In June, the Securities and Exchange Commission (SEC) revealed that, in addition to its ongoing work developing climate risk disclosure standards, it was considering ‘requirements for investment companies and investment advisers related to environmental, social and governance (ESG) factors, including ESG claims and related disclosures.’ It’s too early to guess just what form those requirements might take, but this blog-post, which expands on my recent article ‘Market Myopia’s Climate Bubble’, highlights some anticipated challenges and paths for future scholarship and debate.
The SEC is responding to growing concerns over ‘greenwashing’ in the investment industry. It’s not clear, for example, just how much funds rebranding as ESG modify their portfolio allocations strategies. But regulating in this area is hard because there’s no easy answer to the question of what an investor is expecting when she signs up for an ESG fund. Is she expecting that the fund is screening for climate-related financial risks, and so will provide better returns due to its resilience in the coming climate chaotic years? Or is she hoping that her investment choice cuts off capital to fossil producing companies and reduces emissions? What about a solar panel company that sources its silicon through forced-labor—does she expect that to be in her ESG portfolio?
What an investor expects should influence the type of ESG fund she chooses. Some funds exclude carbon-intensive industries entirely (resulting in portfolios over-weight in Big Tech). Other funds pick ‘best in class’ ESG performers, investing in fossils but excluding the worst actors. And there are many funds with complex methodologies that rely on inputs from a handful of proprietary ESG data providers. Metrics like these have been critiqued for having no correlation across one another; a company with a high ‘Sustainalytics’ score may be rated poorly by ISS. Perhaps this isn’t a problem—the SEC traditionally isn’t in the business of policing investment methodologies. But these investment methodologies were traditionally carried out by regulated investment advisers rather than unregulated index and metric providers. Further, inconsistency across ESG providers extends beyond methodology to factual information, like annual emissions. The SEC should consider whether the ballooning use of ESG metrics in index construction requires oversight in the service of investor protection.
Recently, voting has become a more important aspect of ESG investing, and asset managers have been criticized for voting shares in lock-step across all fund families, ESG and non-ESG alike—typically against climate proposals. A new exchange traded fund (ETF) from activist hedge fund ‘Engine No. 1’ promises investors to vote shares in accordance with a climate-aligned mandate. One area of potential SEC action is updated disclosure of voting practices, including disclosure of how the fund interprets its ESG voting mandate.
Another area with room for SEC oversight is fund branding. One Vanguard ESG fund was called-out for containing companies like ‘Kinder Morgan’ and ‘Marathon Petroleum’, despite claiming to ‘specifically exclude”’ fossil fuels. This outright deception appears to be of the type easily patrolled by the securities regulator; you can’t lie. But what about the critique that more than one-third of UK funds marketed as climate or low-carbon focused nevertheless contained oil and gas stocks? What counts as ‘low-carbon’—especially now that the appropriate amount of new carbon investments is confirmed to be zero? Should the SEC establish ‘low carbon’ thresholds, and do they have the staff expertise to do this?
Measuring financial asset alignment with climate goals is a tricky business. The now-commonplace emissions accounting of Scope 1, Scope 2, and Scope 3 emissions isn’t granular enough to keep track of financed emissions. If an oil company sells to a refinery that then sells to a gas station that sells to me, how do we divide up responsibility for my car’s CO2 emissions between a shareholder of the oil company and a bond investor in the refinery?
Given the stated expectation of the world’s mega institutional investors that portfolio companies align their business plans with a goal of net-zero emissions by 2050, one of the most important tasks for the SEC is to hold these investors and companies to their net-zero claims. Corporate net-zero goals should be reflected in capital allocation decisions and align with financial disclosures of asset impairments and write-downs. At present, CapEx significantly lags claimed ambitions. Regulators should direct auditors to scrutinize claims about carbon capture potential; Shell’s CEO has a vision of net zero that relies on planting a new rainforest the size of Brazil—where exactly isn’t clear. The carbon offset industry, similarly, deserves regulatory skepticism. Finally, the SEC should crack down on plain and simple fraud in the oil and gas industry.
In this way, getting climate disclosures to be comprehensive and correct at the issuer level is a fundamental step to oversight of fund-level greenwashing. The SEC has its work cut out for it in the months ahead, even with the advantage of learning from its faster-moving European peers.
Madison Condon is an Associate Professor at Boston University School of Law.
This post is part of the series ‘Business Law and the Transition to a Net Zero Carbon Economy’. This series consists mainly of posts summarizing papers presented and presentations made at the 5th Annual Oxford Business Law Blog conference on ‘Business Law and the Transition to a Net Zero Carbon Economy’ which took place online on 25 to 27 May 2021. The recordings are available here. This post is forthcoming in Andreas Engert, Luca Enriques, Georg Ringe, Umakanth Varottil and Thom Wetzer (eds), Business Law and the Transition to a Net Zero Carbon Economy (CH Beck and Hart Publishing 2021) (forthcoming).