What is ESG Impact?

Businesses and investors have begun to adopt Environmental, Social, and Governance (ESG) frameworks to help them maximize the good they do while minimizing the bad. ESG frameworks and reporting standards have since proliferated, and a recent proposed rule from the United States Securities and Exchange Commission (SEC) aims to protect investors from potential ESG-related greenwashing. The proposed rule, among other things, aims to group ESG funds into three categories: ESG Integration, ESG-Focused, and ESG Impact funds. In this article, we will examine ESG Impact funds as described by the SEC and look at how the proposed rule affects ESG investors and related funds.

According to the proposal, a strategy would have to meet certain criteria to be considered ESG Impact. ESG Impact strategies have “a stated goal that seeks to achieve a specific ESG impact” or “impacts that generate specific ESG-related benefits.” ESG Impact is a subset of the ESG-Focused category, but a fund’s goal to have a specific effect within the ESG space distinguishes it from other ESG-Focused Funds. Impact funds have a goal to manage portfolio investments that drive “specific and measurable environmental, social, or governance outcomes.”

An example of an ESG Impact fund would be one that declares its goal is to “finance the construction of affordable housing units” while seeking current income. Another is a fund that aims to “advance the availability of clean water by investing in industrial water treatment and conservation portfolio companies.” This category is specifically defined because it faces additional disclosure requirements compared to other ESG-Focused funds and advisers.

ESG Impact Category Requirements

The SEC makes it clear that ESG Impact funds and advisers will be subject to the same requirements as ESG-Focused ones, as they are still included in the category. In addition, they will have to disclose “how the fund measures progress towards the stated impact; the time horizon used to measure that progress; and the relationship between the impact the fund is seeking to achieve and the fund’s financial returns.”

To share how they measure progress towards the stated impact, ESG Impact funds will have to include key performance indicators, or KPIs, that are similar to or the same as KPIs of other ESG funds. They will provide an overview and a more detailed report later in the prospectus.

If a fund’s financial returns come second to the stated goal, this will have to be disclosed. Conversely, if the goal is meant to enhance financial returns, and returns are the top priority, this will also have to be disclosed. Both types can count as ESG Impact, but investors should be informed of what the fund prioritizes.

ESG Impact funds will also be subject to annual reporting on progress towards their goals. Here, they will “summarize briefly the Fund’s progress on achieving its specific impact(s) in both qualitative and quantitative terms during the reporting period, and the key factors that materially affected the Fund’s ability to achieve the specific impact(s).”

The Impact of ESG Impact

According to the SEC, the increased disclosures will make it more clear what impact funds seek to achieve as well as what they prioritize. For investors, this can be crucial to aligning impact investments with their personal goals. With increased disclosures, investors will also be able to evaluate a fund’s progress towards its stated goal. Disclosures also “address the risk of investors being misled through exaggerated ESG claims” because Impact Funds will be differentiated from other funds that “have more general aspirations or goals, or from other ESG-Focused Funds.” In the end, the proposal aims to protect investors by making ESG funds more transparent so that investors can make more informed decisions that align with their goals.

The SEC invites feedback on whether this is the right approach, and we have yet to see if they will adopt ideas from the public’s commentary. If adopted, the framework for ESG Impact and other categories will redefine the parameters in which ESG funds and advisers operate. A new framework for ESG products will be noted across the securities industry in the US and internationally. This makes the proposed rule an important development in how we may talk about ESG in the future and in how investors may find products and services that best suit their individual investment goals.

Published on August 26th, 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).

About the Author

Kristina Bjorksten is an Operations Analyst at Humankind Investments, whose ambition is to make companies more sustainable and enhance the quality of life for humankind. She gained her industry experience at a broker-dealer and brings fresh ideas and an international lens to her role. She studied economics, earning her Master’s in European Economic Studies from the College of Europe and her Bachelor’s in Economics from UC San Diego.