Aug. 16, 2022
August 16, 2022 At one time, businessmen with the sole purpose of increasing personal wealth were the lone participants in the securities game. And while current regulation fulfills this type of investor’s demands, regulation has not accounted for the evolution of an investor’s needs. A significant shift in investor priorities has taken place, but the corresponding revision in regulation needed to meet these new participants’ needs has yet to happen. Therefore, the SEC should begin regulating environmental, social, and governance (ESG) metrics and disclosures, as the SEC is responsible for providing a trustworthy marketplace, and with the substantial growth in socially responsible investing (SRI), the use of ESG metrics has amplified, despite evidence that current ESG material is misleading and unreliable. As the financial marketplace has considerably progressed due to information and participation accessibility via technology, the description of investor has correspondingly diversified. This capitalist reconstruction has ultimately formed a popular investing strategy known as socially responsible investing. To define SRI, The Journal of Cleaner Production states, “SRI can be defined as a strategy through which investors integrate ESG issues to balance financial returns with ethical and sustainable goals (Gangi et al., 2022). To better align financial decisions with personal values, the SRI investor seeks to increase financial wealth through principal-based investments. As this strategy has experienced substantial growth in popularity and is likely to continue on this path, regulation concerning SRI practices is no longer a consideration but a requirement. According to a national poll conducted in 2021 by the business and finance publisher Kiplinger, more than 70% of survey respondents stated ESG factors were either somewhat important or very important to them when making investment decisions (Kiplinger Personal Finance, 2021). This percentage will presumably maintain, if not continually rise, as an Allianz Life Insurance Co. survey, along with Kiplinger's survey, found that when comparing current investors by generation (not considering Gen-Z), Millennials are more likely to consider ESG factors when choosing investments (Wallace, 2019; Kiplinger Personal Finance, 2021). As younger generations are more inclined towards an SRI strategy, it is likely that the movement will eventually dominate the marketplace. Institutional investors are already prepared for this takeover as seen in a 2020 Edelman Trust Barometer Special Report which found that, “98% of the top-100 institutional investors in the United States say they consider ESG data in the investment process” (Williams & Nagy, 2021). As can be seen, SRI is no longer an up-and-coming trend but rather a staple in the investing community. The growth in concern for ESG considerations is also substantiated through monetary data. Morningstar reported cash inflows into U.S. ESG funds (active and passive) at $5.4 billion, $21.4 billion, and $51.1 billion, for the years 2018, 2019, and 2020, respectively (Hale, 2021). In 2021, inflows continued to increase totaling a record-breaking $69.2 billion (Gresham, 2022). The results show an impressive CAGR of 134% from 2018 to 2021. It is clearly seen through the data that investors are rapidly increasing their desire to participate in SRI strategies, which, in order to be achieved, requires marketplace participation. As a natural progression of increased investor demand for SRI accessibility, the market has provided investors with ample supply by way of securities and outlets. According to a 2020 global benchmark survey performed by the IIA (Index Industry Association), “ESG indexes were the main growth drivers in indexing in 2020 with a 40.2% increase” (Lovas, 2021). The US SIF Foundation’s “Report on US Sustainable and Impact Investing Trends” stated, “The US SIF Foundation identified 836 registered investment companies with ESG assets in 2020, including 718 mutual funds and 94 ETFs” (US SIF Foundation, 2020). Furthermore, the number of available EFTs to meet SRI needs internationally (U.S.A, Europe, and Asian Pacific) was roughly 1,281 in 2022 (Barrak, 2022). Even bonds exhibit the marketplace’s newfound consideration for SRI strategies, ”Sustainable bonds—bonds with a green, sustainability, or social label…passed the $1 trillion mark in annual global issuance for the first time in 2021” (Kashmanian, 2022). Overall, sustainable and ESG AUMs have experienced impressive growth, “The total US-domiciled assets under management using sustainable investing strategies grew from $12.0 trillion at the start of 2018 to $17.1 trillion at the start of 2020, an increase of 42 percent” (US SIF Foundation, 2020). The $17.1 trillion represented 33% of all 2020 U.S. assets under professional management. As can be seen, in the last couple of years the investing market has become extremely focused on expanding SRI opportunities for investors. This has proved to be a successful endeavor, as the lack of regulation has made it easy for the marketplace to provide investors with instruments claiming SRI, whether or not beneficial for the investor’s actual goals. Based on the evidence, it can be concluded that ESG and sustainability considerations have become a staple in the world of investing by way of SRI. And while it may seem like investors’ needs are being met with the surplus of securities, this is not the case. Investors are being misled due to the rampant amount of unsubstantiated claims spreading across the investing industry. For investors' needs to be accurately met, the SEC should not only regulate the financial marketplace, but companies’ sustainability reports, disclosures, and Sustainable Rating Agencies (SRAs) rating methodologies as well. While unregulated, ESG metrics are unable to be compared, unreliable, and inconsiderate of the investor. The majority of these issues stem from the lack of regulation in companies’ disclosures and sustainability reports combined with SRA rating methodology. As greenwashing lawsuits have become increasingly common, it can be seen that corporations exaggerating CSR (Corporate Social Responsibility) participation is not an isolated issue. From 2018 to 2022, over thirty large corporations, including Burger King, Walmart, Burt’s Bees, Kohls, McDonald's, Whole Foods, and Coca-Cola, were sued for making false sustainability claims (Truth in Advertising, 2022). This is especially concerning when considering the sources used by SRAs to determine company ESG ratings. Knowing that comprehensive company information is a requirement for any investor to make a suitable investment decision based on their expectations, the financial marketplace has started to utilize self-titled experts in sustainable and ESG factors, SRAs. ESG rating firms or SRAs have claimed to provide the link between a company’s CSR practices and the investor's SRI demands. Currently, these firms are problematic due to the sources used for determining ratings as well as the inconsistency across different firms. MSCI, one of the largest SRAs, states that the determination of companies' ratings come from government databases, NGOs, media sources, company disclosures, and macro data sites (MSCI, 2022). While SRAs are using all the public information sources available to them, this is not enough to provide accurate rating determinations. There are multiple problems that can be identified from analyzing the sources used by SRAs, which reiterates the need for ESG rating regulation. The first issue to note is that data sources like government databases, NGOs, and macro data sites, will likely be unable to provide enough relevant information to make accurate determinations on rating scores. This may be why there is such a large quantity of media sources used. MSCI claims to use 3,400+ media outlets, which includes global and local news (MSCI, 2022). Unfortunately, many media sources, such as news outlets, social media, and articles that are not reviewed for accuracy, cannot be considered trusted sources of information as they are easily influenced by biases and often contain misinformation. While this in itself is a problem, SRAs are also heavily relying on company ESG disclosures and sustainability reports which have proved to be an equally concerning source, if not the most problematic source. Investors cannot, nor should they be expected to, put their trust in a document that does not follow any sort of regulation and is not legally reviewed for accuracy. An article published in the Journal of Corporate & Financial Law states, "voluntary reporting allows for near complete customization of style, format and content of disclosures, and provides ample room for companies to manipulate the disclosure process” (El-Hage, 2021). Essentially, a company can curate its sustainability reports and/or disclosures to fit the criteria of an index or SRA, though the company’s claims may be exaggerations or misrepresentations of the truth. The article continues on this idea, “Unlike financial statements used for investment analysis, these ESG disclosures are unaudited, which creates further incentives for companies to try to adjust favorably to rating methodologies and to consequently always put the company in a good light” (El-Hage, 2021). Reports and disclosures are able to manipulate investors and SRAs by essentially leaving out concerning behaviors and instead presenting an inflated version of a company’s CSR practices. This issue of a lack of trustworthy ESG and sustainability reporting by public companies is again reiterated in the Texas Law Review, “83% of America's largest 100 public companies are voluntarily producing reports containing such sustainability information, but without the clarity to companies and assurance to investors that would come from using standardized reporting frameworks” (Williams & Nagy, 2021). In the same way a financial advisor would use financial statements to make determinations regarding a company’s financial health, SRAs are using sustainability reports and disclosures to make determinations regarding company ratings. The problem is financial statements are regulated and audited, while sustainability reports and ESG disclosures are not. If they are to be used for investment decision-making in the same way that financial statements are used, then the SEC should just as heavily regulate these reports and disclosures. When it comes to analyzing sustainability reports in a similar fashion as financial statement analysis, SRAs are not alone. The financial service industry, along with retail and institutional investors, make determinations based on these reports. Regulating sustainability reports and ESG disclosures could provide the necessary information needed to properly execute an SRI strategy. A study performed by Nejla Ould Daoud Ellili, an associate Professor of Finance at the Abu Dhabi University, sought to find the benefits of having such disclosures. As noted in the article’s abstract, “This study aims to examine the impacts of environmental, social and governance (ESG) disclosure and financial reporting quality (FRQ) on investment efficiency” (Ellili, 2022). The results were very telling, “ESG disclosure improves transparency, mitigates information asymmetry and enhances investment efficiency” (Ellili, 2022). The results can be compared to the purpose of financial statements which seek to fulfill the results of the study from a monetary information standpoint. It is the investor's right to be provided with faithfully represented and reliable information that is practical for making knowledgeable investment decisions. At this point, investors cannot compute accurate ESG metrics for themselves based on the information available, and the financial institutes and SRAs that say they can, are unable to be trusted or compared. As of 2022, there are over 140 different data providers who rate companies based on varying ESG factors, most of which provide ratings that are not comparable (The Impact Investor, 2022). This should be considered a wildly unnecessary amount as the data available when determining ratings is equally accessible. Additionally, the methodologies between agencies should not vary to such an extreme to allow for this level of distribution in the industry. Timothy Doyle, the VP of Policy & General Counsel at the American Counsel for Capital Formation (ACCF), drafted a report titled “Ratings that don’t rate: The subjective world of ESG rating agencies”. The report shares the biases, inconsistencies, and limitations that can be found in SRAs. Specifically, Doyle shares the concerningly low correlation between two of the largest SRAs, MSCI and Sustainalytics. When comparing the agencies' ESG ratings for companies listed in the S&P Global 1200 index, a weak correlation of only 0.32 was found (Doyle, 2018). As the desire for regulation and accuracy heightens, the inconsistency of SRAs continues to be investigated. Another study to evaluate the comparability of ratings was performed in 2022 by four professors in Italy. The purpose of the study was to, “verify whether, despite the current mainstreaming era of… (SRI) and the ongoing spread of… (SRAs), there is convergent validity between… (ESG) ratings assigned to investment funds” (Gangi et al., 2022). The results of the study showed a similar low convergence across the board and confirmed disparities among raters (Gangi et al., 2022). Given these results, it can be seen that the inability to compare ratings is not due to a lack of resources but rather a lack of systematic uniformity between SRAs. The culmination of these issues can only lead to the conclusion that investors require regulation to partake in an SRI strategy to any extent. Ultimately, the responsibility of establishing the needed regulation falls on the Securities and Exchange Commission. The reasoning for this is fully explained by their self-proclaimed mission. The SEC’s mission is as follows: “The mission of the SEC is to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation. The SEC strives to promote a market environment that is worthy of the public's trust” (SEC, 2022). The term investor has at no point been defined by the SEC, meaning they should not exclude any individual based on strategy choice. As the financial market has fully embraced such investors by way of accessibility and information, whether accurate or not, SRI has proven to be an integral part of the marketplace. The investor who is participating in an SRI strategy, in any capacity, is not able to trust the material that is provided through ratings, indexes, funds, reports, disclosures, or even advisors. Therefore, the investor is unable to participate in a fair, orderly, or efficient market. Without regulation, the current marketplace cannot be trusted. Although regulating ESG ratings and disclosures is necessary, it does not come without difficulties. In July 2021, the FER (Financial Economist Roundtable) met to discuss the regulation of ESG factors. Ultimately, they recommended that the SEC should not mandate disclosure of a firm’s Environmental and Social activities unless they affect cash flows. There are three reasons they believe this should not happen, 1) aggregation issues, 2) measuring societal impacts is difficult, and 3) side effects, one of which included, detracting the SEC from its other priorities (Karpoff, et al., 2022). Although some of these issues may present difficulties, one particularly critical point should be considered above all else. Regardless of the difficulty, the SEC has a mission that it must stand by, and if they were to forsake that mission simply due to difficulties, it would make the SEC an arbitrary organization that is unfit for its purpose. Additionally, the SEC has experience on their side as they have already mandated financial statements and financial disclosures. At one time, there was no regulation for such material, and while it was sure to have been a challenging task at the time, it was able to be done and can be done again in the case of ESG metrics. Quantifying ESG data may prove to be a formidable task, but that does not mean it is not possible. The FER did suggest that the SEC be a part of creating a glossary of ESG terms. This process would help in the objective to measure and regulate qualitative content. Reaching out to the participants of SRI, such as financial institutions, investors, and public companies could provide insight and information that would help with the structuring of regulation. One side effect noted by the FER was that if the SEC begins regulation, the work towards regulation may take away from other priorities as the SEC is already limited on resources and time. While regulation will take a considerable amount of time and resources to implement, the SEC is already being diverted from other priorities to address the consequences of no regulation. For instance, the SEC has had to launch investigations against large banks such as Deutsche Bank, Bank of New York Mellon, and Goldman Sachs due to their insincere claims of ESG and sustainability metrics, which ultimately misled many investors (Nguyen & Goldstein, 2022). It should be noted that investigations are not an easy or quick process. Without regulation, the SEC will constantly have to monitor financial institutions and investment firms for accuracy in their ESG and sustainability claims. This in itself is a sort of unofficial regulation measure, which validates the point that some level of regulation is a requirement for investors to not be misled. Although it cannot be denied that effective regulation will be an ambitious endeavor, it is not required to happen overnight. Companies, SRAs, and fund creators will likely try to perform some amount of self-regulation once they believe regulation is in the works. Additionally, by simply starting with auditing sustainability reports, ESG disclosures, and fund labels, it could vastly improve the quality of information available to the investor. From the investor’s standpoint, any amount of progress towards functioning regulation is better than the perceived unending spread of needless disinformation. It is important to remember that to the investor, an SRI strategy is not only for financial gain but for the betterment of the world they reside in and for humanity as a whole. To this type of investor, SRI is their goal, making regulation their need. In conclusion, regardless of the difficulty or any additional costs incurred, there is a need for ESG regulation. So long as investors are participating in an SRI strategy to any extent, and the financial marketplace is making this possible by way of accessibility, straightforward information should be provided that is dependable and without outside influence. The very purpose of the SEC is to ensure all investors can fulfill their investing goals by providing the necessary regulation. To remain true to its mission, the SEC should begin the process of ending the current misinformation and confusion surrounding sustainability and ESG metrics. References Barrak, E. (2022, June 17). Introducing the three largest ESG ETFs. Trackinsight. https://www.trackinsight.com/en/article/introducing-three-largest-esg-etfs El-Hage, J. (2021). Fixing ESG: Are mandatory ESG disclosures the solution to misleading ESG ratings? Fordham Journal of Corporate & Financial Law, 26(2), 359-390. https://www.proquest.com/docview/2571981792/abstract/9AAFE4CBFEB34E11PQ/1?accountid=3783 Ellili, N. O. (2022). Impact of ESG disclosure and financial reporting quality on investment efficiency. Corporate Governance, 22(5), 1094-1111. https://www-emerald-com.ezproxy.snhu.edu/insight/content/doi/10.1108/CG-06-2021-0209/full/html#loginreload Doyle, T. M., (2018). Ratings that don’t rate. American Council for Capital Formation. https://accfcorpgov.org/wp-content/uploads/2018/07/ACCF_RatingsESGReport.pdf Gangi, F., Varrone, N., Daniele, L., & Cosciac, M. (2022). Mainstreaming socially responsible investment: Do environmental, social and governance ratings of investment funds converge? Journal of Cleaner Production, 353(131684), 1-12. https://www-sciencedirect-com.ezproxy.snhu.edu/science/article/pii/S0959652622012987 Gresham, T. (2022, February 04). Record-breaking year for sustainable funds: Morningstar. Benefits Pro. https://www.benefitspro.com/2022/02/04/record-breaking-year-for-sustainable-funds-morningstar/?slreturn=20220708190545 Hale, J. (2021, January 28). A broken record: Flows for U.S. sustainable funds again reach new heights. Morningstar. https://www.morningstar.com/articles/1019195/a-broken-record-flows-for-us-sustainable-funds-again-reach-new-heights Iacurci, G. (2022, June 5). That socially responsible fund may not be as ‘green’ as you think. Here’s how to pick one. CNBC. https://www.cnbc.com/2022/06/05/picking-a-socially-responsible-fund-can-be-confusing-heres-what-to-know.html Karpoff, J. M., Litan, R., Schrand, C., & Weil, R. L. (2022). What ESG-related disclosures should the SEC mandate? Financial Analysts Journal, 78(2), 9-18. https://www.tandfonline.com/doi/full/10.1080/0015198X.2022.2044718 Kashmanian, L. (2022, March 21). What fixed income ESG investors should keep on the radar in 2022. Parametric Portfolio. https://www.parametricportfolio.com/blog/fixed-income-esg-investors-should-keep-on-the-radar-in-2022 Kiernan, P. (2022, May 25). SEC proposes more disclosure requirements for ESG funds; Agency votes to float plans to give investors more information on environmental, social and corporate-governance vehicles. The Wall Street Journal Markets sec.: https://ezproxy.snhu.edu/login?qurl=https%3A%2F%2Fwww.proquest.com%2Fnewspapers%2Fsec-proposes-more-disclosure-requirements-esg%2Fdocview%2F2669103696%2Fse-2%3Faccountid%3D3783 Kiplinger Personal Finance. (2021, October 12). Kiplinger – Domini poll: ESG investing is gaining traction. Kiplinger. https://www.kiplinger.com/investing/esg/603503/esg-investing-is-gaining-traction Lovas, G. (2021, June) ESG drives growth in indexing. BrokerChooser. https://brokerchooser.com/how-to-invest/esg-becomes-the-fastest-growing-area-of-indexing MSCI (2022, June). MSCI ESG rating methodology: Executive summary. MSCI [PDF]. https://www.msci.com/documents/1296102/21901542/ESG-Ratings-Methodology-Exec-Summary.pdf Nguyen, L., & Goldstein, M. (2022, June 12). Goldman Sachs is being investigated over E.S.G. funds. The New York Times. https://www.nytimes.com/2022/06/12/business/sec-goldman-sachs-esg-funds.html SEC. About the SEC. U.S. Securities and Exchange Commission. https://www.sec.gov/about.shtml#:~:text=The%20mission%20of%20the%20SEC,worthy%20of%20the%20public's%20trust The Impact Investor (2022, June 21). 8 Best ESG rating agencies – Who gets to grade? https://theimpactinvestor.com/esg-rating-agencies/ Truth In Advertising. (2022). Companies accused of greenwashing. Truth in Advertising. https://truthinadvertising.org/articles/six-companies-accused-greenwashing/ US SIF Foundation. (2020). Sustainable investing basics. https://www.ussif.org/sribasics Wallace, C. P. (2019). ESG investing. CQ Researcher, 29(34), 1-28. https://library-cqpress-com.ezproxy.snhu.edu/cqresearcher/document.php?id=cqresrre2019092702&type=hitlist Williams, C. A., & Nagy, D. M. (2021). ESG and climate change blind spots: Turning the corner on SEC disclosure. Texas Law Review, 99(7), 1453-1485. https://www-proquest-com.ezproxy.snhu.edu/docview/2568031800/abstract/C042ADCEBA08479DPQ/1?accountid=3783