Shareholder Advocacy Review – Fall 2022

Our Moment

Anyone who’s been a sustainable and responsible investor for more than 30 years, long before it was popular, knows how difficult it’s been for the approach to gain mainstream acceptance. We’ve all watched with great pleasure as more and more investors have increasingly aligned their investments with their values, but it took quite a while for conventional financial firms to embrace it, and even longer for the regulatory agencies to endorse it.

While we had allies at the Securities and Exchange Commission (SEC) under President Obama, under President Biden we finally have an SEC willing to take a regulatory position and issue rules regarding how investment companies, advisers, and funds disclose the environmental, social, and governance (ESG) measures they use to make investment decisions. This information deserves to be public so that investors can make informed decisions about how to  invest their money.

Earlier this year, the SEC released a draft of a proposed rule, “ESG Disclosures for Investment Advisers and Investment Companies.” The public comment period ended in August. We submitted a comment letter, as did many of our colleagues, applauding the SEC’s foray into this realm, but imploring the commissioners to “get it right.” For example, in the proposed rule, the agency created several categories of ESG investments, with specific requirements for each:

  • ESG-Focused: ESG is a primary criterion for selection
  • Impact Funds: contains a single ESG theme (such as carbon mitigation or racial equity)
  • ESG Integration: ESG is a lesser factor but still included

The primary point in our letter was that “ESG Integration” is the problem category, popular as it has become. Experienced ESG practitioners know that firms may, for example, address E issues but not S or G issues. And even within E, they may only address a small subset of E issues. As such, investors who believe they are getting a comprehensive ESG strategy are not aware of what they’re not actually getting because it is too difficult and time consuming for them to make ESG comparisons among advisers, funds, and managed programs.

This is why we created our Heart Rating, the leading tool investors use to get a snapshot of socially responsible investment mutual fund ESG performance. But even with this and newer rating systems, investors remain largely unaware of how “ESG Integration” is or is not actually ESG in nature.

In our view, ESG needs to be the primary purpose of the adviser or fund for it to deserve the label. Even selecting the “best” ESG performer in each sector, which is the weakest standard in the industry, doesn’t adequately advance the intent of sustainable, responsible, and impact investing to mitigate against certain company risks. Even the “best” petrochemical or fossil fuel company, or the company with the fewest violations of labor and human rights standards, isn’t necessarily one that should be defined as sustainable or responsible. Many investors have deep understanding of what these terms mean and should not be manipulated by firms claiming that their selection of the “least bad” securities warrants an ESG label.

In our view, “ESG Integration” is not actually ESG and should therefore not be validated by the SEC just because it’s a current reality. This approach may have an ESG leaning, flavor, or aspiration, or such practitioners may view ESG issues as a component of their overall assessment of company risk, but this is not the kind of comprehensive ESG strategy responsible investors desire. Such weak standards can lead investors to question the veracity of the approach and even prevent prospective ESG investors from taking it seriously.

As such, “integration” is not a reasonable minimum standard. ESG should be reserved for advisers and investment products that place equal to greater emphasis on ESG issues – the “ESG Focused” approach – as they do financial issues given that this is what responsible investors are looking for when they choose advisers and funds claiming to be ESG, sustainable, responsible, or impact.

We further suggested that “ESG-Focused” is a broad category that actually does include what the proposed rule describes as “Impact Funds.” A fund that has a single-issue focus or a theme is still ESG-focused, but the ESG issue needs to clearly be ESG in nature and not merely a somewhat benign sector fund (e.g., renewable energy), because sector funds don’t examine the way companies operate from an ESG perspective. You may have heard that this is why Tesla was recently removed from the S&P 500 ESG Index: battery power is not all that matters when assigning an ESG score to a car company.

We have long been clear that without universal standards to define the terms sustainable, responsible, or impact, financial firms have lumped them together. This ultimately has confused investors who may not understand how varied the approaches truly are. As the saying goes, “there are many shades of green.”

We look forward to seeing the final SEC rule, hopefully this Fall.

Given how widely financial advisers are interpreting terms like “sustainable” and “responsible,” we encouraged the SEC to take a stronger stand regarding what qualifies as ESG criteria.

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Michael Kramer

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