What Does ESG-Focused Mean?

ESG is a term commonly used to incorporate three broad categories of interest for investors: Environmental, Social, and Governance. ESG factors can play an important role in investing and business decision-making. As time goes on, more ESG frameworks and reporting metrics are being created and updated, and investors and businesses alike can use these tools to gauge and improve upon their investments’ impact on humanity or shield their portfolio from ESG risks.

In May 2022, the SEC released a proposed rule to enhance disclosure requirements for investment products and investment strategies. The proposed rule, while neglecting to provide a definition for ESG, nevertheless seeks to create a consistent regulatory framework that protects investors and shareholders without limiting ESG innovation in the asset management industry. To facilitate this, the SEC proposed classifying ESG investing strategies into three categories: ESG-Integrated, ESG-Focused, and ESG-Impact. While the three categories differ in disclosure requirements, they are intended to increase transparency for shareholders and investors while limiting harmful and unethical practices like greenwashing.

What Is ESG-Focused?

The SEC proposed to define “ESG-Focused Funds” as funds that consider one or more ESG factors as significant or primary factors in selecting investments or in engagement with portfolio companies. ESG-Focused Funds include, for example, funds that apply inclusionary or exclusionary screens, funds that focus on ESG-related engagement with issuers, and funds that track an ESG-focused index. The category also includes any fund that markets itself as having an ESG focus.

ESG-Focused and ESG-Integrated strategies differ in that ESG factors would generally not be given greater weight or consideration than other business-related factors in the investment selection process. An ESG Integration fund may not review ESG issues or use ESG criteria for every decision. These factors are not the primary reason fund managers might select or exclude a security in an ESG Integration fund. Impact funds, the third category proposed by the SEC, are an extension of the ESG-Focused branch, with heightened attention towards achieving one or more specific ESG goals.

Proposed ESG-Focused Disclosures And Reporting

Under the proposed rule, an institution engaged in ESG investing could be required to disclose additional information on how it implements ESG factors in its principal investment strategies through a layered disclosure framework in its brochure, annual report, and prospectus. Open-end funds would need to provide a concise description of this information in the fund's summary prospectus and a more detailed description in the fund's statutory prospectus. For closed-end funds, disclosure of summary information would be provided as part of the general description of the fund in the prospectus.

The SEC’s proposal requires ESG-Focused funds and strategies to provide more detailed disclosure than Integration funds, such as the inclusion of an “ESG Strategy Overview table” in the fund’s prospectus. The table would require funds to disclose the ESG strategies they employ along with a narrative of how the fund selects and measures their ESG goals and incorporates these factors into its business decisions. The disclosure requirements would also require these funds to address, among other things, any internal methodology or third-party data provider (when applicable) used in selecting investments, identification of the tracking index, and a description of any ESG frameworks being used. In addition to the proposed prospectus disclosure requirements, the SEC proposed rule mandating funds to include additional ESG-related information in annual shareholder reports. ESG-Focused funds that utilize proxy voting as a large part of their ESG strategy would also be required to disclose information about the fund’s voting record on related ESG matters. If the fund applies an inclusionary or exclusionary screen to select or exclude investments, the fund’s summary must briefly explain the factors the screen applies, such as particular industries or business activities it seeks to include or exclude, and if applicable, what exceptions apply to the inclusionary or exclusionary screen.

All ESG-Focused funds, under the proposed rule, would be required to disclose the carbon footprint and the weighted average carbon intensity of their funds in their annual shareholder reports unless the fund states that it does not consider issuers' Greenhouse gas emissions as part of its investment strategy in the ESG Strategy Overview Table. The SEC also proposed that all funds tag their ESG disclosures using the Inline eXtensible Business Reporting Language to provide machine-readable data that investors and other market participants could use to access and evaluate ESG funds more efficiently.

Defining ESG

These disclosures proposed by the SEC do try to divide up the world of ESG investment strategies into clear categories. However, the SEC remains reluctant to place a definition on ESG. On one hand, leaving the term ESG undefined fulfills the SEC’s wish to not hamper ESG innovation, but on the other hand, leaving ESG as a nebulous term could prove detrimental to the SEC’s efforts to limit greenwashing in ESG funds.

Conclusion

The key ideas behind ESG will likely continue to be relevant, and the SEC proposal may provide greater transparency for investors who care about ESG issues. The current alphabet soup of ESG frameworks and reporting standards can become a double-edged sword – companies could simply choose the framework that makes them look the best and engage in greenwashing. The proposed rule from the SEC could provide socially conscious investors with a more consistent framework, but it remains to be seen whether the proposal will become policy. Even if the SEC proposal fails to become policy, ESG-related disclosures will not simply cease to exist. Businesses, investors, and fund managers will likely continue to muddle through defining what ESG means to them.

Published August 11, 2022

References

United States Securities and Exchange Commission, Enhanced Disclosures by Certain Investment Advisers and Investment Companies about Environmental, Social, and Governance Investment Practices. May 25, 2022, Release No. 11068, 34-94985, IA-6034, IC-34594, File No. S7-17-22. https://www.sec.gov/rules/proposed/2022/33-11068.pdf.

Proxy Voting by Registered Investment Companies, 2017. Investment Company Institute, July 2019, https://www.ici.org/system/files/attachments/pdf/per25-05.pdf.

About The Author

Jesse Opoku joins the Humankind team from an expert network, where he first developed an interest in Business Operations. Jesse holds a B.A. in Global Affairs from Yale University. Jesse is an avid birdwatcher, with vultures being his favorite species.