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Proposed ESG Fund Disclosure Rule Aims To Help Investment Strategies

June 10, 2022

Recently, the Securities and Exchange Commission (SEC) issued another proposed rule, which if adopted, will significantly affect the available information from Investment Advisers and Regulated Investment Funds concerning environmental, social, and governance (ESG) factors. We sometimes refer to this as the “ESG Fund Disclosure Proposal.” Assuming you are interested in ESG as an investment strategy, this should assist you in the evaluation of the ESG in your portfolio. Note that the proposed regulation covers 362 pages of background, discussion, and regulation with 198 Requests for Comment. The SEC believes that the proposed rule would enable investors to better evaluate funds by differentiating among funds for which ESG is a major focus (“ESG Focused Funds”), other funds for which ESG is one factor among many (“ESG Integration Funds”), and funds that do not consider ESG as part of their investing strategy (“Non-ESG Funds”).

What is ESG?

There is some confusion as to what ESG really means or what it might represent to the investing community. Concerns about greenwashing – in which ESG claims fall short of reality – are a significant concern. The SEC has been able to leverage current statutes and rules to combat greenwashing (see, e.g., the recent $1.5 million settlement between BNY Mellon Investment Adviser and the SEC). Nonetheless, ESG remains a slippery concept without widely accepted definitions, criteria, and/or metrics.

ESG is an expansive term that incorporates broad categories of interest for investors and asset managers, environmental issues, social issues, and governance issues. Certain buzzwords such as Sustainable, Responsible, Climate, Carbon, Green, ESG, Energy, Environmentally Friendly, Socially Responsible, Sustainable Natural Resource/Agriculture, Greenhouse Gas Emissions, Diversity, and Board and Employee Engagement are examples of some of the words used in fund names, investment company names, or in investment adviser disclosures to indicate some form of ESG investment strategy. As stated in the proposed SEC Regulation, “Investors looking to participate in ESG investing therefore face a lack of consistent and comparable information among investment products and advisers that claim to consider one or more ESG factors.” (pp. 286-287)

Currently, multiple reporting frameworks exist globally to address climate change issues including the United Nations Principle for Responsible Investments (PRI), the Carbon Disclosure Project (CDP), the Sustainability Accounting Standards Board (SASB), the Global Reporting Initiative (GRI), the Climate Disclosure Standards Board (CDSB), the International Integrated Reporting Council (IIRC), and the Task Force on Climate-Related Disclosures (TFCD) recommendations. The SEC reviewed elements of each of these reporting frameworks in constructing its proposed regulations.

As mentioned, a primary stated purpose in the ESG Fund Disclosure Proposal is to identify: (1) Non-ESG Funds, (2) ESG Integration Fund, and (3) ESG Impact Funds.

ESG Strategy Overview Table

The Proposal would require any Fund that manifests itself through its name or marketing materials as having an ESG Focus to provide a proposed “ESG Strategy Overview Table”. [Note that the SEC indicates that providing the “ESG Strategy Overview Table” would not provide assurance or a safe harbor that the name or marketing materials are not materially deceptive or misleading.]

Overview of the Fund’s [ESG] strategy
How the Fund incorporates [ESG] factors in its investment decisions The Fund engages in the following to implement its [ESG] Strategy:

  • Tracks an index
  • Applies an inclusionary screen
  • Applies an exclusionary screen
  • Seeks to achieve a specific impact
  • Proxy voting
  • Engagement with issuers
  • Other
How the Fund votes proxies and/or engages with companies about [ESG] issues

ESG Metrics Disclosures

The Proposal would require ESG Focused Funds to disclose two main metrics including the (1) carbon footprint and (2) the Weighted Average Carbon Intensity (WACI) for its portfolio. Carbon footprint is the total carbon emissions associated with the fund’s portfolio, normalized by the fund’s net asset value and expressed in tons of CO2 per million dollars invested in the fund. The WACI measures the exposure to carbon-intensive industries expressed in tons of carbon dioxide equivalent per unit of revenue. It is a calculation of the tons of CO2 emitted per $1 million of company sales. Proposed disclosures would require a fund to aggregate the total using the percentage weight of the holdings within the fund.

How to Calculate Carbon Footprint

To calculate the fund’s carbon footprint under the SEC proposal, a fund would first determine the portfolio company’s enterprise value, calculated as the sum of the portfolio company’s equity value plus its total debt. The fund would then calculate the carbon emission associated with each portfolio holding by dividing the current value of the fund’s investment in the portfolio company by the portfolio company’s enterprise value, and then multiplying the result by the portfolio company’s Scope 1 and Scope 2 direct greenhouse gas (GHG) emissions, determined under United States Environmental Protection Agency (EPA) guidelines. Finally, the fund would add up the carbon emissions associated with each portfolio holding and divide the resulting amount by the current net asset value of the portfolio to derive the fund’s carbon footprint.

How to Calculate the WACI

To calculate the fund’s WACI under the ESG Fund Disclosure Proposal, a fund would first calculate the portfolio weight of each portfolio holding by dividing the value of the fund’s investment in the portfolio company by the current net asset value of the fund. The fund would then calculate the carbon emissions of each portfolio company by dividing the portfolio company’s Scope 1 and Scope 2 GHG emissions by the portfolio company’s total revenue (in millions of dollars). These emissions would then be attributed to the fund in proportion to the weight of the investment in the fund’s portfolio. The fund would perform this calculation for each portfolio company in its portfolio and the sum of the emissions attributable to the fund would be the fund’s WACI.

The SEC believes these measures together would provide investors in environmentally focused funds with a comprehensive view of the GHG emissions associated with the fund’s investments, both in terms of the footprint or scale of the fund’s financed emissions and in terms of the portfolio’s exposure to carbon-intensive companies.

Basic ESG

In order to evaluate an ESG portfolio, the fund would be required to assess the Scope 1, Scope 2, and Scope 3 emissions for each portfolio company.

  • Scope 1 are direct emissions from the activities of an organization from sources it controls. These would include company vehicles and fuel combustion on site, like gas boilers.
  • Scope 2 are indirect emissions from the generation of electricity and heat used by an organization.
  • Scope 3 emissions are those from all other activities of an organization from sources it does not control. These would cover all emissions associated with business travel, employee commuting, goods or services that are bought or sold, waste disposal, and investments.

The fund would initially use the Scope 1, 2, and 3 emission calculations from the SEC filings of the portfolio company, but in the absence of SEC-designed disclosures, other public disclosures can be used. In limited circumstances, estimates could be used based on specific industry projections.

ESG Investing Strategies

The level of ESG disclosures required by the SEC would depend on the extent to which a fund considers ESG factors in the fund’s investment strategy. A fund identified as an ESG Integration Fund would be required to provide limited ESG disclosures. ESG Integration Funds consider one or more ESG factors with other, non-ESG factors in investment decision-making consistent with traditional investment considerations.

If a fund identifies as an ESG Focused Fund, it would be required to disclose in some detail its strategy for evaluating, selecting, or excluding investments so that investors might be able to identify funds that are aligned with their ESG preferences. In addition, if the ESG Focused Fund engages or interacts with portfolio companies on ESG matters, they must disclose how they engage, including such actions as meeting with portfolio company management or voting on shareholder proposals. Specific information on the fund’s voting policies and voting records would be required disclosures to assist investors in selecting funds and investment advisers.

Investment Advisers

Currently, registered investment advisers (“RIAs”), whether registered with the SEC or individual states, are required to provide information about their advisory services in a narrative format on FORM ADV Part 2, describing their firm’s method of analysis and investment strategies, fees, conflicts, and personnel. Currently, RIAs and exempt reporting investment advisers are not required to report to the SEC ESG-specific information on Forms N-CEN and Form ADV Part 1A.

The SEC is proposing to require RIAs that consider ESG factors as part of their advisory business to provide enhanced ESG-related disclosures to current and prospective advisory clients in their adviser brochure.  In addition, the SEC would collect information on RIAs’ use of ESG factors in their advisory business in Form ADV Part 1A. The SEC proposes that RIAs be required to increase the amount of ESG-related information they provide, and how funds and advisers consider ESG so that investors can easily compare RIAs and how their investment criteria might align with the investor’s ESG objectives.

Conclusion & Comment on SEC Proposals

Many SEC-registered funds and RIAs advising institutional and retail clients consider ESG factors in their investment strategy. The SEC’s proposals are allegedly designed to create a consistent, comparable, and decision useful regulatory framework for evaluating the ESG aspects of SEC-registered funds and the ESG strategies of RIAs. The SEC believes that the proposed rules would allow investors to easily differentiate between funds for which ESG is a major focus (ESG Focused Funds), other funds for which ESG is one factor among many (ESG Integration Funds) and funds that do not consider ESG as part of their investing strategy (non-ESG Funds).

It will be important for interested parties to let the SEC know whether they agree or disagree during the public comment period. The SEC rulemaking process is often lengthy and involved, and this rulemaking will likely be no different. The SEC anticipates many public comments, which, after SEC review, will likely influence the final SEC regulations. It would be wise to review in detail the 362 pages of the SEC’s “Enhanced Disclosures by Certain Investment Advisers and Investment Companies about Environmental, Social, and Governance Investment Practices” proposed rule (announced May 25) to prepare and submit public comments and/or to better understand the approach that the SEC intends to take. The separate but associated SEC proposed rule on “The Enhancement and Standardization of Climate-Related Disclosures for Investors” continues to be open for public comment until June 17.

A full list of SEC proposed rules is available at this link, along with additional details and instructions for submitting comments.

If you have any questions regarding the SEC’s various ESG- and climate-related proposed rules, including the comment submission process, please contact the authors or a member of Clark Hill’s ESG & Sustainability advisory practice.

The views and opinions expressed in the article represent the view of the authors and not necessarily the official view of Clark Hill PLC. Nothing in this article constitutes professional legal advice nor is intended to be a substitute for professional legal advice.

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