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So-called greenwashing by asset managers misleads investors by labeling products with false claims of environmental, social and governance (ESG) benefits. But the SEC’s initiative to restrain this malpractice falls short because it does not distinguish between risk- and ethics-driven ESG products.
For all the challenges ESG investing faced in the past year – from pushback by large institutional investors to anti-ESG legislation in certain states – one bright spot was increased attention to greenwashing by U.S. regulators. The SEC introduced several new initiatives in 2022 designed to increase transparency and disclosures around ESG. For investors skeptical of the greenwashing that has discounted the ESG movement, this new government regulation is a strong force for good in helping advisors and their clients regain trust.
One of these recent initiatives included an SEC proposal that would provide structure around the use of ESG labels in investment products and strategies. More specifically, it would regulate funds and advisors claiming to achieve a precise ESG impact and require them to describe the specific goals they seek to achieve and summarize their progress. According to SEC Chair Gary Gensler, “This gets to the heart of the SEC’s mission to protect investors, allowing them to allocate their capital efficiently and meet their needs.”
The proposal has the potential to create labels and require disclosures that ultimately provide clarity to investors, but the main issue is that it fails to make the distinction for investors about the why. Is the fund investing in ESG to minimize business risk for financial outperformance (business risk-driven) or to support the companies that are changing humanity for the better (ethics-driven)? Without this important distinction, investors with ethical concerns may be duped into investing in ESG products that only aim to minimize risks for financial reasons versus doing the right thing. This results in a critical mismatch between the goals of the fund and the investor.
The issue of labeling
This issue of labeling and marketing is particularly critical to combatting greenwashing. There are simply too many firms claiming they’ve put in the work to identify sustainable companies without having the methodology to back it up. As such, I am supportive of the government’s efforts to restrict bad actors in this space as sustainable fund products expand to meet investor demand.
But this proposal does not go far enough in creating change due to one key flaw.
Investors don’t just need effective labels, but rather more context as to how different issues are being weighted in a portfolio. For example, a business risk-driven fund may label a company that moves its factory from the coast to the mountains as earning an improved “E” score because its factory is now less likely to be flooded because of climate change. However, an investor who prioritizes “E” issues for ethical reasons would want to invest more in companies that are trying to mitigate climate change itself – not specifically in those companies that are merely preparing for its impact on their business.
The importance of labeling distinctions
If the SEC were to mandate a labeling distinction between business risk-driven and ethics-driven strategies, investors and their advisors who come to the ESG space for moral, humanitarian, or ethical reasons would be able to subdivide the world more easily into the set of strategies that interest them. Likewise, other investors who are simply seeking profits in a strategy that mitigates ESG risks would be similarly well-informed.
There are also important advertising implications from this distinction. Funds that are business risk-driven, which exclusively incorporate ESG issues/risks that are “financially material” in their analysis, should be more clearly advertising that they work to avoid business risks stemming from ESG issues with this portfolio. They should not be advertising that they will invest in more ethical firms, or align their portfolio with the values of their investor clients. On the contrary, these funds may need a warning label that they are not simply trying to invest in ethical companies.
Looking ahead
Investors deserve to know the kind of strategy in which they are investing. Government regulation is only part of the solution. Advisors can be a key resource in evaluating different ESG strategies. The SEC can do its part by revising the proposal to reflect this critical distinction in ESG strategies.
James Katz is founder and CEO of Humankind Investments, a sustainable and quantitative asset manager focused on socially responsible investing. He is also a CFA charterholder.
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Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.