Looking Ahead to the SEC’s ESG Disclosure Rule

The U.S. Securities and Exchange Commission (SEC) has recently approved the Climate-Related Disclosure Rule. However, another significant regulatory change is anticipated. In the second quarter, the SEC will likely implement disclosure regulations concerning environmental, social, and governance (ESG) investing. Initially introduced in May 2022, these regulations will introduce standardized ESG labels for investment funds and advisors to promote their environmental and social responsibility. The key components of the proposal comprise the following:

• Definition & Disclosure Requirements: These efforts aim to standardize ESG label usage and reduce inconsistency by introducing specific disclosure requirements. 

• Verification & Oversight: The proposal detailed possible approaches for validating the accuracy of ESG disclosures and adhering to ESG labeling regulations, such as through independent third-party verification.

• Consistency: The new ESG labels have specific requirements to assist investors in using standardized metrics and methodologies to evaluate ESG factors. This includes using common language and formatting in ESG disclosures.

• Risk Management & Materiality: ESG factors must be incorporated into the overall risk management process of investment funds. Funds are anticipated to evaluate the importance of ESG factors in making informed assessments.

The proposed rule stirred controversy, with over 200 public comments submitted to the SEC’s website. These comments shed light on the key issues the SEC needs to address in the final rule. Here are the main concerns and recurring themes identified in the draft rule:

• The ESG Fund Disclosures Proposal might have unintended consequences if funds categorize themselves as the “least burdensome” to minimize disclosure requirements.

• The broad definition of the “Integration” fund category could accommodate various ESG or sustainability approaches, leading to the risk of misperception and greenwashing by lumping all integration funds together.

• The ambiguity surrounding the term "materiality" raises questions about who should define it, potentially causing varying interpretations and challenges.

• The proposed definitions for the three ESG label categories may be considered too broad. They could potentially encompass funds that do not desire or deserve an ESG label, leading to confusion and mislabeling.

• The complexity and costliness of the ESG Fund Disclosures Proposal may deter funds and advisers from considering ESG investment strategies. Due to the broad fund definitions, funds may face disclosure obligations that are not pertinent to their objectives or investment strategies. This could also lead to difficulty determining relevant compliance regimes, resulting in compliance costs exceeding expectations. Commentators like JP Morgan suggested that the SEC remove the proposed list of specific ESG factors considered by the fund and the disclosure of GHG emissions. This would help reduce confusion and lessen the overemphasis on ESG factors in the fund’s investment selection process.

• The ADV disclosure requirements could overly focus on ESG-related strategies, possibly requiring the disclosure of proprietary investment methodologies. Commentators such as Franklin Templeton have expressed concerns that the new form ADV disclosures could potentially mislead investors regarding the significance of ESG factors in investment decisions. They argue that mandating such specificity about ESG factors would compel advisers to provide more information than they do about other equally important factors in their investment strategies, unintentionally promoting greenwashing and creating unbalanced disclosures.

• There are differing opinions on the Impact fund category:

  – Some believe Impact funds should be a separate category rather than a subset of Focused funds, or,

  – Others believe Impact funds should be treated as one of the strategies within the Focused fund category, and a separate category is not necessary.

  – Commentators like JPMorgan support a third category of funds that promote ESG-related outcomes. However, they suggest labeling them as “Outcome-Oriented” funds rather than “Impact” and revising the definition accordingly. “Impact” investing has a narrower definition, which registered funds may only be able to meet in extremely limited circumstances. 

The SEC’s approach to addressing these concerns will have major impacts on the future of ESG investing in the United States. Investment professionals must continue to evolve their approach to meet the different regulatory developments in their applicable jurisdictions, such as the U.S. and European Union. Integrity 2 ESG, LLC will continue to monitor these regulatory developments and can help with advisory or validation needs.