Taxonomy matters, part 1: Defining ESG and Integration Funds - The next era in ESG investing

What does it take to Define ESG?

What is considered an ESG investment product? How can you tell it from other products? What about a fund that says it ‘considers’ ESG, but in the end product, the companies are selected for performance over anything else? When you buy an impact-focused fund, do you know the direct impact it’s making?

There are hundreds of questions that can come from trying to decipher an ESG investment product or even an ESG strategy, and many end investors are left wondering if they are invested in a product that is marketed as one thing, but in reality, it’s more similar to a Large Cap value fund in the end.

The SEC did a good job of outlining these issues of ESG variability and, though they are not defining what ESG is, they are building a spectrum to help bucket different ESG strategies into ESG Integration, ESG-Focused, and impact investing.

In our first post, we briefly defined that the SEC proposal requires funds that consider ESG factors to disclose additional information regarding how they consider ESG. The amount of disclosure required is set along with how critical ESG factors are to the funds; strategy.

• Integration Funds: Funds that integrate ESG factors alongside non-ESG factors in investment decisions would be required to describe how ESG factors are incorporated into their investment progress.
• ESG-Focused Funds: Funds for which ESG factors are significant or main considerations would be required to provide detailed disclosure, including a standardized ESG strategy overview table.
• Impact Funds: A subset of ESG-Focused Funds that seek to achieve a particular ESG Impact would be required to disclose how it measures progress on its objective

These are helpful definitions to guide our orientation to how the new proposed rules and disclosures affect different funds in a layered approach to help guide advisors and investors to a better-informed decision, while also offering a better overall standard of analysis for tools, like YourStake, MSCI, Sustainalytics, to find commonality across these buckets to give a better analysis of ESG alignment to client needs.

ESG funds are like an onion, they have layers

As the SEC states in this layered approach, "Funds that meet the proposed definition of “Integration Fund” would provide more limited disclosures. “ESG-Focused” Funds, which would include, for example, funds that apply inclusionary or exclusionary screens, funds that focus on ESG-related engagement with issuers in which they invest, and funds that seek to achieve a particular ESG impact, would be required to provide more detailed information in a tabular format. "

These separations are somewhat helpful in building out the difference between ESG funds that have a slight consideration on ESG alignment versus funds that say they are focused on, working to change, or impacting the world on any portion or all of the themes within the environment, society, or governance.

A standout question the SEC offered in this first discussion section is:

1. We are not proposing to define “ESG” or similar terms, and, instead, we are proposing to require funds to disclose to investors (1) how they incorporate ESG factors into their investment selection process and (2) how they incorporate ESG factors in their investment strategies. Is this approach appropriate? Should we seek to define “ESG” or any of its subparts in the forms?

We feel that there are two lanes of thought when it comes to defining ESG. The first is, “I know it when I see it” as a form to say, we know that these products cover themes of the environment, society, or governance, so if we’re looking at a fund and it states it considers bettering working conditions globally, along with exposure to renewable energy, and stronger workplace diversity, one could feel confident that it is an ESG focused or Impact focused product. Whereas the second lane of thinking is, that we need an explicit definition because, without one, anything could be considered ESG if the process seems sound.

There is hope that explaining the process of how an investment is considered ESG and what a fund manager does to assess a company, and how is it tracked to help create and drive change across the E, S, and G spectrum is the correct form to not limit ESG investments from consideration, time will tell on how this might be adjusted in the near future following this proposal.

Integration Funds - Incorporation of ESG factors and GHG emissions

As we move past the idea of defining ESG, let's dig into the layers of ESG investments that these rules would apply to.

The first is the Integration Fund. The SEC is proposing to require these funds to summarize, briefly, how the fund incorporates ESG factors into its investment selection process including what ESG factors the fund considers. They gave a good example to consider, “an Integration Fund, might provide a brief narrative of how it incorporates factors, or provide an example on how to illustrate how it considers ESG factors with other factors.” (Page 26)

This is helpful, especially for investors, who might be new in ESG investing where they want slight exposure to the space, but maybe not want to explicitly focus on ESG themes directly, or want a thematic ESG product. The advisor and investor, ought to be able to know how deeply an Integration Fund considers ESG factors among non-ESG factors in the end investment decisions. The SEC is also helpful to state that, “ESG factors may not be determinative in deciding to include or exclude any particular investment in the portfolio.” (Page 27)

However, the SEC is concerned in this proposal that if they were to require a more detailed discussion of ESG factors, it could cause an Integration fund to overemphasize the role of ESG factors in the investment decision-making process. We also believe that this thinking is aligned with a best practice for ESG disclosure, as an over-analysis of an ESG investment screen for a non-ESG-focused investment product would be an overstatement of thought or consideration in the end investment decision.

One other additional disclosure for Integration Funds would be for the funds that consider Greenhouse Gas (GHG) emissions the fund would be asked to provide details information on how the fund considers GHG emissions of portfolio holdings as one ESG factor and describe the methodology it uses to determine emissions and the sources of said emissions.

The SEC notes that there is growing investor demand for more data and information on how funds assess GHG emissions for their product and offering more transparency is key to helping create a better comparison to other funds.

Overall, these changes to Integration Funds should help in increasing investor transparency, particularly for funds considering GHG emissions at any level. One outstanding issue we still see if, without a strict definition for ESG, many products are left expressing their ideas on this system of investing which could still cause confusion for the end investor. These new rules to help describe how a fund considers ESG is a welcome change to help break down issues of greenwashing.

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