SEC addresses ‘truth in labeling’ for ESG ratings

The SEC’s Asset Management Advisory Committee is considering possible recommendations on ESG investments, including a regime of strong intervention in the market to ensure investments are living up to their claims.

The Securities and Exchange Commission is broadening its initial objective on third-party ESG ratings to address “truth in labeling” and concerns around “greenwashing,” the Commission’s Asset Management Advisory Committee (AMAC) said on Wednesday.

AMAC aims to address “truth in labeling” and concerns around “greenwashing,” according to a presentation of a September committee meeting.

This represents an expansion of its initial objective, which is to provide recommendations for how and whether to suggest or require the use of third-party ESG ratings systems and benchmarks for investment portfolios that brand themselves as ESG, the presentation said.

The committee will give its final recommendations in December.

The committee may also recommend that managers include performance attributions that demonstrate how the disclosed ESG practices affect returns.

Private Funds CFO recently reported that ESG ratings firms are already dipping into private markets. The firms are regularly used to verify the claims made by issuers of ESG and ‘green’ bonds.

The committee set out a spectrum of potential recommendations that its members are considering before the SEC issues official guidance in December.

Option one: Do nothing

The first potential recommendation is that the SEC require little or no change to current disclosure requirements for ESG funds, the presentation said.

This option offers low cost for managers and allows continued development in the field to flourish on its own. The Commission could also walk away without being accused of holding this asset class to an arbitrarily higher standard than others.

But by doing nothing, the potential for misrepresentation in ESG scoring will persist and it will be difficult to distinguish between strategies of varying quality, the presentation slideshow added.

Option two: Moderate intervention

AMAC could also recommend that the Commission provide best practice guidelines for ESG fund disclosure, detailing an investment process for managers to follow that likely standardizes on ICI-recommended taxonomy, the presentation said.

Fund disclosure best practices issued by the Commission could be introduced at low cost to managers and offers better comparability and consistency, while still allowing for the ESG rating field to develop and permitting a variety of different styles in charting an ESG strategy.

But the voluntary nature could lead to selective disclosures by managers, and without mandated definitions, comparability could be misleading, AMAC added.

Option 3: Strong intervention

This option would “require funds claiming [to be] ESG to have a higher ESG score than their benchmark from a [nationally recognized statistical rating organization] for ESG,” the presentation said.

If the Commission were to develop a strong intervention regime on ESG ratings, it could promote a consistent, measurable approach to ESG investing. It also has the benefit of being easier to put in place than an enhanced issuer disclosure regime.

But strong intervention could lead to higher costs for managers. There may also not be enough NRSROs to handle such a regime, which could limit future development in the rating field. If, on the other hand, there are too many, then comparability suffers. Rating approaches differ significantly between firms, AMAC said.

Option 4: Fund disclosure taxonomy detail

The fourth and final potential recommendation from the Commission details the possibility of enhanced fund disclosure using common language from the Investment Company Institute (ICI) taxonomy. This would require firms to detail with specificity how a fund achieves its ESG strategy, whether the fund includes securities or not and whether the fund uses qualitative or quantitative third-party scoring systems, or a combination of both.

“Having a fund board approve the disclosure might add an extra quality control,” AMAC said. The committee may also recommend that managers include performance attributions that demonstrate how the disclosed ESG practices affect returns.