Commentary

Why the SEC’s Proposed Rules Won’t Bring the Change we Need

Coleen Scott, Legal and Policy Associate, Inclusive Development International, calls for a fundamental reform of ESG ratings, indexes and investing apparatus.

Earlier this year, my colleagues at Inclusive Development International published an investigation that revealed a staggering figure: more than US$13 billion of ESG-labeled investments have gone to companies involved in arming, funding and legitimising the brutal military regime in Myanmar.

As shocking and disturbing as that is, it is not an anomaly.

That report is part of a growing body of evidence that the ESG investing industry is misleading investors with false promises about “aligning their values with their fund selections.” Case in point –

that quote was pulled from marketing materials for Vanguard’s ESG funds, which, according to a recent report, have invested billions of dollars in companies with poor social and environmental records. I doubt those investments “align” with the values of those of us truly wishing to invest our savings ethically.

Allowing funds to market themselves as sustainable or ESG-friendly while their portfolios are riddled with companies that contribute to adverse human rights and environmental impacts does more than direct undeserved “responsible investment” to harmful corporations—it undermines efforts to hold those corporate offenders accountable.

Shedding light on a black box

Two new rules proposed by the US Securities and Exchange Commission aim to tackle this issue by requiring funds to disclose additional information about their ESG methodologies and by restricting the use of misleading ESG labels in fund names.

These new measures would shed much-needed light on the black box that is ESG investing today and introduce basic safeguards against false advertising of funds, but they won’t bring an end to rampant ESG greenwashing. That will require a much more fundamental reform of the ESG investing apparatus – including ESG-labeled funds themselves, but also the index providers and research and data firms whose flawed methods underpin this broken system.

First, the SEC must go beyond a disclosure-based framework, which simply compels investment advisors to share information about their ESG strategies but does little to ensure that those strategies meaningfully advance responsible investment goals, that they are aligned with international human rights standards or that they capture a company’s actual impact on society and the environment. Under the current proposals, an ESG-labeled fund can invest in any company that meets that fund’s self-determined criteria, no matter how ineffective those criteria are for assessing ESG-related practices or outcomes (financially material or otherwise) and even if that company has a dismal record on one or more ESG issues. Under the proposed rules, ESG-labeled funds could continue investing in companies known to be enabling genocide and crimes against humanity in Myanmar as long as loopholes in their ESG criteria allow it, and it would be left to retail investors to investigate and find fault with those criteria.

Broader oversight

Instead, the SEC should develop a clear and consistent standard for what ESG is and isn’t. Otherwise, there is no way to ensure ESG funds invest in companies that act responsibly and ethically, as consumers would reasonably assume. This would align with the European Commission’s approach in developing its taxonomy for sustainable activities.

The SEC should broaden its oversight to include third-party ESG data providers, including the firms that develop and maintain the ratings and indexes that most ESG funds track to build their portfolios. As purveyors of the underlying information that so many ESG funds are based on, ESG ratings firms and index providers wield enormous influence over investment allocation decisions. In many ways, the ESG industry’s systemic issues originate with the flawed practices of these actors (something we explore in more detail in the Myanmar report). But they aren’t subject to any specific, tailored regulatory oversight, so have absolute freedom to define criteria and adopt their own methodologies. The SEC should heed recent calls by the International Organisation of Securities Commissions, and follow in the footsteps of regulatory bodies in the EU and UK, to expand its mandate and regulate these entities.

The SEC should prohibit any ESG fund from relying on amalgamated ESG ratings, which conflate and obfuscate human rights risks and impacts. It is common practice for ratings agencies to combine E, S and G scores to produce a single ESG rating, which means a company with a terrible human rights record – for instance, one that caused a humanitarian crisis and mass displacement – can save its ESG score by announcing a net zero emissions goal, landing it on key ESG indexes and securing its inclusion in ESG funds. That has to stop.

Assessing impact

Finally, the SEC should follow the lead of European regulators and adopt a double materiality standard for disclosure and consideration of ESG-related risks. That means requiring asset managers and investment advisors to assess the impact of a portfolio company’s practices on society and the environment, independent of its impact on the company’s financial performance. Under this standard a company’s actual emissions, its impacts on the environment and its treatment of employees, consumers and local communities would determine its inclusion in an ESG fund—and not just how those factors affect its value or bottom line. Adopting a double materiality standard that explicitly reflects the interests of ESG investors – and helps prevent them from being misled – is crucial to upholding the SEC’s mandate.

The SEC has a critical role to play in reforming the ESG industry and protecting investors from misleading ESG greenwashing claims. The commission’s proposed rules are extremely welcome and encouraging, but a lot more is needed to ensure that ESG-labeled funds stop investing in companies implicated in human rights abuses, environmental harms, corruption and other serious societal harms.

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