Searching for Standards: What Does ESG Mean Anyway?

The acronym ESG, which stands for “Environmental, Social, and Governance,” was first coined by the United Nations in a landmark 2004 report, “Who Cares Wins.” The report stated, “better consideration of environmental, social and governance factors will ultimately contribute to stronger and more resilient investment markets, as well as contribute to the sustainable development of societies.”

The report was focused on elevating the use of ESG factors in investment analysis to better assess risk. The authors went so far as to say, “we have refrained from using terms such as sustainability, corporate citizenship, etc., in order to avoid misunderstandings deriving from different interpretations of these terms.” 

ESG, as originally defined by the report, was clearly different than responsible investment strategies that were based on investor values and preferences. Those strategies, often called ‘ethical investing’ in the UK and Europe or ‘socially responsible investing’ (SRI) in the US, were ways for investors to align their values with their investments.  Common SRI strategies excluded stocks like alcohol, tobacco, gambling, pornography, and weapons. ESG attempts to price the risks companies face from their environmental footprint, their social impact, and their governance practices.

Europe Leads the Way

In 2019, the European Union proposed the first major attempt to formally organize and mandate standardized sustainability disclosures by investors with the SFDR (Sustainable Finance Disclosure Regulation effective as of January 1, 2023. The SFDR is designed to allow investors to properly assess how sustainability risks are integrated in the investment decision process.

The SFDR continues to be refined and updated, and it has proven to be a catalyst for other countries (including the United States Securities and Exchange Commission) to launch their own versions of uniform and required disclosures around sustainable investing.

In addition, the EU was a “first mover” in the standardization of ESG terms when it launched the EU Taxonomy in 2020. The EU Taxonomy is a classification system designed to clearly define what constitutes an “environmentally sustainable economic activity.”

The six major classifications defined in the Taxonomy Regulation are:
1.) climate change mitigation
2.) climate change adaptation
3.) sustainable use and protection of water and marine resources
4.) transition to a circular economy
5.) pollution control and prevention and
6.) protection and restoration of biodiversity and ecosystems.

Accompanying the Regulation is an extensive list of industries and sub-industries and how their attendant activities impact each of these six categories. It is the most in-depth attempt to date by any regulator to identify and standardize evaluation criteria for companies as the world transitions to a more sustainable future. More information can be found here: https://ec.europa.eu/sustainable-finance-taxonomy/taxonomy-compass/the-compass

The SEC Response

As a result of the global movement towards greater disclosure on sustainability matters, and growing demand by investors for “clarification” on a plethora of divergent claims by fund managers around ESG strategies, the SEC acted in 2022 to address for the first time the issue of “standardized ESG disclosures.”

The SEC has had Rule 35d-1 of the Investment Company Act, usually referred to as the “Names Rule,” on the books since 2001. This rule was meant to preclude managers from using names that were deceptive or inconsistent with their actual investment strategy.

On September 20th, 2023, the SEC adopted final amendments to the “Investment Company Names” rule.  The new requirements expand the coverage of the 80 percent investment policy requirement (“80 percent rule”). The 80 percent rule requires any fund with certain names to adopt a policy to invest at least 80 percent of the value of the fund’s assets in investments that match the fund’s name. Previously the name rule applied to terms like “bonds” or “equities” or certain sectors or countries. Going forward, fund managers using names such as “growth,” “value,” “ESG,” “sustainable,” “green,” etc. will have to abide by this rule. Fund managers have 24-30 months, depending on their size, to comply with the new rule.

The goal of the amendment is to provide investor protection through increased clarity. It is an attempt as well to combat “greenwashing,” the practice of claiming a fund is more sustainable than it really is. By improving fund names, the rule contributes to market integrity, and provides more consistency and standardization.

The SEC has recognized that the significant demand for ESG-positioned products raises the risks of customers being misled as more managers launch more funds in this space. The regulator even stated that it would consider further rulemaking more narrowly focused on ESG.

This is an except from an article first published in the Winter Issue of Defined Contribution Insights. Read the full article here.

Samuel C. Adams and Robert E. “Emery” Pike, CFA, AIF are members of PSCA’s Investment Committee. Sam Adams is CEO & Co-Founder of Vert Asset Management and Emery Pike is a Senior Advisor at Sheets Smith Wealth Management Inc.