Regulators Gear Up for New World of Ethical Responsibility

Environmental, social, and governance (ESG) considerations are becoming increasingly integral to many investment opportunities. But, what’s driving this change and what’s the regulatory response?

What came first, the chicken or the egg? A similar question could be asked in regards to ESG investing; what came first, a more socially responsible society that wants to tackle environmental issues, pushes for equal rights, and holds businesses accountable for the treatment of employees, or investors placing greater importance on the role of ESG factors in predicting the performance and success of a business?

Whether you believe businesses are merely adopting more moral principles to attract an increasingly ‘woke’ consumer base, or think their attempts to “do the right thing” are genuine, one thing is for sure – investors appear increasingly confident that companies with a strong ESG proposition will protect their interests, and provide a return on investment.

Looking at the annual flows of ESG funds in the U.S. alone, there has been a 10-fold increase from 2018 (US$5.4 billion) to the end of 2020 ($51.1 billion). What may have previously been dismissed as a passing fad is clearly here to stay.

If further evidence is needed, consider the machinations happening within investment behemoth Blackrock. A June 2021 New York Times article reported: “…over the past year, Larry Fink [Blackrock Chairman and CEO] has transformed the place into an ESG cultural center. Fink talks ESG nonstop at company town halls. Seminars on ESG investing seem to take place every week.”

Some of the biggest players on Wall Street have entered the ESG game but, as with any rapidly emerging trend in the world of finance, there’s still much to be understood, defined, and regulated when it comes to ESG investing.

What Is ESG Investing?

ESG investing considers environmental, social, and/or governance factors in addition to more traditional financial analysis and performance.

The Environmental component may focus on a company’s energy use, carbon footprint, or pollution output. It may also focus on the risks and opportunities associated with the impacts of climate change on the company, its business, and the wider industry.

The Social factors may include the company’s relationship with people and society – for example, issues that impact diversity and inclusion, human rights, the health and safety of employees, customers, and consumers locally and/or globally, or whether the company invests in its community, as well as how such issues are addressed by other companies in a supply chain.

Governance refers to issues relating to how the company is run – for example, transparency and reporting, ethics, compliance, shareholder rights, and the composition and role of the board of directors.

The Regulatory Response To ESG Investing

Regulators are playing catch up in a bid to decide what ESG-related information is material to investors. Until now, investment firms have been able to market and define the standards of ESG funds as they please. 

Typically, these funds include businesses that score well on a range of environmental, social, and/or governance factors alongside more traditional financial factors. However, with no defined framework or scoring system for the myriad of ESG factors, there are little to no assurances for investors other than faith in the investment firms’ research, methodology, and the business disclosures they’re able to draw information from. 

A U.S. Securities and Exchange Commission Risk Alert issued in April 2021 stated, “…the variability and imprecision of industry ESG definitions and terms can create confusion among investors if investment advisers and funds have not clearly and consistently articulated how they define ESG and how they use ESG-related terms, especially when offering products or services to retail investors.”

The Risk Alert followed the news in March 2021 that the SEC had set up an enforcement task force focused solely on ESG issues. Gary Gensler, SEC Chairman said, “I’ve asked staff to propose recommendations for the commission’s consideration on human capital disclosure. This builds on past agency work and could include a number of metrics, such as workforce turnover, skills and development training, compensation, benefits, workforce demographics including diversity, and health and safety.”

While we are waiting to see exactly how ESG factors are defined by the SEC, the disclosures that are required of businesses, and whether a universal framework for the assessment of ESG can be agreed on, there has already been significant political push back.

Although the SEC believes that ESG factors align with the financial success and stability of a company, Republicans have warned the regulator not to impose a requirement for climate risk disclosure, claiming that the regulator is overstepping its bounds.

However, Gensler believes that ESG disclosures are material to investment returns and that everything the SEC asks for doesn’t necessarily have to be “material” to require disclosure.

What The Future May Hold

Taking a look at the ESG scoring methodologies currently used by financial institutions provides insight into what may become the regulatory norm for assessing environmental, social, and governance factors.

MSCI, for example, breaks down each pillar of ESG factors into 10 themes and 35 key issues ranging from carbon emissions to labor management and business ethics. The firm scores businesses against the issues that relate to their industry and by how they manage those risks relative to their peers.