Earlier today, the Securities and Exchange Commission (“SEC”) held an open virtual meeting with the Asset Management Advisory Committee to discuss the impact of the coronavirus (“COVID-19”) and, in particular, to hear updates and recommendations from its subcommittee on ESG (the “ESG Subcommittee”).  The ESG Subcommittee provided an overview of its current areas of research, which has taken the form of five separate workstreams.  Moreover, the ESG Subcommittee offered preliminary recommendations for regulatory measures which could provide consistency to ESG investment policies and disclosures in light of the growing push by asset management stakeholders to implement ESG practices, which has become a particularly important consideration in light of COVID-19.

After opening remarks from Chairman Clayton, Commissioners Peirce and Lee, Director of the Division of Investment Management Dalia Blass, and Committee Chairman Ed Bernard, the SEC heard from the ESG Subcommittee as each member provided a high-level overview of its workstreams.  While research and data-collection within each workstream remains ongoing, the ESG Subcommittee, led by Michelle McCarthy Beck of TIAA Financial Solutions, noted its plan to provide more definitive research and recommendations on ESG regulations in the asset management space by the end of 2020.

  • Workstream 1: Whether ESG is about “values” or “value”
    • ESG Subcommittee Member: Rich Hall, University of Texas/Texas A&M Investment Management Co.
    • Determining the Appropriate Outlook of ESG Policies.  Mr. Hall, who is leading this particular workstream, was not present at the meeting this morning, but Ms. Beck described that the scope on his behalf.  Mr. Hall aims to provide recommendations concerning whether the focus of ESG policies should be on “values” or the “value”.  If asset managers and/or investors consider their ESG focus to be on ESG “values”, then ESG would predominately focus on consumer choices to participate in investments that align with their environmental or social preferences.  In a “values” context, the “ingredients of the fund” and the types of investments chosen based on ESG issues matter the most.  Alternatively, if the focus of ESG is on “value”, then ESG investments are primarily driven by financial metrics and how well ESG investments perform.
  • Workstream 2: The considerations in assessing performance of ESG Strategies
    • ESG Subcommittee Member Speaker: Ayo Soe, S&P Dow Jones Indices
    • ESG Performance.  Ms. Soe began her overview of this workstream by noting her research findings that ESG does not detract from financial performance.  She stated that ESG funds and investment strategies have limited downside risk and lower portfolio volatility, which are attractive to investors who want consistent fund performance.  Further, certain data implies that companies which have high ESG scores have, on average, stronger balance sheets and are less volatile.
    • Understanding ESG Returns. Ms. Soe stated that, to better understand how ESG-conscious investments perform, it is important to keep in mind that ESG strategies have come to market over the past five years, during which time several changes have taken place—among them, the decline of energy and the dominance of big technology and healthcare sectors. Ms. Soe will conduct her analysis and develop recommendations based on a consideration of the following factors:
      • the “momentum effect” in ESG, which asks whether flows in ESG funds are the main drivers of performance; and
      • determining whether ESG is a proxy for “quality”, and in particular, whether good corporate governance strategies  result in better financial quality.  In general, Ms. Soe noted that this consideration remains to be fully established and that there is “mixed evidence” on whether good corporate governance policies are indicative of financial quality.  However, Ms. Soe noted that mixed evidence may be due, in part, to the fact that ESG scores do not go very far back in history.
    • Determining the Appropriate Benchmark for Assessing ESG Investments. Ms. Soe noted that assessing ESG performance is currently difficult because there are more than 300 open-ended and exchange-traded ESG funds in the United States.  Moreover, nearly all of these ESG funds have varying investment objectives and different focuses, such as (but are not limited to):
      • thematic objectives, such as gender diversity or clean technology;
      • investments in “best in class” companies, or ESG leaders in the industry; and
      • integrated (with quantitative factors and alpha overlay), optimized with tracking error budgets, i.e., assessing how the statistical expectations fall within normal distributions of return patterns.
    • Developing a Consistent Framework for Assessing Performance.  Ms. Soe concluded her discussion by stating that she believes there is a lack of a well-defined framework describing or assessing how asset managers integrate ESG into their investment processes.  A lack of a well-defined framework makes it difficult to determine how ESG impacts particular asset managers’ performance.  Ms. Soe stated that she believes it necessary to develop ways to compare how different asset managers’ ESG policies perform, and in particular, creating more consistency for:
      • ESG disclosures on how ESG data is used, the expected non-financial outcomes, the alignment of such outcomes with the fund’s objectives, and the degree to which particular elements of ESG (e.g., directly independence, human rights, employee protection, climate change, diversity) are being considered; and
      • benchmarks for assessing ESG investment.
  •  Workstream 3: The consideration for proxy voting in ESG strategies
    • ESG Subcommittee Member Speaker: Jane Carten, Saturna Capital
    • Main Areas of Research for ESG Proxy Voting Practices.  Ms. Carten stated that proxy voting in ESG funds is a topic that has been widely covered by the media and continues to make headlines.  The main questions that Ms. Carten and the ESG Subcommittee are grappling with now, and will continue to research before providing recommendations and analysis at the end of 2020, are listed below.
      • (1) What are funds trying to accomplish in their proxy voting.  In other words, are they trying to help shareholders, help the environment, etc.?
      • (2) What are the potential pitfalls of proxy voting in ESG funds?
      • (3) Who benefits from proxy voting in ESG funds, and who loses?
      • (4) What is the role of proxy advisory firms specifically as proxy voting relates to ESG funds?
        • Is it significant that ESG funds do not always vote the ESG positions that such firms advise?
        • Should the ESG funds themselves be held accountable for proxy voting instead of advisory firms?
        • Is it appropriate to outsource any voting decisions to proxy advisors so long as there are sufficient and adequate rules developed for ESG voting processes or considerations?
      • (5) What should proxy voting practices look like in fund disclosures?  In other words, should funds be required to have more consistent disclosures with respect to ESG proxy voting, or be required to include certain requirements?
  •  Workstream 4: Considering potential enhancements to ESG issuer disclosures
    • ESG Subcommittee Member Speaker: Jeffrey Ptak, Morningstar Research Services
    • Current State of Issuer ESG Disclosures.  Mr. Ptak noted that, at present, there are multiple standards available to issuers in drafting ESG disclosures, as well as many stakeholders, or users of that information, who have different incentives.
    • Opportunities for Meaningful Disclosures.  Mr. Ptak stated that, despite the fact that there are multiple disclosure standards and stakeholders, he believes there are many ways to improve the quality of ESG disclosures among asset management firms.  Specifically, Mr. Ptak recommended improving each of the following elements of an ESG disclosure:
      • comprehensiveness of the disclosure and how detailed it is in describing the ESG policies being pursued. This includes both adequacy of the disclosure and its accuracy in explaining ESG policies;
      • meaningfulness of the disclosure;
      • materiality of the disclosure—that is, whether the disclosure itself is written in a way that would actually impact outcomes, or whether it is written merely as a formality or in boilerplate language; and
      • comparability of the disclosure—that is, creating disclosures that allow for easier comparisons between different issuers.
    •  Objectives in Determining Practices for Appropriate Disclosures.
      • Mr. Ptak noted his desire to uphold comparability and consistency in ESG disclosures in the asset management industry, which he believes are currently lacking.  At present, he believes that fewer than 30% of public companies disclose ESG risks, and that percentage is even smaller for private issuers.
      • Mr. Ptak stated that ESG disclosure should be both backward and forward looking.  In the context of ESG disclosures, he believes that there is more of a backward-looking-only focus, and issuers often appear to “cherry pick” their ESG information for use in marketing materials.  To create a forward-looking focus would mean that issuers provide more comprehensive details in their disclosures about how their pursuit of ESG investment policies will be in investors’ best interests in the long-term.
      • Mr. Ptak also noted that requiring public standards would also require issuers to include hundreds of different types of metrics in their disclosures, which would be difficult for investors to consume in a single disclosure, or compare against other issuers.  Therefore, Mr. Ptak believes that a balance must be struck between standardizing information to investors and simply editing already-existing disclosures.
  • Workstream 5: ESG rating systems and their benchmarks
    • ESG Subcommittee Member Speaker: Michelle McCarthy Beck, TIAA Financial Solutions
    • What are ESG Rating Systems?
      • Ms. Beck described ESG rating systems as being developed by third parties to rate and rank investment portfolios based on their commitment to one or more ESG principles, akin to credit rankings.  Elements of “E”, “S” and “G” may not necessarily be a unit, or investors may not necessarily want data that considers these elements together.  However, ESG rating systems can focus on the individual “E”, “S” or “G” or any combination of those elements.
      • Ms. Beck noted that one interesting thing about rating systems in the ESG context is that information that is used in rating systems is often not available in public documents.  Therefore, Ms. Beck noted that the SEC would likely consider tackling issuer disclosure by regulating the amount and type of rating systems that are needed for ESG disclosures.
    • What role should ESG rating play?
      • Ms. Beck stated that the quality of ESG data has increased in recent years, and there are a number of rating systems that focus only on environmental and/or governance practices.  However, Ms. Beck noted that she believes that ESG disclosures are still fragmented and inconsistent across most sectors.  Moreover, ESG data providers attempt to fill these gaps through estimates and other proprietary processes.
      • Ms. Beck listed several kinds of data used to assess ratings, such as: controversy scores; direct disclosure elements; news sentiments; impact metrics; shareholder and governance engagement data, and other emerging categories, such as proximity to water resource.
    • ESG rating systems have different “philosophical” goals. Ms. Beck concluded her discussion of ESG rating systems by noting that such systems differ in terms of their specific focus.  Some rating systems pay more attention to, or base their ratings on, how companies perform relative to other peers in the same sector, while others focus on how the company performs individually (an “absolute” metric). Other rating systems focus on the financial materiality of the ESG disclosure, while others simply focus on how stakeholders, such as investors, consider the adequacy of the ESG disclosure.
  • ESG Subcommittee Concluding Remarks: Ms. Beck ended the ESG Subcommittee presentation by proposing three questions for the members of the SEC Asset Management Advisory Committee.  She expressed her hope that the members would provide responses so that the ESG Subcommittee can continue its research and provide recommendations on next steps at the end of 2020:
    • What workstreams or questions, if any, are missing that need to be explored?
    • What concerns does the Asset Management Advisory Committee have about potential regulatory responses?
    • What concerns does the Asset Management Advisory Committee have about the way the ESG investment industry currently works?  For instance, what are the positive components of this industry that should be retained, and what are the negative components that should be eliminated?