Over the past year, there has been a flurry of activity from regulators and standard setters globally on the topic of responsible investment product disclosure across asset classes. How do local ESG regulatory developments across North America and Europe impact institutional investors globally, including in Canada?
In May 2022 the U.S. Securities and Exchange Commission (SEC) proposed two rule changes related to investor ESG disclosures. The first proposed three ESG-related fund categories, ESG Integration Funds, ESG-Focused Funds and Impact Funds, with layered disclosure requirements. Essentially, the greater a fund’s purported focus on ESG, the greater the disclosure requirements.
The SEC defines an ESG Integration Fund as one that considers one or more ESG factors alongside non-ESG factors in its investment decision-making. In the case of an ESG Integration Fund, ESG factors need not be more significant than other factors considered and thus need not be determinative. An ESG-Focused Fund, on the other hand, would focus on one or more ESG issues as a main consideration in selecting investments or engaging with investee companies. An Impact Fund is an ESG-Focused Fund that also seeks to achieve specific ESG impact(s) or outcomes. The following table summarizes the key disclosures proposed for each fund classification.
Key Proposed SEC ESG Disclosures by Fund Category
ESG Integration Funds
– Describe how the Fund incorporates ESG factors into its investment selection process.
– Funds that consider GHG emissions would be required to disclose the Fund’s emissions.
– Provide concise disclosure in a standard tabular format specifying which responsible investment activities the Fund engages in (e.g., tracks an ESG index, applies an exclusionary or inclusionary screen, seeks to achieve a specific impact, proxy voting, engagement with issuers).
– Describe how the Fund incorporates ESG factors in its investment decisions.
– Describe how the Fund votes proxies and/or engages with companies on ESG issues.
– Provide all the disclosures required for ESG-Focused Funds.
– Provide an overview of the impact(s) the Fund is seeking to achieve.
– Describe how the Fund measures progress towards specific impact, including KPIs.
– Provide the time horizon the Fund uses to analyze progress.
– Describe the relationship between the impact the fund is seeking and financial returns.
The SEC has also issued a proposal to modernize the existing “Names Rule,” making ESG-related fund names subject to the existing “80% requirement,” which states that if a fund’s name suggests it has a particular focus, 80% of the value of the assets in the fund must be consistent with the name.
Alongside the newly proposed rules, the SEC has also stepped up enforcement action against managers who have failed to consistently follow their own ESG policies and procedures.
The EU’s ESG fund disclosure and categorization rules have already come into effect. The Sustainable Finance Disclosure Regulation (SFDR) requires financial market participants to categorize ESG-related funds and provide significant disclosure at the product level. Similar to the SEC’s proposal, the SFDR created three fund categories: Article 6 funds, which may or may not take into account sustainability risks; Article 8 funds, which “promote” environmental or social characteristics; and Article 9 funds, which have sustainable investment as a formal objective.
Article 9 funds can be considered as impact funds, because SFDR stipulates that sustainability must be a formal objective alongside, and not subordinate to, financial considerations. The definition of Article 8 funds is far less clear as the EU has yet to provide comprehensive guidance on what constitutes “promoting” environmental or social characteristics in the context of an investment. However, there is some clarity on what Article 8 funds are not: 2021 guidance published by the European Supervisory Authority confirmed that ESG integration alone does not qualify a fund for Article 8 status. SFDR also requires disclosure of “principal adverse impacts” (PAIs) – a set of indicators for negative sustainability impacts associated with investments – on a comply or explain basis. This poses a significant challenge for investment managers since they are expected to aggregate PAI data for investments globally and many issuers do not yet disclose all the relevant information.
Overall, SFDR poses many challenges for investors because, while it has already come partially into effect, the reporting requirements are complex and, in many cases, still murky. These challenges are exacerbated by phased implementation with moving deadlines. With its many unclear categories and acronyms, and with apologies for the mixing of metaphors, SFDR has emerged as an order of alphabet soup, delivered late, in a cart that has been put before the horse.
Prior to the SEC putting forward its proposed rule changes, in November 2021 the CFA Institute, an important international standard setter in the asset management industry, published voluntary global standards for disclosing how an investment product considers ESG issues. While less specific than the SEC’s proposal and SFDR, the guidelines are nevertheless quite comprehensive, with expectations for managers to disclose information such as how a product’s investment process identifies financially material ESG information, any ESG-related targets, stewardship activities and how they are relevant to the investment process and, if applicable, how impact is measured and under what time horizon the impact is expected to be attained.
There has been a more muted response from Canadian regulators. In January 2022 the Canadian Securities Administrators (CSA) issued guidance based on existing, general investment fund disclosure rules, clarifying how these rules should be applied to ESG-related considerations for investment products. The key message was that marketing materials and fund names must be consistent with a fund’s formal objectives.
Comparison of ESG Investment Fund Disclosure Regimes
New rules or standards?
Specific and clear standards?
Directly addresses impact investing?
The CSA’s guidance is arguably weaker than the provisions published or proposed by the SEC, EU and CFA Institute. Firstly, the CSA has not introduced any new ESG-specific disclosure requirements or expectations. Secondly, the CSA has not provided a framework for product categorization and required disclosures based on those categorizations. Finally, the CSA guidance does not specifically address the rapidly-expanding category of impact investing.
But even without enhanced local ESG fund disclosure requirements, Canadian and global institutional investors won’t be off the hook. They can be affected by regulations and standards enacted in other markets in three ways:
Rules and standards enacted in local markets are likely to drive best practices globally and increase asset management client expectations more generally.
Products launched or marketed by Canadian and international asset managers into the EU, and potentially in the future the U.S., may be subject to local disclosure rules.
If money is managed for clients in markets with enhanced fund disclosure rules and standards, these clients may request assistance from their international managers in assembling the information necessary to make disclosures. This is already impacting Canadian sub-advisors of EU investors that are subject to SFDR, and proposed SEC rules could have the same result for sub-advisors of U.S. investors that fall under the scope of the regulation.
Issuers may wish to take note as well. As pressure increases on asset managers, companies may in turn experience increased pressure for greater ESG disclosure from their investors.
How Should Investors Respond?
When it comes to cross-jurisdictional investment, faced with fast-paced regulatory changes and complex local disclosure requirements, it is important that asset managers do their homework and ensure they have access to both the global ESG and responsible investment expertise and the specialist local legal advice that will allow them to win international mandates and stay on the right side of fund disclosure regulation.