With ESG assets under management projected to surpass $40 trillion this year, the U.S. Securities and Exchange Commission is working to crack down on “greenwashing” funds that claim an ESG label but don’t actually meet environmental, social or governance standards.
The SEC recently voted to propose rules that would create consistency for ESG disclosures and create categories of funds that mix ESG and traditional factors. This comes after proposed rules on climate change disclosures from investors, and pending rules on human capital management disclosure data, such as benefits offered or pay disparities based on race and gender.
These rules signify that SEC is not just getting serious about “greenwashing,” but also seeking higher standards for the “S” and “G” aspects of Environmental, Social and Governance products. It’s no secret that ESG investors have focused more on environmental strategies. This environmental focus ignores broader trends that are contributing to rising global instability across markets, including growing income inequality that is hollowing out the middle class, making economies more brittle and prone to political instability.
Trends like these directly affect investor portfolios. For example, when the income share of a country’s wealthiest 20% of people increases by just 1%, GDP growth declines 0.08%.
To tackle these issues, investors cannot keep operating in the same ways they have for decades. Instead, investors must consider the effects of systemic risks to their portfolios in the same way they mitigate other material risks to investment performance.
These risks — for example, climate change, income inequality, racial justice and political instability — span industries and threaten long-term investment returns across all asset classes in ways that traditional risk management cannot cope with.
The challenge is that while most investors understand the need for taking on these risks, they don’t know how to do so, especially when it comes to social issues. The Investment Integration Project (TIIP), an organization I lead, recently surveyed close to 100 investors, financial advisers and other stakeholders to understand their comfort with what we call “system-level investing” and their needs, to better tackle environmental and social challenges.
More than 95% of those surveyed by TIIP said that social and environmental risks not only affect investment performance, but that the financial industry has an ability to mitigate these risks. Investors understand that stronger systems which lead to fewer market disruptions are better for business. But they do not know how to take on these challenges to improve their bottom lines alongside social and environmental outcomes.
The survey found that investors particularly struggle with systemic social risks. Respondents in the survey and follow-up focus groups highlighted that while investors are mostly aware of and concerned about systemic environmental challenges and their intersection with investment, few are as focused on or knowledgeable about systemic social issues.
The existing proposed rules from the SEC are a good step in this direction. But the SEC should build on and go beyond the disclosure of human capital management data and recognize the need for investors to consider broader systemic social risks when making investment decisions and determining investment approaches, in the same way they are requiring data disclosure on climate change. Many of these human capital issues, such as diversity in hiring, have been around for generations, and merely disclosing data will not be enough to reverse the trends.
In its regulatory approach, the SEC should acknowledge the benefits of collaboration when investors who share the same interests work together to reduce costs and facilitate implementation of their fiduciary obligations. The SEC’s Office of the Investor Advocate and its Office of Investor Education could develop and curate knowledge resources from leading practices used by investors (and regulators in other jurisdictions) for management of systemic social investment risks and opportunities.
Investors can also do more to avoid the greenwashing equivalent of social and governance issues, incorporating systemic social risks into their investment beliefs and policy statements, shareholder engagement, manager selection and target investment programs.
As social issues become more salient, investors will seek opportunities for tackling these challenges through their investments. Government regulators should get ahead of this shift before the greenwashing of social issues becomes widespread. Investors should also work to support regulations and set standards to ensure all are playing on the same field, operating with the same playbook.
William Burckart is CEO of TIIP, The Investment Integration Project.