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Lindsey Hall: I'm Lindsey Hall, Head of Thought Leadership at S&P Global Sustainable1.

Esther Whieldon: And I'm Esther Whieldon, a senior writer on the Sustainable1 Thought Leadership team.

Lindsey Hall: Welcome to ESG Insider, a podcast hosted by S&P Global, where we explore environmental, social and governance issues that are shaping investor activity and company strategy.

Esther Whieldon: The ESG investing market is growing rapidly. U.S.-based assets under management using sustainable investing strategies grew from $12 trillion at the start of 2018 to $17.1 trillion at the beginning of 2020, and that was a 42% increase. And those numbers are according to the most recent U.S. SIF Foundation Trends report.

Lindsey Hall: And amid this growth, we've seen some related regulations come out in recent years. One example is the EU Sustainable Finance Disclosure Regulation, or SFDR. And in general terms, that regulation aims to make it easier for investors to understand the sustainable investing strategies of asset managers and investment advisers as part of the EU's push towards making the economy greener.

Now we've covered SFDR quite a bit on this podcast and will include a link to an episode in our show notes for listeners who want to learn more. About a month ago, on May 25, 2022, the U.S. Securities and Exchange Commission proposed 2 rulemakings involving sustainable or ESG-labeled funds. One would update the SEC's fund Names Rule and the other entails ESG disclosures for investment advisers and investment companies. The SEC is accepting comments on the proposed rules through August 16, 2022.

Esther Whieldon: In this episode, we're going to talk with regulatory and sustainable investing experts to dig into that second of the 2 SEC rule makings. One aspect we will explore is the SEC's plan to require certain environmentally focused funds to disclose the greenhouse gas emissions associated with the portfolio investments. To understand the implications of that proposed emissions disclosure requirement, I turn to Aniket Shah.

He is Managing Director and Global Head of Environmental, Social and Governance and Sustainability Research at Jefferies Group LLC, a financial services company. We'll also explore the implications of the SEC's rule with regard to international regulations with George Raine, a partner in the asset management group at the law firm Ropes & Gray.

And we'll learn about the SEC's proposal to create 3 new buckets or categories of ESG funds. They are Integration Funds, ESG-Focused Funds and Impact Funds. For this, I talked with Lance Dial, a partner in the ESG and Sustainability Group at law firm, Morgan Lewis.

So let's start off with my discussion with Lance, where he explains how these 3 new categories of funds serve as sort of the linchpin for both rule makings. One quick note. Lance mentions REITs that stands for real estate investment trusts and refers to publicly traded companies that own and finance income-producing real estate. Okay, here's Lance.

Lance Dial: So the SEC has put forward this new rule, 2 new rules, the ESG Rule and the Names Rule. And the linchpin of these rules are these 3 new categories. So there's ESG Integration, ESG-Focused and ESG Impact. What's going on here is they're trying to figure out how to compartmentalize and bucket ESG funds in a way that's digestible to investors. So people know what they're going to get and advisers know how to talk to investors about what their products and services are. And they don't incorrectly or inappropriately overcommunicate the ESG weight of a given strategy. 

So you look into these buckets, ESG integration, ESG-focused, ESG impact. And one of the things that I find interesting about this is they're not categorized based on the way a fund is sold or the way the fund is described necessarily, but they're actually based on how the fund is managed.

So let's look at ESG integration. ESG integration is a fund that considers one or more ESG factors alongside other ESG and non-ESG factors in its investment decisions, but those factors are not generally more significant than other ones. That's the lowest level of ESG fund. And what they're trying to differentiate there is a fund that just says, "Hey, I recognize ESG as a risk or an opportunity. And I'm going to consider that."

But the fund itself is not going to focus on ESG, the way the ESG-focused fund would. And so they don't want an investor who really wants to invest in an environmentally conscious fund go into a fund that is just an ESG integration fund, thinking that, that fund pursues an ESG objective, when, in fact, it's just looking at ESG factors as one of many criteria on which they make investment decisions. And so that fund may actually not promote the ESG goal that, that investor is looking to achieve. And therefore, they're concerned that the integration label may overstate that ESG-ness, if you will. 

So ESG-Focused Fund is the second level category, and that's ones that are really more -- well, I guess, for lack of a better word, ESG-Focused. I guess that means the SEC got the names right.

So the ESG focus fund is one that selects investments where it is -- where ESG factors are a significant or main consideration. Now unfortunately, the SEC didn't define that for us. And so it's left to us to try and figure out what that means. And I think that's going to be a challenge when funds actually go to categorize themselves and put themselves in these buckets.

But the idea here is that if you are an ESG-focused fund, the investors need to know what your ESG strategy is, and they need to know more about how you accomplish ESG goals. And so they want to signal to investors by including a new chart in a prospectus that outlines several different factors about an ESG strategy, gives an overview.

It gives specific information on check boxes about how the ESG strategy is made. It gives more detail in a layered disclosure format about how the fund incorporates ESG factors and its investment decision process. And so people are getting more information. The core theme of these funds, though, is that they really are focused on ESG, in a way that ESG integration funds are not.

And then because they're doing that and because that's what investors are buying, there's new heightened disclosure requirements in this tabular format, but also and importantly, in a fund's annual report. And that's where some of the more challenging things come through with the new rule for ESG-focused funds. One of them is describing how your proxy voting policies have worked throughout your management of the fund during the course of the year. And the other one is how ESG engagement is informing your ESG strategy and your ESG focus as part of your fund. 

And then the last category of funds, just getting back to your original question -- what are the categories is ESG Impact. And these are funds that, for lack of a better word, seek to achieve an ESG objective.

So an example of that would be, let's say, you have a fund that invests in REITs, but wants to invest only in those REITs that finance housing in developing neighborhoods or underprivileged communities. That would have a specific ESG impact objective and would, therefore, be an impact fund. And the impact funds have the same requirements as ESG-Focused Funds as far as disclosure, but they have some additional requirements relating to their impact objective.

What are the key performance indicators for accomplishing the impact objective? What are some of the metrics you're using to determine whether or not you are successful? And what are some of the additional proof of concept on how your impact is working? And finally, with your investment performance, how that will relate to your investment objective for your ESG impact?

A lot of what they're doing is trying to codify some of the best practices that they're seeing for firms that are really walking the walk. And going back to the policy behind this, what the SEC is concerned about is kind of people using ESG terms to describe strategies that aren't really ESG strategies.

So if you -- as you're looking through these proposals and thinking about these rules, if you look at it through the lens of trying to separate the performers from the nonperformers, the people who are legitimately considering ESG factors from those who aren't, that's a conceptual model that this rule is trying to apply. And I'll give an example under the ESG integration framework.

It's very clear that if you are just considering ESG factors, you need to talk about under the rule, how you consider the ESG factors, how they're weighted and what impact they have on your investment process. And what they're trying to get out there is giving investors more information about that process, instead of merely allowing funds to disclose that they just consider ESG factors.

That's not enough and under the new rule. The new rule says, if you're going to say you consider ESG factors, you need to put some meat on that. You need to describe exactly what that looks like for investors so they can understand what your integration process is. And in the background of this is a concern from the SEC that they want to have things that they can examine, that they can investigate, and they can enforce and ensure you are walking the walk.

So yes, ESG back funds, the bonafide ESG impact funds who are really seeking to accomplish ESG impact typically do have KPIs and typically do have metrics and time horizons to ensure that they are actually achieving their objective. And so this is something the SEC wants to require to ensure that people who are investing in ESG impact mutual funds are getting that same sort of diligence.

Esther Whieldon: To what extent have these 3 buckets, any of them, existed before?

Lance Dial: They have not in the sense that there haven't been official buckets but the thinking behind them has existed for quite some time. So ESG integration has been around. People are thinking we're integrating ESG into our investment process. We see that ESG is a way to assess risks, a way to find opportunities.

Give you an example. If you have a company who has extremely bad employee relations, there are lots of studies out there that show that happy workers are productive workers. And so if you look at that company against the company that maybe spends more in a total employee cost, but has better employee relations. You may, from an ESG factor -- this would be a G or maybe even an S -- determined that the company, too, with the better employee relations, is a better investment long term, even though it has higher employee costs because happy workers are more productive workers. And so they may be better positioned to survive in a competitive labor market, for example. So that's an example of where ESG integration, and that's been going on for a long time. 

On the other end of the spectrum, ESG Impact has been going on for a long time in various different stripes. So you've had funds that seek to pursue certain either environmental goals like a lower carbon world or preserve forests. Those have existed for quite some time, especially in Europe. 

The newest category that really has just been called into the existence by the SEC is this ESG-focused strategy. And that's kind of been there lurking in the background, but it's never had a name, at least, like this. And I think that this is an area where, through the comment process, I think we're going to have a lot of industry feedback about whether they've gotten this name and category right because it's fairly expansive. It includes some things that it may not be meaning to include, specifically like faith-based investing are really any fund that employs an ESG-related screen appears to be included in the definition of ESG-focused fund. And that may have some corollary impacts for being a little over inclusive. And so that's something that I think that I know I'm interested in seeing what the comment file reveals on how people think about this new category.

Esther Whieldon: I ask Lance how the SEC's proposal to require emissions disclosures from certain environmentally focused funds fits into the agency's broader efforts to provide transparency to ESG funds. As a quick primer on some of the terms you'll hear in this clip, Scope 1 emissions or direct emissions from a company's operations, Scope 2 emissions are indirect emissions. Those are primarily derived from purchased energy. And lastly, there's Scope 3 emissions. Those occur up and down the company supply chain as well as when a customer uses the products. Okay. Let's turn back to Lance.

Lance Dial: So this is one that I have a problem with or, at least, I have concerns about, I should say. So if you are an ESG-focused fund that incorporates environmental concerns and specifically carbon emissions into your management, then you need to disclose in your annual report various complicated metrics of GHG emissions, either at a portfolio level or a weighted average carbon intensity actually -- you have to do both.

That's a heavy lift. And I don't want to minimize that because I think it's such a heavy lift that it might discourage people from launching these sorts of products or maintaining these sorts of products. And it's also really hand-in-hand with the recent issuer proposal on climate risk, which also would require issuers of public securities to disclose their carbon emissions in Scope 1, 2 and, if material, Scope 3.

These 2 go hand-in-hand because that proposal becoming a final rule and complied with by issuers is very important, if not, absolutely critical for funds to be able to make this reporting. But assuming that becomes the case, then any fund that has an environmental or certainly a climate change aware investment strategy as an ESG-focused fund will need to make these GHG emissions reports.

And I worry about the opposite side. So what happens if you're an ESG-focused fund? And your portfolio manager decides to buy or not buy an issuer on the basis of their carbon emissions? Does that mean you now have to start including these GHG disclosures? Or does that mean your portfolio manager can't consider carbon emissions when making an investment because you haven't made these disclosures?

This is one of the artifacts that I find challenging coming out of the fact that they've keyed the definitions on the investments of the fund and the investment process as opposed to how the fund is positioned. And I'll contrast that with what you have in Europe with SFDR, where it's whether or not a product promotes a sustainable objective. And it doesn't get into bucketing based on whether or not an investment was motivated by a certain rationale, which is very subjective and challenging to prove.

Esther Whieldon: So if I understand right, what you're saying is it could potentially create some big uncertainties about when you have to start disclosing, if you're going to consider carbon at all, right? Like if you didn't disclose it in the last year, do you have to immediately start disclosing it, if you start then considering it? Like how do you handle that? Yes.

Lance Dial: Exactly. And this theme goes through the rule. So I had a portfolio manager asked me the other day, says, "I run a fund, and it's not an ESG fund. I just have a standard non-ESG strategy. And I'm not looking to be ESG integration, I'm not looking to do any of this stuff. My fund -- I have my philosophy and process, and I've been following it for years, and it's perfectly fine."

"But if I wake up one morning and I make an investment decision because I don't like how a company is being run by senior management, did I just become an ESG integration fund because I considered an ESG factor, alongside other factors when making an investment decision? Have I now moved into this category and now is my disclosure in division?"

And I don't have a great answer for that under the proposal because, again, this proposal is tied to the investment rationale and not the overall characteristics and positioning of the fund, which I think creates again, as I said, a lot of -- I think, unintended consequences. 

Like faith-based investing. That has not necessarily been considered a ESG fund. But now I've had at least one faith-based adviser talk to me and say, "Hey, are we now an ESG fund? That's not at all what we thought we were before this rule proposal came out." And so it's going to grab some people who make investments based on certain social considerations into this group unless it's amended in some way. And I'm not actually sure how you do that.

But I think that the SEC has come up with a very clear delineation among these 3 strategies or what they think is a clear delineation. But when you actually apply that to practice, it's much more murky than I think they anticipated. And so again, I'm looking forward to seeing the comment file with some examples from issuers of products that will kind of weave between strategies as they move along.

Esther Whieldon: We heard Lance say in that last clip that some components of the rule could prove confusing to interpret. He used the term murky. Lance also cited some potential concerns with the agency's focus on greenhouse gas emissions. In fact, the greenhouse gas emissions component of the fund disclosure rule came up in all 3 of my interviews for this episode. For example, here's what Aniket Shah of Jefferies had to say.

Aniket Shah: There is a general misunderstanding in the world, I would say, about decarbonizing one's portfolio versus decarbonizing the world. And those of us in the industry in capital markets should, I think, understand the two. But to be honest, I come across many well-intentioned people who don't understand that distinction.

If you don't have a high fossil fuel exposed portfolio, it means very little in terms of whether the world is emitting a lot of fossil fuels because you can simply divest your assets, your hydrocarbon stocks and bonds to somebody else.Or the companies in your portfolio, which might be hydrocarbon-intensive, might actually just divest their underlying assets to private equity or to other private nonpublicly traded stocks.

So people who have low-carbon portfolios are not necessarily driving for a low-carbon world. It means they just don't have exposure to high-carbon companies. Our general take is that the push for portfolio-level carbon intensity measurement might actually further confuse folks or it might lead to significant divestment. And divestment is all well and good, it has its role, but it won't lead to the decarbonization that you might think the world is heading towards. And it also won't -- you will have periods of significant underperformance when fossil fuel assets go up like we're currently living through right now.

Esther Whieldon: You kind of hit at this. And I think it would be worth exploring a tiny bit more, which is how will this potentially impact the divest versus engage debate?

Aniket Shah: I think that the divest versus engagement debate will be significantly impacted if there is a lot of interest in the ESG-focused funds, which is, as you know, one of the 3 categorizations that the SEC is proposing. It's ESG Integrated, ESG Focused and that Impact. If you are calling yourself an ESG-focused fund, then you will have to disclose your weighted average carbon intensity measurement.

Or according to this proposal, you may have to disclose that. And if that's the case, then I think over time, it will be hard to call yourself a ESG Focused Fund and have high and potentially growing weighted average carbon intensity of your portfolio. In other words, if you call yourself an ESG Focused Fund, you will then have to -- you will have some -- eventually forced to divest from your hydrocarbon or high greenhouse gas emitting assets.

Which we think is a slightly unfortunate outcome because it just -- I don't think it achieves very much. If the fund management community decides, you know what, being an ESG Integrated Fund, I mean, the first of those 3 designations is enough, then I don't think there's going to be a significant impact on the divest versus engaged debate because that one metric is not going to be overly emphasized.

My guess, Esther, is that, that is where we end up in the U.S. in particular. A lot more comfort saying that you're ESG Integrated and then a much higher bar to be ESG Focused. And I think ESG Integration is actually what the end goal of this project should be. So I actually -- with that logic, I don't think it's going to have a big impact on -- or a big force on divestment, unless the asset owner community really pushes for ESG Focused Funds, in which case I think it may.

Lindsey Hall: As we've heard in this episode, the SEC's rule making is happening as other parts of the world work on their own sustainable finance regulations. I asked as George Raine, the lawyer from Ropes & Gray, how the SEC's rule making might interplay with other regulations, such as the SFDR. Here's his answer.

George Raine: Well, the SEC is certainly aware of that this is going on globally, and they certainly are cognizant that they're stepping into the ring here, where other regulatory regimes are also placing a similar focus or a similarly significant focus on matters of ESG investing. That said, I think the SEC is not -- does not feel it needs to be creating a framework that interlocks perfectly.

There's a very clear notion that the SEC's mandate is different, and it's -- than maybe other regulators might be. And a real sense that they've got -- they're concerned with protecting the American public, in context of how the industry is developing in the United States. So while there are -- there's a definite nod to what's going on globally, the real focus from the SEC is investor protection and providing appropriate choice and appropriate context for U.S. investors.

So if you try to think about how this is going to work for global managers, it actually could be really quite complicated once we get into the weeds. A good example being the SFDR, as the -S indicates is about sustainable investing, right, sustainable finance. And sustainability has a definition, and as a concept, at least is sort of a direct focus on that regulation.

By contrast, the ESG requirements really go to E and/or S and/or G and therein lies a certain complexity and problem. But none of those environmental, social or governance considerations is defined. The SEC has asked, should they define the terms. We can certainly talk about whether that's a good idea or a bad idea, be careful about you wish for, but those are not defined.

Yet managers will have to consider each of those separately and all of them together, which can be easy in some cases but for many managers can cause complexity. It's not just running along one metric of sustainability, say, which is itself a complex concept, but rather you might have a manager that is focused on governance and doesn't really think of that as an ESG category. But if they really think that good governance is fundamental to the values of stocks.

That's a certain style of investing that probably has a lot of resonance in mainline standard equity stock pickers. The -E and the -S get a little more complicated, and might go down more of a different flavor of management that might focus on those more particularly. But when we put them all together, it can create all sorts of pitfalls and complexities as to how you balance, and how you disclose one, but not the others if you're looking at the 3 different factors.

So it's just one example of how, yes, there are 3 categories, much like the SFDR has, but the devil is in the details and how you dig into those each individual factors, it can create a very -- a different dynamic depending on the strategy and the manager and how they're defining and approaching these different aspects of the investment process.

Esther Whieldon: Okay. That's very interesting. And I think I wonder if the SEC decides not to define these terms, which as you said, is sort of like a double-edged sword, depending on what they decide to do there, then could it end up being a default that like an international definition becomes the standard where they don't really get to make that call?

George Raine: So at this stage, I don't think there's going to be a great round of support that folks have confidence that the SEC, giving a definition to what is environmental investing, is going to help move everyone forward. So my guess on the response from the industry is to say, given a prescribed definition for each of these factors is going to create more problems than it's going to solve.

So given that reaction, I would find it hard to see the SEC thinking that it's a good idea to necessarily be more prescriptive. So my guess is they're not going to define it. But that being said, I think one of the better theoretical or principal reasons why they shouldn't define it is that these terms have no consistency of definition.

And they will not have consistency across jurisdictions. They will not have consistency over time. So it is fundamentally a rapidly developing area of investing. It's not an industry per se. It's a lot of different industries. It's a lot of different viewpoints and there are more standard makers out there than you would necessarily need, but this diversity of voice has kind of been a theme over the last years as ESG investing has developed.

And just even landing on a particular term and what it means, what does it mean to be impact? What does it mean to integrate ESG? All of these factors are going to be just changing over time and different managers are fundamentally going to have different approaches. So the -- presumably the SEC's hope here is that, at least, they can create a framework for how managers should package their ESG investing and with the hope that it doesn't overly disrupt the actual investment process. 

One problem you've seen as you have, across jurisdictions, seen regulators trying to impose categories. I think in the case of SFDR, there's a real conviction that what started out as an effort to provide framework for understanding has turned into a marketing exercise. And suddenly, the industry's reaction is to turn around and say, "Well, what do we need to do to qualify for each category? We want to sell into this area, into the style box almost. What do we need to do to be able to justify putting a label of ESG Focus on our fund, for instance, or ESG Integration? What do we need to do?

And what you're going to see is the marketing folks talking to their compliance and legal folks trying to convince them that a particular strategy qualifies for one box or another or can be expanded into a different one. So it's going to create a set of categories, which I think is what the SEC is looking to do, is to create some sort of standardization that people know what they're getting.

The problem being, given the diversity of resources, given the diversity of analytical viewpoints and the diversity of frankly, the diversity of managers' willingness to be strict or a little more loosey-goosey how they meet their categorization requirements, you're going to see a wide range of different strategies falling under a given bucket or a given category. So who knows? You definitely will see managers trying to fit themselves into particular categories that have been created by regulation, I think, is the upshot of what this is going to do.

Lindsey Hall: Given that the SEC rules are still pending, I asked Aniket what asset managers can do right now to get ready.

Aniket Shah: Yes. So the first thing you should -- that the asset management community should do is read these proposals in detail. So I know everyone is short on time, but I would highly recommend taking 1 day off, shutting down your e-mail. Maybe go to a quiet corner office or go to the beach and just go page by page in this rule proposal because it is actually really insightful writing.

The SEC did a lot of work on it. So the first thing is get to understand what is in these proposals. The second thing I would do is I would have a review with your Chief Investment Officer of all of your different funds and within your platform and how they are positioning themselves with regards to ESG. So are they labeled funds? Are they integrated funds? How is ESG in the prospectus? How is ESG mentioned in the marketing materials? 

Just go and take stock of each and every fund and how ESG -- how each of those funds interacts with ESG. That's the second thing I would do. The third thing I would do, if I was in the fund management role, if I was a client of ours right now, is that I would make sure that for any fund that is touching the letters, E, S, G. -- I mean, in their disclosures in their materials, marketing materials, et cetera, start going through and understanding what is the way in which you are documenting how ESG is being integrated into your portfolio. So -- and if you don't have a documentation around that, I would be a little worried. If your colleagues are saying, "Oh, yes, we integrate ESG in our -- in all of our investments."

Okay, show me. Show that to me on a sheet of paper for a Company X in your portfolio. How have you actually integrated these ideas into your decision-making? Not just in terms of did you -- how you bought or sold the stock, but what you did while owning the security. So that whole idea of memorializing or documenting your ESG process, I would spend a lot of time on, number three.

And number four, frankly, is I would spend some time with lawyers. I would pick up the phone and call one of these -- there's now growing ESG practices at all the major law firms, and just get a legal counsel because the SEC is knocking on people's doors. And for most fund managers, they'll be okay. But the big difference from what we have heard and as you know, we've hosted several calls with leading lawyers on this is the difference between now and the past is that the SEC is wanting to talk to the actual investors. It's not just good enough to talk to the Compliance Team or to talk to the ESG Team. They want to talk to the people who are actually buying and selling stocks and saying, "How have you incorporated these ideas that you said you were incorporating?"

Remember, the SEC is about disclosure. So how are you actually documenting and doing what you say that you are doing to your investors? And that's what I would recommend our clients and your clients and listeners to this do.

Esther Whieldon: So as you can hear, Lindsey, there's a lot to unpack in these newly proposed regulations.

Lindsey Hall: That's right, Esther. So please stay tuned as we continue tracking this evolving world of ESG regulation. Thanks so much for listening to this episode of ESG Insider and a special thanks to our producer, Kyle Cangialosi. Please be sure to subscribe to our podcast and sign up for our weekly newsletter, ESG Insider. See you next time.

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