SEC Recommends Creating Disclosure Framework for ESG Investments

Now that environmental, social, and governance (ESG) investing has reached a critical mass, and 2,300 global asset owners and managers representing $80 trillion have signed the United Nations Principles for Responsible Investment, committing to incorporate ESG issues into their investment analysis and decision-making investment processes, the US Securities and Exchange Commission (SEC)’s investment committee moved forward this month to recommend creating a framework for ESG disclosure.

The goal, in part, is to eventually provide investors with “the material, comparable, consistent information they need to make investment and voting decisions” and a framework to disclose material so they don’t have to rely on third-party ESG data providers or disclosures. The hope is that, with a consistent framework, it will level the playing field of investments, and allow those that have made great strides in the ESG space to shine, regardless of market cap size or capital resources. It’s also a proactive maneuver. With the European Union becoming a key player in the ESG space and ironing out its regulations, there’s growing competition. The tighter regulations in the United States are thought to ensure the continued flow of capital to stateside companies and “enable the SEC to take control of ESG disclosure for the US capital markets before other jurisdictions impose disclosure regimes on US issuers and investors alike.”

The industry has long faced confusion about what determines whether something is a strong ESG investment. Exchange-traded funds (ETFs) with a sustainability label drew $20.6 billion in new funding in 2019, up from $5.5 billion in 2018. Despite that, greenwashing abounds. A CIO once mentioned a manager who tried to pass something off as an ESG investment after painting a parking space for an electric vehicle.

Without a standard structure, ratings vary. Companies are given reports to fill out and often don’t realize that ignoring the report dings their ESG rating. And for more than 50 years, the SEC has pondered whether ESG disclosures should be integrated into the formal disclosure processes. On Thursday, the investment committee—chaired for the last time by retiring head Anne Sheehan, formerly of the California State Teachers’ Retirement System (CalSTRS)—decided “the SEC is best-placed to set the framework for issuers to disclose material information upon which investors can rely to make investment and voting decisions.”

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The committee has been reviewing the issue over the past three years. It expressed that the matter has become much more urgent since it has taken up global importance by “very major global economic centers,” according to Allison A. Bennington, former partner at ValueAct Capital, who wrote the proposal and said the discussion is currently a flexible recommendation and at a very high level. “The point is, this is converging,” she emphasized. Her proposal mentioned that standards from the Global Reporting Initiative, Sustainability Accounting Standards Board, and Task Force on Climate-related Financial Disclosures may help shape the framework’s development, but the committee will not endorse or recommend any in particular.

Anne Simpson, director of board governance and strategy at the California Public Employees Retirement System (CalPERS), expressed the fund’s support of building the disclosure framework, citing the Aggregate Confusion Project from the Massachusetts Institute of Technology (MIT), which notes the discrepancies between ESG rating firms. According to the MIT research, “It is very likely (about 5 to 10% of the firms) that the firm that is in the top 5% for one rating agency belongs to the bottom 20% for the other. This extraordinary discrepancy is making the evaluation of social and environmental impact impossible.”

Simpson said, “Now if the market has noise and does not have a clear signal, that’s a real problem, a problem on both sides.” It’s a problem for both investors wanting to price, allocate capital, and exercise votes, and for companies seeking capital, because those that are making tremendous progress in the space “aren’t being rewarded through the capital markets the way they should.”

Now that there is significant capital being put toward ESG investments, if confusion is being caused by best practice disclosures, then “it really is time for regulators to bring some order to the chaos,” she said. “At CalPERS, we genuinely think this is both going to be a benefit for the corporate community as well as us as long-term investors.”

Skepticism and dissenting votes were cast by Mina Nguyen, managing director of Jane Street Capital; J.W. Verret, a law professor at George Mason University; and Steven Holmes, general partner emeritus, InterWest Partners, who expressed concerns about the ambiguity of the term “materiality,” and that ESG ratings should be left to the private parties, rather than “opining and mandating some central group, such as by the SEC,” Homes said. Creating such a framework would be both expensive and inconclusive, he said, since private parties have yet to come to consensus themselves due to the issue’s complexity. “One size does not and will not fit all,” he said. The naysayers also suggested protecting the Financial Accounting Standards Board from being “diluted” by the new ESG standards.

The broad recommendation is just the beginning. Now comes the time to unravel the ball of yarn and actually forge the disclosure framework.