Sustainable investing, like any other hot retail investment trend, is vulnerable to hype. Regulators now are stepping up their efforts to ensure investors are getting what they’re promised from environmental, social and governance (ESG) investments.
When ethical investing was a fringe activity, regulators didn’t have to worry too much about what was going into investment funds that promised green or socially conscious investments. The firms involved in the space were mostly true believers in the cause of responsible investing, and the assets at stake were relatively modest.
However, as ESG investing goes mainstream, it’s become increasingly susceptible to marketing hype designed to drive sales rather than meet investor needs.
This danger has not escaped the attention of regulators. In recent weeks, members of the Canadian Securities Administrators (CSA) — including both the Ontario Securities Commission and the British Columbia Securities Commission — have been reviewing fund managers’ ESG activities to ensure that what they’ve stated in their marketing materials matches what’s in their portfolios.
“The CSA is currently doing a sweep on marketing practices of registrants to monitor their compliance with securities laws,” said Ilana Kelemen, senior advisor, communications and stakeholder relations with the CSA. “We further focused the scope of our review of investment fund managers [to concentrate] on the marketing materials for ESG products and services.”
The results of the CSA’s reviews are expected by end of the third quarter, Kelemen said.
Similar concerns about the ESG activities of portfolio managers and investment advisors were the focus of recent compliance work by the U.S. Securities and Exchange Commission (SEC). That regulator uncovered a variety of issues, including “potentially misleading” communications from firms to investors about ESG investing processes and their adherence to global ESG practices.
The SEC also found firms that had inadequate or inconsistent approaches to implementing both positive and negative portfolio screens; had proxy voting that diverged from stated practices; made baseless or misleading performance claims; or had poor internal controls and compliance programs to adhere to the global ESG standards they claimed to be following.
The SEC also found some funds’ portfolios were heavily populated with companies that carried poor ESG scores despite promising investors the opposite.
Time will tell if the CSA turns up similar issues during its compliance reviews, but regulators around the world are paying more attention to investor protection in the growing sustainable investment market.
Last year, following a review of the sustainable finance sector, the International Organization of Securities Commissions (IOSCO) established a task force to address regulators’ emerging investor-protection concerns in the ESG space. These include inadequate disclosure by issuers and asset-management companies, and so-called “greenwashing” — i.e., firms making overblown or inaccurate claims about the ESG credentials of their investing strategies.
Ensuring that firms provide investors with accurate disclosure is a traditional regulatory priority. In sustainable investing, though, the challenge of ensuring truth in advertising is compounded by a lack of clear, universal standards.
To date, developing more useful ESG disclosure has focused on issuers — encouraging companies to be up front with investors and provide details on the risks they face and the opportunities they see from sustainability trends, such as the shift to a low-carbon economy. Increasingly, though, regulators are turning their attention to the representations asset-management companies and advisors make to investors about their ESG activities.
The IOSCO task force is slated to publish a report on issuer disclosure by the end of June, and plans to release reports on disclosure by asset-management companies (including greenwashing), ESG ratings and data providers by the end of 2021.
In the meantime, some regulators are introducing reporting requirements specifically focused on sustainability. On March 10, rules took effect in the European Union that require fund portfolio managers to classify their funds into one of three categories based on sustainability content.
According to a review by Morningstar Inc., the EU’s initial classification efforts revealed that about 25% of the overall European fund market qualifies as having some sustainability component under the new standards. Morningstar stated its researchers anticipate that 25% will increase “as managers enhance strategies, reclassify funds and launch new ones [to meet the new classification standards].”
In the future, the emerging focus on greenwashing and other ESG-driven investor protection concerns could have implications for investment dealers. But to date, greenwashing at the retail investor level hasn’t been a big concern for the Mutual Fund Dealers Association of Canada, according to Karen McGuinness, senior vice-president, member regulation, compliance.
“We really don’t have a lot of [issues with advisors meeting individual clients’ ESG criteria] in the retail mass market space,” McGuinness said. “We do come across situations where clients have asked not to invest in a particular sector or to invest in particular ESG funds, but it is uncommon.”
The Investment Industry Regulatory Organization of Canada (IIROC) foresees clients’ ESG preferences as a potential suitability consideration, along with risk tolerance and other essential information.
“As the Canadian investing landscape is transforming, ESG may be a relevant part of advice,” IIROC stated. “These are important conversations that advisors should [be], and are, having with their clients.”
Notwithstanding regulators’ growing investor-protection concerns regarding sustainable investing, the supply and demand for it is only increasing — particularly in the wake of the Covid-19 pandemic.
According to data from London-based Refinitiv, global sustainable finance activity reached record levels in both equity and debt issuance in 2020. That momentum has only strengthened this year, hitting record levels in the first quarter as countries prioritize sustainable infrastructure investment as a key catalyst for a post-pandemic economic recovery.
At the same time, the pursuit of superior returns and growing awareness of ESG risks is likely to help drive investor demand for sustainable investments. With ESG investing no longer a niche interest, the mainstream investment industry can expect regulators’ scrutiny to continue to ramp up.