfolio companies’ refusals to accommodate concerns expressed in the engagement process. Ensuring that asset managers clearly articulate their engagement objectives, strategies and metrics, and then provide quantitative and qualitative progress reports, will be critical to the ESG Disclosure Rule’s success in protecting investors from deceptions around the efficacy of engagement.

3. Proxy Voting. In a 2020 report, ShareAction reviewed the disclosures of 75 of the world’s largest asset managers, including 20 domiciled in the U.S., and found that these asset managers were not fully disclosing their proxy voting records. In a 2021 report, it examined 65 of the world’s largest asset managers’ votes on 146 social and environmental resolutions and concluded that, in general, asset managers “continue to block efforts to make progress on environmental and social issues.”

These findings are significant because a small number of large asset managers, by virtue of their diversified holdings, effectively decide the fate of most shareholder resolutions. Ensuring that these asset managers uphold their duty of loyalty to investors is a key challenge facing the SEC.

The Commission began acknowledging this problem in 2021 by proposing enhanced disclosure of proxy voting records on Form N-PX. In its proposed ESG Disclosure Rule, it would require several additional disclosures from ESG-Focused Funds where proxy voting is a significant part of the ESG strategy, such as (in fund prospectuses) disclosures of proxy voting policies and (in annual reports) disclosures of the percentage of ESG-related voting matters for which the fund voted to advance the initiative.

In providing comments to the Commission regarding its approach to proxy voting disclosure, investors should address whether greater transparency is needed from both investment companies and advisers. The approach of large asset managers to systemic financial risks such as climate change, inequality, and the decline of democracy and the rule of law, in particular, warrants scrutiny. These major societal challenges are of concern to more than just investors in Impact Funds; they jeopardize the financial performance of virtually every company within a fund’s portfolio. On climate change, Deloitte recently estimated that by 2070, if emissions continue on the current path, losses to the global economy (from increasing weather-related disasters, failing crops, land losses from sea level rise, lost productivity from extreme heat and increased disease, among other impacts) will amount to $178 trillion. The Commission should be encouraged to require disclosure from asset managers of how their proxy voting (and other engagement) policies address these and other systemic risks to portfolios.

Another key question deserving investor comment is how asset managers are empowering their clients to express their preferences on proxy votes. Important experiments with shareholder democracy are underway in the asset management industry. Investors need standardized disclosures about these experiments so that they can evaluate and compare them. 

4. Investing for Impact. Under the proposed ESG Funds Disclosure rule, ESG Impact funds would be required to disclose in annual reports their progress in achieving their stated impact objectives in quantitative and qualitative terms.  They also would be required to summarize the key factors that materially affect their ability to achieve the stated impact objectives. Considering the significant influence that asset managers have on the social, environmental and governance outcomes at portfolio companies, investors should closely review these requirements and identify any opportunities for strengthening the reliability and comparability of disclosures.

5. GHG Emissions Disclosure. The rationale provided by the SEC in the ESG Funds Disclosure Rule for requiring GHG emissions to be disclosed by Environmentally Focused Funds is strong. First, investors have long expressed a strong desire to obtain standardized and reliable GHG emissions data, both to evaluate portfolio companies’ transition risk as well as to evaluate their environmental impact. Moreover, climate change / carbon is by far the largest asset-weighted ESG criterion used by fund managers, and yet fund managers’ reporting of financed GHG emissions has been inconsistent at best.

Investors should support the concept of a GHG emissions disclosure but review carefully the mechanisms by which it would be accomplished.  To the greatest degree possible, the Commission’s approach to disclosure of financed emissions should align with the industry standards crafted by the Partnership for Carbon Accounting Financials (PCAF), its own proposed climate risk disclosure rule for public companies and the EU’s Sustainable Financial Disclosure Regulation

Unfortunately, a key feature of the proposed ESG Funds Disclosure Rule appears to be weaker than these standards. Unlike under those disclosure regimes, under the proposed ESG Funds Disclosure Rule, asset managers would not be required to disclose the Scope 3 emissions of portfolio companies if those data are not publicly available. Because the holdings of large asset managers include fossil fuel companies and others with substantial undisclosed Scope 3 emissions, allowing this loophole would deny investors access to critical information about transition risk and environmental impact in their ESG funds. The Commission should be encouraged to require Scope 3 emissions of portfolio companies to be disclosed and authorize reasonable estimates if the data are not publicly available.

Finally, investors should consider whether the Commission should require quantitative disclosures that would help them evaluate other systemic ESG-related risks in addition to those required for climate risk. 

Call to Action

For the first time, a financial regulator is proposing a detailed set of rules to counter greenwashing and other deceptions regarding ESG funds by asset managers. Once the SEC’s rules are strengthened and finalized, investors’ rights to allocate their savings in a manner that aligns with their values and their financial risk preferences will have been vindicated. Investors should offer technical comments to help strengthen the rules and offer strong support of the SEC’s actions in the public square.

John Kostyack is founder and principal of Kostyack Strategies.