How Does the SEC’s Focus on ESG Impact Investment Managers?

How Does the SEC’s Focus on ESG Impact Investment Managers?

On May 25, 2022, the SEC proposed new rules for ESG investment practices. The new guidelines appear somewhat daunting, so we sat down with two of our specialists to get some clarification. Louis Bruno, a partner responsible for Regulatory Compliance Services, and Lourenco Miranda, managing director of ESG and Sustainability Solutions, offer their analysis of what the proposed rules entail for fund managers and investors by answering six of the most commonly asked questions.

1. Could you please summarize the major requirements of the recently proposed SEC regulations regarding ESG disclosures?

Lourenco Miranda: The SEC is essentially asking that three issues are considered. The first is for additional disclosure in terms of the ESG strategies that are used in the different funds. The second point to consider is standardization. The third one focuses on GHG emissions for the targeted environmental funds.

Essentially, registered investment companies and registered investment advisors are required to disclose specific ESG strategies that are used in the funds in the prospectus, in the annual reports and brochures that they file with the SEC.

These disclosures are to be made in such a way that they are comparable, transparent, and open to the investors or public. The SEC is asking that procedures and reporting be standardized. Investors will be able to compare the various funds at a glance thanks to standardization. This would make understanding the distinctions between the various types of funds much easier.

If there is a specific environmental-targeted fund, the fund management will be required to publish the greenhouse gas emissions of that specific portfolio, which presents a significant problem in terms of data and data acquisition.

Louis Bruno: It’s also important to mention the “Naming Rule.” Since 2001, the SEC's naming rule has required that 80% of a fund's holdings be invested in assets that correspond to the strategy implied by the fund's name. The threshold isn't a new requirement for fund managers, but the proposed rules would not allow ESG investment funds to utilise ESG terms in their names if they invested the remaining 20% of their assets in non-compliant investments.

2. Could you please explain the importance of ESG funds in the current world of investment and shed some light on the types of ESG funds that are available?

Lourenco Miranda: I have been working with ESG for approximately 20 years. At the beginning of that time, ESG was a “nice to have” topic. ESG was a plus, because there was nothing about ESG that was part of the conversations at the time. Today, it is a “must-have.”

I cannot fathom any investment conversation that does not include ESG in the mix. ESG is becoming increasingly important. An investor will be attracted to a fund if the fund can demonstrate transparency and compliance, and the monitoring of internal controls. Also, if the fund administrators are as transparent as possible in disclosing these initiatives, they will improve what is called information symmetry.

With transparency, a fund will become more appealing to potential investors. I would feel much safer and much more comfortable investing in the fund that meets my investment strategy and my investment philosophy, which may include environmental and social concerns.

Answering the latter part of the question, the first type of ESG fund is known as an “ESG Integrated Fund,” which means it is not specifically targeted for ESG, but the fund manager integrates ESG metrics, criteria, and other features in the investment decision process and then informs, discloses, announces, and markets the fund as integrating ESG. Integrated ESG funds are funds that use ESG principles in their decision-making.

The second type is when you have a “targeted ESG fund,” which is one that is specifically focused on environmental, social, and governance issues. Targeted ESG funds have a specific industry, or a specific set of metrics that are used to build the investment strategy and policy.

The third type is referred to as “impact funds.” Impact funds are a subcategory of ESG funds that have a clear impact on the environment, society, or both. The fund manager must show and prove that the fund has that precise impact on the environment for instance, or has a direct impact on the society, improving the quality of life of a community, for instance. One of the reasons the SEC is asking that the GHG emissions for those targeted funds be included in the portfolio is because of the direct impact that the fund claims to have on a specific theme. Having said that, the challenges differ depending on the type of fund.

3. What would be the top three immediate challenges for private fund managers?

Lourenco Miranda:

The most challenging task for ESG integrated funds, in my opinion, is incorporating ESG targets, ESG metrics (data), and ESG principles into your decision-making and investment processes.

Strategy is the first thing a fund manager should consider. How can they embed ESG into the investment strategy? What is important to the fund manager, and what is significant to the investors? What is the philosophy, and how do you plan to implement it?

ESG is a long-term investment, and thinking about the long-term view of ESG can be a big challenge for funds.

The second challenge, which is more relevant to ESG focused funds, is establishing that you are not greenwashing, so you want to demonstrate the actual impact of the fund on improving a specific environmental or social target. The fund manager must do so using quantitative methods. They must demonstrate that the portfolio is compliant with the rules and that it can be denominated as ESG, as measured quantitatively using metrics.

The third is about data on GHG emissions. Within a portfolio of equities, this is a challenge in and of itself. Whatever asset you want to invest in, whether it's real estate or something else entirely, you must evaluate scope one, scope two, and scope three, which is a huge undertaking in terms of data acquisition.

Louis Bruno: I'll put another layer on top of that, which is that all of these new policies will necessitate specific controls. It's one thing to change all of these policies to address the requirements, but the new controls required will be challenging to define.
Lourenco Miranda: That's a very good point. Internal controls will certainly need to be implemented. ESG general controls are a new addition to the funds' portfolios. So, yes, that will be a significant adjustment.

4. Most people might perceive the proposals as cost-intensive. What is your view on this regarding the proposed requirements?

Lourenco Miranda: At first glance, this appears to be a cost-intensive undertaking. It is a huge process that demands a lot of data and could be initially quite pricey. However, implementing internal controls, processes, and compliance measures can help fund managers adapt their strategy. They should keep an eye on it throughout the process. Integrating and disclosing ESG can be seen as a competitive advantage. Transparency, internal controls, processes, and compliance will help the fund attract more investors and elicit a more positive opinion from the analysts, and be a differential for the fund.

Imbuing a fund with all this transparency and adherence to SEC guidelines can demonstrate to investors that the risk of greenwashing is low. With these SEC rules, the risk of greenwashing is reduced.

The cost of implementation should be seen as a long-term investment in the fund because it creates a competitive advantage among other funds.

Louis Bruno: I'd argue that the reason this is expensive, or may be expensive, is that the essential controls may not be already in place.

Many of the proposed standards include topics or fundamental elements that should already be part of your compliance program. For example, the concept of greenwashing investments is something that should be prevented by existing policies related to marketing and advertising practices. Preventing fraudulent or misleading marketing is not a new requirement, and it’s good compliance hygiene.

The ESG disclosure regulations should be easier (and less expensive) to apply if an investment advisor already has a compliance structure in place to comply with existing codes of ethics and procedures to prevent false or misleading information. The disclosure rules encourage good compliance hygiene and present a clear competitive advantage for those who provide transparency to their investors.

5. The SEC will require some private fund managers to disclose greenhouse gas emissions in their portfolios. What would be the biggest challenge for managers in this space?

Lourenco Miranda: The number one issue is, of course, data. As a result, quantifying or estimating your specific greenhouse gas emissions is a difficult task in and of itself.

Why is the SEC asking? This is because the funds are claiming that they are targeting a specific impact on the environment. One way of measuring this impact is through greenhouse gas emissions. It makes sense.

However, the fund managers have never done anything like this before, so they must start from scratch.

The task becomes significantly more difficult if they must do it for the components of the assets that are in the portfolio. Consider the following scenario: a fund that is a collection of equities, and the manager needs to estimate the weighted average of GHG emissions of that fund. The question now is, "What is the weighting measure to estimate the average GHG emissions of the portfolio?”

The manager must estimate the greenhouse gas emissions for each of these assets and then weight them so that the portfolio has a weighted average of greenhouse gas emissions, which is the metric that will estimate the impact of the portfolio on the environment.

The fund administrator must first understand the data collection process before beginning to design and scale processes throughout the portfolio. Because if the fund manager does it, and if you treat it as a one-time thing, the cost will be even higher.

6. What would you recommend for private fund managers as a logical path toward compliance?

Lourenco Miranda: First and foremost, I’d recommend a broad assessment of the portfolio, the investment process, and the investment decision process. How to classify the fund in terms of ESG integration, and what that means in terms of incorporating this into the decision-making process, investment strategy, and investment policy.

Regardless of whether the fund manager is integrating, targeting, or striving for a specific impact, there will be a need for data to feed a set of key performance indicators (“KPIs”) that will be used to monitor performance. There will be a need to create the process to declare, capture the data, and establish KPI reporting.

The fund manager must create a mechanism for periodic reporting of the KPIs and monitor internal controls over time. Also, the process must be documented as an external party must be able to audit it. The fund has to show that they are following all of the criteria or requirements over time as it progresses. It is not a one-time thing. It is a matter of compliance for the duration of your portfolio and investments.

Therefore, my number one recommendation to fund managers and investment advisors and companies is to start as soon as you can. Review the investment strategies and investment policies and start creating internal controls to monitor them. It is an extremely data-intensive process.

And there must be a person checking the progress. A dedicated person to do all these checks and balances would be ideal. I strongly recommend that all these funds start thinking about creating a devoted position.

Louis Bruno: Based upon these proposed rules (ESG Disclosure Rules and the Proposed Names Rule Amendments) and the SEC’s ESG risk alert from last year, I think it’s safe to say that the SEC expects a well-documented ESG compliance program and that the chief compliance officer will be expected to test the policies and procedures on an annual basis.