Loyola University Chicago School of Law, JD 2025
The ethical investor
Environmental, Social, and Governance (“ESG”) are all factors that investors measure when analyzing a company’s sustainability efforts. Environmental responsibility concerns how a company manages their environmental impacts on the planet. This might include carbon emissions, energy consumption, pollution, and renewable energy. Social responsibility includes how companies are developing people and culture as well as their impact within the community. Lastly, governance entails how companies are directed and controlled and whether they hold their leaders accountable. While this has become increasingly important to corporations across America, it has also become important to investors.
Sustainable investing and effective altruism have brought high demand for investment managers to offer ESG products. Investors who invest in an ESG fund are putting their money to work in companies that strive to improve the world through ethical investing. Beyond non-financial investment interests, policies in Europe like the net zero goals of the Paris Accords have further increased demand for ESG. The growth of ESG led to the EU adopting European Sustainability Reporting Standards (“ESRS”) which will require publicly traded and large private companies to report greenhouse gas emissions. The SEC is set to release similar standards for the US in the SEC’s proposed climate disclosure rule.
Investment managers across the country adjusted their products to offer ESG funds. While many investment managers practiced what they preach, some simply have not. Such greenwashing efforts violate financial regulations and fall under the authority of the SEC. The SEC fined Deutsche Bank’s investment subsidiary, DWS, $19 million for materially misleading statements relating to greenwashing in ESG funds. Concerns for greenwashing further led the SEC to respond with important rule changes.
Rule changes in the United States
In tandem to rules directly pertaining to ESG, investment managers must also follow the recently adopted amendments made by the US Securities and Exchange Commission (SEC), to the rule governing fund names (the Names Rule) under the Investment Company Act of 1940. The change comes under Rule 35d-1. The amendments apply to any fund name that includes terms that suggest a focus in investments that have, or investments whose issuers have, “particular characteristics” and will require an 80 percent investment policy for such funds. Thus, if a company has an ESG-related title such as “Clean Energy ETF” with 65 percent of the ETF invested in clean energy, then the Names Rule applies, and the fund would need to increase its investment in clean energy to at least 80 percent. Funds must further adhere to new compliance and reporting requirements.
The names rule will affect ESG when funds use an ESG related title. Environmental, social, and governance (ESG) terms in a fund name will require an 80 percent related investment policy, but ESG terms indicating a portfolio level overlay may not. The amendment to the Names Rule will result in public reporting on Form N-Port which will allow unprecedented access for SEC staff into the funds’ compliance with the Names Rule. The SEC has set a target date for compliance with the Amendments by end of 2025, with smaller entities having an additional six months to comply.
Contenders or pretenders?
The recent changes to ESG rules may reveal bad actors amongst investment managers and corporations. The names rule was amended over a concern that investment managers would name funds with a title related to ESG; however, a substantial portion of the fund would be packed with more profitable non-ESG investments.
While the United States lags behind Europe on ESG awareness, the popularity of ESG’s has seen a surge in interest across America. Google Search Trends data shows that ESG searches have doubled in popularity since 2021. The increased interest caused fund managers and businesses began to market themselves as green-minded companies with ESG products or ESG campaigns.
Environmentalists have expressed concerns that some ESG funds were stuffed with non-environmental investments in order to boost returns. A 2022 study by ESG Book found that ESG funds on average produced 14 percent higher greenhouse gas emissions than traditional funds. The same study also concluded that some ESG funds were actively investing in mining and fossil fuels such as Shell, Exxon Mobile, and BHP Group.
ESG funds often carry higher fees which places pressure on investment managers to create higher than average returns. Investors pay 40 percent higher fees on average for sustainable funds than non-ESG funds. Consequently, the increased pressure to generate strong returns has led to ESG funds investing heavily in non-ESG. The SEC will very likely expose that some ESG funds with the strongest returns do not belong atop the ESG leaderboard. Thus, separating the contenders from the pretenders.
A timely pivot
I believe that demand for ESG will remain high for the foreseeable future. However, it is likely that changes will be necessary to ESG as we know it. As federal reporting requirements and state regulations continue to evolve, the marketplace will continue to evolve as well. It is a time for ESG fund managers to listen to criticism and acknowledge that change is necessary.
The new tone should be about how ESG strategy can be good policy for business and less about being altruistic. This might include investing in an oil and gas company that has shifted its business model into renewable energy. An additional strategy should be to lower the high fees on ESG funds. This will reduce pressure for managers to stuff the fund with non-ESG products that produce sufficient returns.
It is likely that we are at a turning point for ESG investing. But it is also certainly possible that the downfall of ESG will occur with new additional reporting requirements that will increase transparency around the funds. A timely pivot in regulation could improve the ESG investment market and result in its long-term success.