By Mark S. Nelson, J.D.
According to the Investment Company Institute (ICI), the SEC needs to better prepare the investment community to make carbon footprint disclosures about portfolio investments that would be required if the Commission were to adopt, as proposed in May 2022, the rules set forth in a rulemaking titled Enhanced Disclosures by Certain Investment Advisers and Investment Companies About Environmental, Social, and Governance Investment Practices (Fund ESG Rule). The proposed rule would address concerns that some funds may already be engaged in “greenwashing” in which they promote ESG aspects of their funds but scantily disclose the actual ESG focus (or lack thereof) of their funds. The ICI’s latest comment letter said the Commission should do more to ensure that the sequencing of effective and compliance dates in multiple ESG-themed rulemakings work in tandem so that portfolio disclosures can be made based on data from public companies whose shares are held in those portfolios.
Sequencing. The ICI and/or several of its members have met with SEC officials regarding the proposed Fund ESG Rule (and a related fund names proposal) six times since the Commission issued the proposal almost a year ago, including twice with Chair Gary Gensler and SEC staff, and once each with Commissioners Jaime Lizárraga and Mark T. Uyeda. The ICI has separately submitted two other comment letters in addition to this week’s comment. The ICI’s main public comment was submitted in August 2022.
In its most recent letter, the ICI summed up its view on sequencing of effective and compliance dates thus: “Our position on sequencing is simple: funds should not have to comply with a requirement to report data in a regulatory filing that is dependent on portfolio companies’ data unless the portfolio companies first have to comply with a corollary requirement to report the data in their own regulatory reports” (emphasis in original).
While the ICI’s letter this week is short on details, an Annex submitted by the ICI following a November 28, 2022 meeting with SEC officials, and simultaneously submitted as a comment letter, suggests the scope of the sequencing problem. By the ICI’s calculation, the SEC’s proposed climate risk disclosure rule and the proposed ESG Fund Rule would both have implementation time frames of at least 26 months, with the largest public companies disclosing climate data first, to be followed by smaller companies.
The ICI explained that its estimated implantation time frame was based on several assumptions, some of which come directly from the SEC’s aspirational goals as stated in the agency’s Regulatory Flex Agenda. Thus, the ICI based its estimates on the SEC adopting the climate risk disclosure rule for public companies in early 2023 (the SEC’s April 2023 goal has since passed) and with the SEC adopting the Fund ESG Rule in October 2023.
By way of background, there has been much public speculation about why the SEC missed the aspirational April 2023 date. Reasons for delay could include an attempt to harden the public company disclosures against an expected legal challenge, to attempt some degree of convergence with similar European rules, to reconsider key aspects of the proposal such as whether to mandate Scope 3 greenhouse gas (GHG) disclosures, to align the effectiveness and compliance dates for at least three interrelated ESG proposals, or to finish reviewing the many thousands of public comment letters received (the most recent comment letter was submitted on April 17, 2023 by Ann Wagner (R-Mo), Chair of the House Financial Services Committee's Subcommittee on Capital Markets, and Bill Huizenga (R-Mich), Chair of the House FSC's Subcommittee on Oversight and Investigations (the letter argued that the SEC’s proposal would violate the major questions doctrine as expounded by the Supreme Court in West Virginia v. EPA).
The ICI’s sequencing analysis also assumed that the SEC would mandate that public companies disclose metrics about at the least their Scopes 1 and 2 GHG emissions. Lastly, the ICI assumed that the SEC would provide a phase-in for companies to comply with the climate risk disclosure rule based on the size of the company.
What fund disclosures would be required? In a nutshell, the ESG Fund Rule, if adopted as proposed, would require funds to make disclosures about the characteristics of any funds that incorporate ESG factors into the making of investment decisions. The SEC’s goal would be to reduce the potential for funds to engage in “greenwashing,” the practice of stating lofty ESG investment goals but, in reality, failing to adhere to those goals.
The proposed ESG Fund Rule would divide ESG funds into three categories. “ESG impact funds” would be those funds that seek to achieve specific ESG impacts. An “integration fund” would be a fund that mulls ESG and non-ESG factors but for which ESG factors would have no greater significance than non-ESG factors. Lastly, an “ESG-focused fund” would be a fund that has one or more ESG factors as a significant or main consideration in selecting investments or for engaging with the companies in which it invests.
The latter type of fund, an “ESG-focused fund,” that indicates it considers environmental factors, would also have to disclose aggregated GHG emissions metrics for the portfolio for the relevant reporting period that include: (1) the portfolio’s carbon footprint and (2) the portfolio’s Weighted Average Carbon Intensity or WACI (an ESG-focused fund that affirmatively states in a required tabular disclosure that it does not consider GHG emissions of portfolio companies in which it invests would not have to calculate its portfolio carbon footprint or the WACI).
The SEC’s climate risk disclosure proposal would have companies disclose metrics about their GHG emissions. These emissions come from seven key molecules thought to be drivers of global warming: carbon dioxide, methane, nitrous oxide, nitrogen trifluoride, hydrofluorocarbons, perfluorocarbons, and sulfur hexafluoride. Disclosures would be further grouped into Scope 1 (company-owned or controlled emissions), Scope 2 (purchased emissions), and Scope 3 (all other indirect emissions).
Under the proposed ESG Fund Rule, funds filing Forms N-1A and N-2 would, for each portfolio holding of an ESG-focused fund (other than funds that do not mull GHG emissions), disclose a portfolio carbon footprint that is based on a calculation that takes into account several ratios and multipliers such that: (1) the current value of a portfolio holding would be divided by that portfolio company’s enterprise value; the result would then multiplied by the portfolio company’s Scopes 1 and 2 emissions; (2) the result of the above calculation is then divided by the current portfolio net asset value (NAV).
A similar calculation is used to determine the WACI, except that here the calculation involves multiplying two ratios such that: (1) the current value of a portfolio holding would be divided by the current portfolio NAV (the proposal uses “current portfolio NAV” regarding Form N-1A but just “current portfolio value” regarding Form N-2); and (2) that result is multiplied by the ratio of the portfolio company’s Scopes 1 and 2 emissions to the portfolio company’s total revenue (in millions).
It is these two calculations that the ICI flagged as problematic if the SEC fails to afford funds enough time to obtain GHG metrics from public company disclosures under a final version of the climate risk disclosure rule. Both calculations depend on having data regarding public companies’ Scopes 1 and 2 GHG emissions.
The ICI explained in its most recent comment on the proposed ESG Fund Rule that the European experience with the similar EU Sustainable Finance Disclosure Regulation (SFDR) demonstrates the issues that can arise regarding sequencing. The ICI said that European asset managers and funds had to rely on third-party data in order to comply with the SFDR. By way of background, the SEC’s proposed climate risk disclosure rule would allow public companies themselves to use third-party data to calculate GHG emissions if certain disclosures are made, including identifying the data source and the process the company used to obtain and assess the data. The ICI noted that the SEC had indicated to it that the agency understood the problems encountered in Europe and that they could likewise occur in the U.S. regarding the SEC’s several ESG proposals.