Investing In ESG Funds? 2 Rules You Need To Know

Published on: 30 September 2022
by KnowESG
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In March 2022 the Securities and Exchange Commission (SEC) began actively probing into greenwashing. They did so by outlining broad rules that would force publicly traded companies to disclose how their business will be affected by climate change. By June, the SEC began cracking down, announcing a probe of two Goldman Sachs asset management group’s ESG-aligned mutual funds.

Similar situations have played out, with one example in May being the raid of Deutsche Bank’s DWS Group. In both situations, these happened due to alleged greenwashing. So, for investors looking to get into mutual funds or considering other financial instruments offered by banks, it’s important to know about any recent developments and changes.

While the likelihood of investing in a greenwashed product from a bank will be smaller now - due to the recent raids - there is understandably still speculation when it comes to the viability and future of these products.

And, this all has to do with 2 rules that the SEC created in May, a week before the Deutsche Bank raid in Germany.

The Two Rules

Both rules, proposed in May, were subject to public feedback, and they came around the time when there were mounting concerns over funds seeking to profit from ESG investing by greenwashing investment products. To discourage such concerns, the SEC rules aimed to result in further transparency and clarity in various ESG factors that were considered by the banks. 

1. Proposed ESG Fund Disclosure Rule:  The first rule required more disclosure into the three categories of registered funds that use ESG factors in investment strategies. Those three categories are ESG-integrated, ESG-focussed, and ESG-impact, depending on which one required further disclosure. For example, ESG-focussed funds that claim to consider environmental factors had to include greenhouse gas (GHG) emissions disclosures associated with their portfolios. If the fund doesn’t disclose, then it’s a clear sign they don’t consider GHG emissions as part of their investment strategy.

2. Fund Names Rule: The second rule expanded the scope of the Investment Company Act’s “Names Rule”. This rule is two decades old and states that, if a fund’s name suggests a certain focus, at least 80 percent of the value of its assets should be towards that named focus. This second rule now covers funds with names that suggest investment decisions cover one or more ESG factors, amongst other criteria.

How These Rules Will Help

Overall, these measures should provide more guidance in how ESG funds market their names as well as investment practices. ESG in investing encompasses a wide array of investments and strategies, and given that the Names Rule wasn’t changed after two decades, there wasn’t much protection for investors. What these new changes bring is exactly that, further protection to investors, and it’s a good step forward.

How These Rules Can Hinder

While these developments are important and helpful, it does set the tone for how the industry is moving forward. First of all, the rule changing is helpful, but it doesn’t fully address the problems of banks’ misleading labelling practices. Furthermore, each company will have their own definitions to apply, a recipe for confusion.

While we all have a general understanding of what ‘sustainable’, ‘fossil-free’, ‘low-carbon’, and even ‘ESG’ mean, in practice, each person or company may have slightly different definitions of those terms. And when it comes to investing, banks will have different definitions too. Investors are therefore going to need to know exactly what banks mean by those terms, amongst many others.

And it’s here where you can see the complications. Because, on the one hand, these rules become stricter and encourage more transparency, yet on the other hand they may be a disincentive, that’s to say giving banks pause for reflection on whether to make an ESG fund in the first place.

Another example is the GHG emissions disclosure requirements. Already, there are challenges with accurate carbon measurement within portfolios, and reporting on those challenges may now be worse as a result of these additions.

All this isn’t going to result in ESG-focussed investing being abolished, but these new rules may well result in the development of these products being slowed down. As an investor, this can mean less choice in available investment products and the institutional sense that there isn’t enough traction gained in ESG funds. 

More Regulations, More Challenges

Despite these circumstances, investors remain optimistic. While there are more regulations to come over the coming months - which will change the ESG funding landscape - there are tools and resources that companies have access to now that can assist in decision-making. As ESG ratings are adopted as a more mainstream corporate practice, such voluntary transparency will help to allay investor reluctance in the face of slowdowns.

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