As government organizations, regulators and end investors have become increasingly focused on the degree to which investment firms are incorporating ESG initiatives and risks into their investment analysis and selection processes, it is critical that investment advisers understand the impact of ESG on the industry and are able to identify and satisfy related obligations, including, but not limited to, with respect to their offering document disclosures. Below we answer several common questions relevant to investment advisers on the topic of ESG implementation:
Why is ESG investing relevant?
ESG is an acronym that refers to “environmental, social and governance” as categories of issues to be considered in the context of corporate operations and governance, as well as investors’ investment strategies. There are many terms used to describe various components of ESG such as “socially responsible investing,” “sustainable,” “green,” “ethical,” “impact,” or “good governance.”
In its April 2021 ESG Risk Alert, the SEC recently noted that investor demand for investment products and financial services that incorporate ESG principles has substantially increased in recent years. And certain studies, including the U.S. Government Accountability Office’s July 2020 report on ESG, 66 indicate institutional investors generally agree that ESG issues can have a substantial effect on a company’s long-term financial performance.
As countries continue to push towards mandatory corporate responsibility disclosures and investors emphasize sustainable and responsible investing, investment advisers have increasingly looked to incorporate ESG into their investment programs and public disclosures.
What are common ESG factors to consider?
While there is not yet a universally accepted definition for what constitutes ESG, there are commonly accepted categories of topics that are considered a part of ESG. The CFA Institute published an ESG investing guide in 2015 that included a robust list of ESG categories. Below is a non-exhaustive list:
- “Environmental” issues, which include climate change and carbon emissions, air and water pollution, biodiversity, deforestation, energy efficiency, waste management, and water scarcity.
- “Social” concerns, which include customer satisfaction, data protection and privacy, diversity and inclusion, employee engagement, community relations, human rights, and labor standards.
- “Governance” considerations, which include board composition, audit committee structure, bribery and corruption, executive compensation, compensation alignment, lobbying and political contributions.
Where do the SEC and other regulatory and quasi-regulatory bodies stand on ESG?
The SEC staff has made it clear that it will examine investment firms to evaluate whether they are accurately disclosing their ESG investment approaches, and whether such firms have adopted and implemented policies, procedures and practices that align with their ESG-related disclosures. Most notably, the SEC Enforcement Division’s Examination Priorities for 2020 and 2021 have both included a focus on ESG investing.
In April 2021, the SEC provided a risk alert for investment advisers on ESG implementation, providing observations of deficiencies and internal control weaknesses based on their examinations of investment advisers and funds regarding ESG investing.
ESG frameworks have also been recommended by, among other organizations, the Task Force on Climate-related Financial Disclosures (TCFD) (See Recommendations of the Task Force on Climate-related Financial Disclosures Final Report. June 2017 and the Sustainability Accounting Standards Board’s Conceptual Framework, 2017).
Is there a mandatory ESG reporting/disclosure framework from the SEC at this time?
There is no mandatory disclosure regime for investment firms at this time, but the SEC is currently working to provide a more global ESG reporting framework. The SEC has, however, previously provided guidance on proper disclosure with respect to climate change considerations, which should be considered when a firm is contemplating how best to make any public, ESG-related disclosures.
Do investment advisers need a special set of policies and procedures for ESG?
No — all firms need not have a separate set of policies and procedures for any investment strategy. Rather, each firm’s policies and procedures should be designed around the specific investment processes and strategies the firm employs, whatever those strategies may be. The SEC identifies as an example of a good practice at firms with “multiple ESG investing approaches” to have “separate specialized portfolio management personnel.”
What is the ultimate expectation of investment firms with respect to incorporating ESG?
The SEC understands investment firms may approach ESG investing in various ways. In making investment decisions, some advisers and funds consider ESG factors alongside many other factors, such as macroeconomic trends or company-specific factors like a price-to-earnings ratio, to seek to enhance performance and manage investment risks. Others focus on ESG practices because they believe investments with favorable ESG profiles may provide higher returns or result in better ESG-related outcomes.
The SEC has publicly stated that it will not second-guess investment decisions through any proprietary scoring system; but rather it will attempt to understand whether investment firms are adhering to their own ESG claims. If those ESG claims include relying on proprietary or third-party scoring services, the staff will want to understand the due diligence the investment adviser has done on that scoring service, as well as the work the firm does to ensure its adherence to the framework it has chosen.
What are examples of quantitative tools and methods that can be used as part of ESG analysis?
There are number of different approaches for incorporating ESG into investment and risk analysis, one of which includes assigning certain ESG metrics a “risk score” when evaluating companies for investment. For example, as one of a growing number of organizations moving into the space, Bloomberg’s Sustainable Finance tool provides scores from third party rating agencies and an overview of a company from an ESG perspective both historically and relative to peers, data which can be incorporated by a firm’s risk or investment teams when formulating investment strategy. It evaluates companies on an annual basis, collecting public ESG information disclosed by companies through corporate social responsibility (CSR) or sustainability reports, annual reports and websites, and other public sources, as well as through company direct contact. Bloomberg offers ESG data service with 10+ years of history for more than 11,800 companies in over 100 countries, organized into 2000 fields.
Other commonly used ESG investment strategies may utilize combinations of one or all of the following: exclusionary screening, best-in-class selection, thematic investing, active ownership, and impact investing.
Can ESG analysis differ by asset class (equities, fixed income, credit, etc.)?
Yes. While most of the discourse on ESG issues has been focused on listed equities, the practice of considering ESG issues with respect to other asset classes, most notably fixed income, is growing. The CFA Institute noted that in fixed income, ESG issues are mostly about risk. ESG analysis in fixed income can include consideration of an issuer’s carbon emissions rates, labor relations, and history of governance-related irregularities. More specifically, as part of standard due diligence with respect to an emerging-market high-yield corporate debt issue, investors are well-advised to take into consideration the issuers’ full corporate structure and governance practices.
What are some initial steps investment firms can take when implementing ESG into their review and investment processes in order to ensure compliance with SEC guidance?
- Principals at investment advisor firms and other investment firms should review any existing disclosures about climate change and other ESG-related policies, whether they are filed in SEC reports (i.e. 10-K, 10-Q, and 8-Ks), sustainability reports, or any reports required by other existing rules. Continue to monitor regulatory updates and new frameworks as they are distributed to industry participants.
- Develop and maintain policies, procedures, and practices that appeared to be reasonably designed in view of the investment firm’s particular approaches to ESG investing. The SEC observed that some firms looked to incorporate detailed investment policies and procedures that addressed ESG investing, including specific documentation to be completed at various stages of the investment process (e.g., research, due diligence, selection, and monitoring).
- Have compliance personnel fully integrated into the firm’s ESG-related processes. Where compliance personnel were integrated into firms’ ESG-related processes and more knowledgeable about firms’ ESG approaches and practices, the SEC noticed that those firms were more likely to avoid materially misleading claims in their ESG-related marketing materials and other client/investor-facing documents.
- The compliance personnel should provide more meaningful reviews of firms’ public disclosures and marketing materials, test the adequacy and specificity of existing ESG-related policies and procedures, and test the adequacy of documentation of ESG-related investment decisions and adherence to clients’ investment preferences.
