Climate change front and center for SEC and President Biden’s infrastructure proposal
The US Securities and Exchange Commission (SEC) joined a series of government agencies and regulators in making climate change and ESG issues a priority. This move by the SEC is consistent with President Joe Biden’s call for a “whole-of-government” approach to addressing climate change, a priority that was also reflected in Biden’s proposed infrastructure plan. Acting SEC Chair Allison Lee announced the creation of the Climate and ESG Task Force led by the deputy director of enforcement. The task force will focus on ESG-related misconduct with two goals:
1) identifying material omissions and misstatements by issuers; and 2) analyzing disclosures and compliance issues by ESG investment managers and strategies.1 The agency has also included climate risk preparedness and ESG (including analyzing whether proxy voting practices align with investor expectations) among its 2021 examination priorities,2 and has appointed a first ever senior policy advisor for climate and ESG.3 Critically, the commission opened a 90-day public comment period requesting input from market participants to inform its views on climate and ESG disclosure. This kicks off a review of a broad swath of SEC guidance on sustainable investing (SI) related issues, ranging from devising a climate and ESG disclosure framework, to reviewing the proxy-voting and shareholder proposal processes making it easier for social or environmental issues to be brought forward for a vote.4
At this stage, it is not clear which regulatory route the agency will take on ESG. Both a mandatory disclosure framework that does not pose realistic expectations, and one that is too lenient, may bring different risks to sustainable investments. While we will monitor these risks, we view the SEC's increased focus on ESG as directionally positive for SI strategies. Investors stand to benefit from increased disclosure from companies, and additional enforcement on ESG investment managers should further increase market confidence in sustainable strategies. The SEC’s increased attention to these topics is consistent with President Biden’s focus on climate change, which features prominently in his proposed infrastructure plan. The plan includes provisions to facilitate climate transition, by proposing support for low-carbon technologies including electric vehicles, developing climate change resilience, and investing in clean water infrastructure.
Issuers that are leaders on disclosure and management of ESG risks and opportunities are likely to face relatively lower adjustment costs from increased scrutiny or disclosure requirements by regulators, and should be more competitively positioned in the face of requirements for additional transparency.
In our view, diversified SI strategies as well as ESG engagement strategies may benefit from improved SI disclosure, a more supportive environment for shareholder engagement, and further scrutiny on SI managers.
President Biden’s proposed infrastructure plan is by no means final. Should it succeed in the current form, the plan would be supportive of several green themes categorized under greentech.
1. SEC, “SEC Announces Enforcement Task Force Focused on Climate and ESG Issues,” March 4, 2021
2. SEC, “SEC Division of Examinations Announces 2021 Examination Priorities,” March 3, 2021
3. SEC, “Satyam Khanna Named Senior Policy Advisor for Climate and ESG,” February 1, 2021
4. SEC, “A Climate for Change: Meeting Investor Demand for Climate and ESG Information at the SEC,” March 15, 2021
EU Sustainable Finance Disclosure Regulation kicks into gear
The EU Sustainable Finance Disclosure Regulation (SFDR) came into force on 10 March. All asset managers and advisers with EU clients now must make ESGrelated disclosures at both product and company level, including reporting a set of metrics showing the negative sustainability impacts of portfolio companies. The goal is to increase transparency on how ESG and sustainability factors are integrated in investment processes to facilitate comparability and enable investors to make informed decisions.
Alongside these enhanced disclosure requirements for all funds, the SFDR introduced two "shades of green" classification for funds labeled sustainable. A "light green" classification is for funds that promote environmental or social characteristics (e.g., ESG Leaders index trackers), while a "dark green" category is for funds that have sustainable investment as a primary objective (e.g., ESG thematic funds, or those with specific environmental targets such as decarbonization). Both categories have to explain exactly how they promote or target sustainable objectives.
The SFDR emphasis is on describing the investment process used by investment managers, but starting in 2022, there will be a requirement for sustainable funds to declare how closely aligned their holdings are to the EU Sustainable Taxonomy. The taxonomy is a framework for investors and corporations to identify which activities are "environmentally sustainable" across six environmental objectives: climate change mitigation; climate change adaptation; protection of water resources; transition to a circular economy; pollution prevention; and protection of biodiversity. Social objectives are not yet covered, and the inclusion of some transition activities such as natural gas is under debate. The taxonomy guidelines put forward an overarching expectation that sustainable strategies meet minimum social and governance standards as well as "do no significant harm" to any of the six environmental objectives.
Overall, we believe that additional transparency on SIlabeled strategies will support the flow of capital to sustainable investments globally. However, the gaps in data and complex administrative burden will be a challenge to many fund managers. Fund managers will be required to classify their funds as "light" or "dark" green based on an interpretation of the SFDR and taxonomy guidance, which may result in an outcome of similar funds being classified differently. And while the regulations currently only apply in the EU, investors and regulators globally are closely watching and starting to develop their own frameworks.
While the increased transparency expectations will help filter the wheat from the chaff in the recent surge in SIlabeled investments, due diligence and specialist advice will remain a critical factor in selection of SI strategies.
Starting this year, every SI-labeled investment product offered to EU investors should come with a standardized set of disclosures that explain why it’s labeled sustainable, what its objectives are, and how it incorporates ESG criteria into the investment process. The disclosures don’t guarantee quality or performance, but should enable better comparison of investment products in an increasingly crowded and potentially confusing marketplace.
The SFDR will also increase pressure on corporations to disclose more standardized ESG data, allowing better insights and management of portfolio risks. Nevertheless, investors will still need to be able to interpret the information in order to assess the financial materiality of the additional sustainability information and to identify products that meet their personal preference. ESG Leaders-type strategies address a broad range of sustainability topics, including the "S" and "G." They may therefore score lower on "taxonomy alignment" than an ESG thematic strategy that focuses exclusively on environmental products and services.
ESG engagement-type strategies could also have relatively low taxonomy alignment, depending on the issues they choose to engage with companies on, but in our view still represent the best source of investordriven impact in public markets.
Active ownership in 2021: social justice and a focus on engagement
In the coming weeks, investors will (virtually) gather at thousands of annual general meetings across the globe. This time of year, dubbed “proxy season,” is when most publicly listed companies hold shareholder meetings. Investors will have a chance to voice their opinion and vote on proposals brought forward by management and other shareholders.
The 2021 proxy season is shaping up to be one dominated by social issues. After a year in which racial inequality and political involvement came into the spotlight, investors are assessing how the companies they invest in factor into these social equations. Consequently, this proxy season is likely to focus more than ever on companies’ contributions to politicians, lobbying efforts, racial equity audits, and diversity in boards. For example, shareholders have brought forward proposals to conduct racial equity audits at six systemically important banks in the United States. While support for socially conscious proposals is often limited, developments in the past year may drive support up.5
Voting at annual general meetings is a direct way for investors to make their voices heard and is an integral part of being an active owner. As management provides voting guidance for each ballot item, a vote with or against this guidance is a reflection of the trust investors have in management. While voting proxies is a critical way of expressing investor attention to ESG issues, it is often a measure of last resort. In our view, long-term engagement with management to drive measurable improvement on disclosure or operational performance on environmental or social issues is a way for investors to drive positive impact. If engagement fails to yield satisfactory results, investors can use their vote to force change, or to block a director’s nomination to the board. Fewer than 15% of shareholder proposals related to environmental and social issues received majority support in 2020, indicating that investors may want to continue engagements behind closed doors.6
Investors can demand and push for additional corporate disclosure based on commonly utilized frameworks (for example, the Task Force on Climate Related Disclosures [TCFD] or the Sustainability Accounting Standards Board [SASB]). These issues are frequently raised for large-cap companies, especially in the United States. Beyond asking for more standardized disclosures, engagement strategies can help accelerate a change in a company’s strategic and operational direction. To achieve consequential change at large companies, investors likely have to coordinate for their voice to be meaningful. Such coordinated engagements are becoming more commonplace, for example through organizations such as ClimateAction100+. In 2020, joint engagement efforts led to oil-major Royal Dutch Shell announcing plans to be net-zero by 2050 or sooner.7 As a result of these coordinated engagement efforts, we may see fewer proposals related to climate change at this year’s annual general meetings, as companies opt to adopt new policies without putting them to a vote.
Voting is the most accessible way for investors to drive change within organizations. Shareholder proposals that are brought to a vote are those issues that are most important to investors—this year addressing social inequalities and political involvement.
Engagement strategies can be used to be a part of the solution; rather than avoiding investing in companies with poor business practices, engagement strategies actively pursue them and push for (strategic) changes.
Not all engagement strategies are created equally; achieving structural change in the corporate sector will require support from a wide range of investors. We find that the most intentional ESG engagement strategies often focus on small- and mid-cap companies because of higher success rates of engagement. Investors should be conscious of the intentionality behind engagements, as well as transparency around the strategy’s goals and progress on engagements.
5. GlassLewis, “2020 Proxy Season Review of Shareholder Proposals,” September 2020
6. ShareAction, “Voting Matters 2020,” December 2020
7. ClimateAction, “Shell announces net zero ambition for 2050,” April 2020