By Amanda Maine, J.D.
At a recent meeting of the SEC’s Asset Management Advisory Committee, the ESG subcommittee presented an overview of its work regarding potential Commission action on ESG (environmental, social and governance) issues. While not an official subcommittee recommendation, the overview sets the stage for its recommendations at the next AMAC meeting in December. The subcommittee outlined five "workstreams" related to ESG: performance management, issuer disclosure, truth in labeling, "values versus value," and proxy voting, of which the first three will provide the basis of the subcommittee’s December recommendations.
Performance measurement. Aye Soe of S&P Dow Jones Indices provided a summary of the subcommittee’s thoughts on how ESG strategies contribute to performance. According to Doe, the subcommittee examined research on the performance of ESG funds during the COVID-19 selloff compared to the broad market index. When controlled for different variables such as industry, liquidity, accounting measures, and intangible assets, the research indicated that while ESG was not significantly associated with market returns during the first quarter of 2020, "COVID crisis" returns were positively associated with intangible assets such as research and development (R&D) and information technology (IT).
Soe also discussed how companies with high ESG scores compare to those with high scores on the individual environmental, social, and governance factors. According to a study by MSCI, the whole is greater than the sum of the parts when it comes to ESG, Soe said. Companies with high ESG scores outperformed those with high individual scores. Specifically, those with high governance scores outperformed those with high social scores, which outperformed those with high environmental scores, the MSCI study found.
The subcommittee noted that existing performance disclosure requirements can be used as a baseline, Soe advised. For example, on Form N1-A, ESG measures can be disclosed on the risk/return summary under the Investment Objectives & Goals and the Investments, Risks, and Performance categories. In particular, risks of investing in a fund can be disclosed on the narrative risk disclosure and the risk/return bar chart and table.
Soe described the pros and cons of potential recommendations that the subcommittee explored regarding performance measurement, from doing nothing to strong intervention. While doing nothing would not impose added costs on managers and allow innovation to continue, it would remain difficult for investors to assess performance without a relevant benchmark.
The subcommittee also described two models of "moderate intervention." Both approaches would incorporate best practice guidelines or mandate the use of ESG performance objectives or secondary style-adjusted benchmarks. While these approaches would provide for greater transparency regarding "values versus value" performance objectives, the subcommittee notes that unless mandated, compliance would be voluntary and could increase burdens on ESG funds and suffer from a lack of standardization.
The "strong intervention" approach would mandate performance attribution of individual E, S, and G as well as ESG factors. This approach would result in greater comparability and more information on ESG factor performance. However, currently the methodology, data, and system infrastructure to measure ESG factor performance does not exist and this approach would result in an increased burden that is placed only on ESG funds and may reduce the incentive to develop new strategies, the subcommittee found. Soe remarked that the market is probably not ready for this level of intervention.
Issuer disclosure. The subcommittee also examined opportunities to improve the quality of ESG disclosure by issuers. Presenting the subcommittee’s findings on this workstream, Jeff Ptak of Morningstar Research Services outlined considerations that should be taken into account by the SEC on any guidance or regulations for how issuers disclose and present ESG information. Implicit in the subcommittee’s work is the concept of materiality, Ptak said. Since ESG issues are material, investors should be able to obtain this information from issuers and that information should be comprehensive, meaningful, and comparable. Each of these "dimensions" have different aspects to examine, the subcommittee outlined.
A comprehensive ESG issuer disclosure regime would require disclosure and metrics of all material ESG issues. However, fewer than 30 percent of public companies disclose ESG risks, and the number is even lower for private companies. Regarding the meaningfulness of disclosure, any new standards should acknowledge the dynamic nature of materiality while keeping in mind that voluminous metrics can make analysis challenging. In addition, some ESG disclosure may be "cherry-picking" by issuers, making it look more like a "marketing glossy" than a true disclosure, Ptak advised.
For ESG issuer disclosures to be comparable, they should balance standardization (which promotes comparison across industries) with specificity (to enhance comparability within industries). The existence of multiple standard setters, including the Global Reporting Initiative, the Sustainability Accounting Standards Board, and the Financial Stability Board’s Task Force on Climate-related Financial Disclosures, can detract from the comparability aspect.
Like its presentation on performance measurement, the subcommittee offered a spectrum of potential recommendations on issuer ESG disclosure, from "do nothing" to "strong intervention." And like performance measurement, the choice of doing nothing would present a low burden on issuers and facilitate market-driven responses. However, it would also impede the development of a common disclosure framework, resulting in continued inefficiency.
The "moderate intervention" approach would encourage and then mandate disclosure according to principles developed by third-party standard setters, tiered by materiality and issuer size. While this approach favors a common disclosure standard that is not overly prescriptive and encourages tailoring and customization, a "gradual patchwork" approach would not promote standardization and comparability. In contrast, a "strong intervention" approach codifying a comprehensive set of disclosure rules through regulation, irrespective of materiality and issuer size, would enshrine a comprehensive standard for the disclosure of ESG matters. However, this approach would also put a heavy burden on issuers, and a rules-based (as opposed to a principles-based) approach could detract from the meaningfulness of the disclosures, the subcommittee reported.
Truth in labeling. The subcommittee’s paper also discussed the role of ESG rating systems and benchmarks. While the initial objective of this workstream was to provide recommendations on third-party ESG ratings systems and benchmarks, the subcommittee expanded it to address "truth in labeling" and concerns regarding the potential for "greenwashing" in ESG funds. The "do nothing" approach may lead to misrepresentations by funds that brand themselves as ESG funds. The "moderate intervention" approach would provide best practice guidelines for ESG fund disclosure. The subcommittee said that this approach could use the Investment Company Institute’s classification taxonomy. Benefits would include relatively low costs for managers and better comparability. However, as the subcommittee points out, the voluntary nature may still result in funds that misrepresent their ESG portfolios or engage in selective disclosure.
The "strong intervention" approach would require funds claiming to be ESG funds to have a higher ESG score than their benchmark from an organization analogous to an NRSRO for ESG. While this approach would improve consistency and reliability, it could also drive costs for managers higher. In addition, if there are too few "ESG NRSROs," development could be limited, while too many could cause comparability to suffer. The subcommittee also notes that current rating approaches for ESG differ markedly.
Values versus value and proxies. The subcommittee’s review also considered workstreams regarding "values versus value" and proxies, although these workstreams will not be included in the subcommittee’s eventual recommendation. The subcommittee considered how ESG should be treated under Rule 35d-1 of the Investment Company Act, also known as the "Names Rule." The Names Rule prohibits materially deceptive or misleading fund names and requires that 80 percent of assets by value to be consistent with certain attributes included in fund’s name. ESG is currently considered a "strategy" and is thus not subject to the 80 percent requirement. Rich Hall of the University of Texas/Texas A&M Investment Management Company said that at some point, ESG may become fundamental, rather than a strategy, but there is still work to be done in this area.
While the subcommittee did contemplate what requirements should govern ESG funds’ proxy voting practices, Jane Carten of Saturna Capital said that the SEC’s new proxy voting rules and related guidance, which were approved in July, effectively improved the process by requiring additional conditions to the availability of exemptions from filing requirements used by proxy advisory firms, requiring the disclosure of conflicts of interest between proxy advisors and affiliates, clarifying that proxy voting advice generally constitutes a solicitation, and clarifying that failure to disclose certain information may be subject to the antifraud provision of the proxy rules. As such, the subcommittee will not move forward on a recommendation regarding ESG proxy voting at the next meeting.