SEC moves closer to setting ESG rules

The Securities and Exchange Commission is getting set to impose new rules on climate-related disclosures and how funds can be named to promote investment strategies like ESG and sustainable.

The SEC closed the comment period for the proposed climate disclosure rule on June 17 after it was extended due to heavy interest, but the proposal to update and modernize its “names rule” will be open until Aug. 16. The climate-related disclosure rule probably won’t be finalized anytime soon, and may even undergo another round of proposal and comment, particularly in light of the Supreme Court’s ruling on Thursday limiting the Environmental Protection Agency’s ability to lower carbon emissions at power plants, which could affect the SEC’s powers as well.

Whatever the outcome, accountants are increasingly getting involved in their clients’ environmental, social and governance efforts as ESG funds gain in popularity among investors and the pace of global climate change accelerates. The climate-related disclosure rule proposal that the SEC unveiled in March would require companies to disclose risks that are reasonably likely to have a material impact on their business, the results of their operations or financial condition, along with certain climate-related financial statement metrics in a note to their audited financial statements (see story). 

Meanwhile, the recently formed International Sustainability Standards Board and the European Financial Reporting Advisory Group have circulated their own proposals that multinational companies will need to keep in mind. KPMG has posted a “talk book” comparing the SEC, ISSB and EFRAG proposals.

A recent survey by KPMG found that 52% of U.S. CEOs reported they are seeing significant demand for increased reporting and transparency on ESG issues, while 55% of the respondents expect to rely increasingly on external assurance of their ESG data to meet stakeholder and investor expectations for consistent and robust sustainability reporting. KPMG recently released a report, ESG as an asset: SEC’s proposed rules mark an inflection point for asset managers, explaining the implications of the SEC’s proposals for asset managers, including expecting an increase in demand for high-quality ESG data; understanding the disclosure implications of an ESG investment strategy; establishing specific ESG policies and procedures; and assessing marketing materials for potential greenwashing.

Marketing materials are sure to play a role in the changes in the names rule to safeguard funds from labeling themselves as ESG or sustainable without proper justification. That too may involve accountants and auditors providing some level of assurance to vet them.

The existing names rule already requires registered investment companies whose names suggest a focus in a particular type of investment (among other areas) to adopt a policy to invest at least 80% of the value of their assets in those investments. The amendments proposed by the SEC in May would enhance the rule’s protections by requiring more funds to adopt an 80% investment policy. They would extend the requirement to any fund name with terms suggesting that the fund focuses on investments that have (or whose issuers have) particular characteristics. In addition to ESG and sustainable, this would include fund names with terms such as “growth” or “value” or terms indicating that the fund’s investment decisions incorporate one or more environmental, social or governance factors. The amendments also would limit temporary departures from the 80% investment requirement and clarify the rule’s treatment of derivative investments.

“The names rule is now being updated to explicitly include ESG funds, so the 80% investment policy rule will apply to anything that’s named in ESG funds,” said Maura Hodge, audit leader at KPMG US IMPACT. “And then the second piece of the ESG enhanced disclosure rule helps to define what ESG means in the context of the naming and the issuance of certain funds, whether they’re considered impact funds or ESG-focused funds, or as ESG integration funds, which combine those ESG considerations as well as other considerations for the funds’ strategy.” 

The naming rule amendments are in some ways an outgrowth of the SEC’s proposed climate-related disclosure rule. “The rules that the SEC proposed in March for corporations and for public registrants requiring them to disclose certain information around how they’re dealing with climate risk as well as greenhouse gas emissions, and then the financial impact of that, to me this is just a natural follow-on because a lot of asset managers and fund advisors have been putting together these funds that are ostensibly based off of ESG performance or information from these corporations, but it’s widely known that a lot of companies have been doing this reporting for a long time,” said Hodge. “But the level of consistency, rigor and standardization around the information that companies are putting out is just not there, so it’s really hard to make decisions and apply strategies when the basis of those decisions is not necessarily consistent and reliable.”

The SEC isn’t necessarily trying to spell out exactly what ESG means in the names rule. “The interesting part of the proposal and what the overarching theme of these rules is the SEC is not going to define what ESG is, or what the definition of what ESG is for everybody,” said Larry Godin, principal and national practice lead for asset and wealth management, regulatory risk and compliance at KPMG. “They understand there’s an expansive and varied amount of investment strategies that are out there. What it appears they are trying to do is have the investment managers, in this case the mutual funds, define what their strategy is in sufficient detail that investors can have the transparency and consistency they need so they can compare it to other strategies, and they can feel good that there is reliable information behind it. Then once that disclosure is done, the SEC is going to hold the advisor to what he says he is going to do. They’re asking the advisor to create the box and they’re going to make sure you stay within the box, as opposed to coming up with a uniform definition that everybody has to fit into.”

Words matter

Nevertheless, words matter and making sure the definitions are clear to investors is going to be critical.

“You may be able to use sustainability or ESG, or whatever term of art makes sense based on your strategy, but you’re going to have to define that so that investors understand what you’re saying,” said Godin. “It’s so they can understand that the experience they’re going to get by investing in a mutual fund or other vehicle with that strategy is actually what the investment manager delivers upon, and that there’s a specific disclosure that they can understand and the right level of transparency.”

Accounting firms may be able to help clients comply with the names rule in addition to the climate disclosure rule, even if there is no audit or assurance requirement for the names rule.

“We do have a number of companies coming to us now, particularly the ones that fall under the definition of an impact fund that are asking us for assurance on a voluntary basis because they want evidence to demonstrate to their investors the rigor with which they are applying the definitions that they have laid out for themselves and in particular the metrics that they have defined to determine the level of impact that they’re having,” said Hodge.

Companies may rely on their accountants to make sure they’re complying with any new requirements from the SEC once the rules and amendments are ultimately finalized.

“They’re worried that currently compliance practices may not be effective in addressing how advisors would be incorporating factors into advisory services,” said Godin. “The proposal is looking for compliance to be able to have policies and procedures and test controls, and understand how screens are implemented when making decisions as to what’s in and what’s out, how proxy voting is handled and marketing materials to make sure they’re consistent with exactly what they are supposed to be doing. ”

While it may take some time for the SEC to finalize its new rules, and the climate-related disclosure rule is likely to be challenged in court, the European Union has already released its Sustainable Finance Disclosure Regulation. The SFDR began to take effect this year for some disclosures, Hodge noted, and the required disclosures will be more extensive in future years.

While more expenses will no doubt be involved, companies may ultimately benefit from being able to provide bona fide disclosures on their ESG efforts to skeptical investors.

“The way companies can keep their eyes on the prize is that there is an opportunity to unlock value around ESG for their business,” said Hodge. “I think this creates a lot of new opportunities for access to capital, the ability to create new investment strategies and really enhance the value of the activities that they’re performing or the work that they’re doing. While there is a compliance component to this, we continually remind management that there is also opportunity on the other side of it. Don’t get so bogged down in the compliance aspect so you can unlock the value for yourself.”

Impact on smaller companies

The climate-related disclosure rule won’t just affect large companies. The proposal to include so-called “Scope 3” emissions from companies that are part of the supply chain could affect smaller companies that sell goods to larger ones. “Many smaller reporting entities are going to have obligations to fulfill when they become mandatory,” said Tim Gearty, national director and editor-in-chief at Becker Professional Education, who has seen demand for professional education courses in ESG skyrocket in recent years as companies of all sizes work to bring their staff up to speed on sustainability issues. “They don’t create a disproportionate or a competitive disadvantage, but the large company may wind up having to select a different vendor.”

However, the costs could be substantial, even for smaller companies, akin to what they have been paying for Sarbanes-Oxley compliance. “These costs are going to be astronomical  on an annual basis,” said Gearty. “For SMEs, they could run $400,000 or more a year. For larger companies, this could run $500,000 or more.” The rules are likely to be challenged in courts once they are finalized.

Companies will be turning to their accountants not only to vet their ESG disclosures, but also to save money where they can. However, according to a study last year by the Center for Audit Quality of the most recent publicly available ESG data for S&P 500 companies, only about 6% of companies had assurance from an auditing firm, while 47% of companies had assurance from an engineering or consulting firm that was not a CPA firm.

“Only a very small percentage of companies that have attestation services, about 264 currently as of the most recent study, only 31 of them used CPA firms,” said Gearty. “The rest of them used engineering firms. That’s the wrong path. CPAs have to make sure we’re the standard bearers.”

The CAQ provided a comment letter last month to the SEC on the climate disclosure rule. “For years, the CAQ has recognized the value of company-prepared climate information for investors and the role public company auditors can play,” said CAQ CEO Julie Bell Lindsay in a statement. “Research shows that assurance over climate-reporting when performed by a public company auditor offers increased investor protection compared with other assurers.” 

Investors are increasingly concerned about the environmental impact of the companies in which they own shares. “Are they doing anything that’s contaminating the air or the water supply near them?” said Gearty. “Do they provide a safe working investment? Those are issues that are starting to permeate the investment community.”

Some of the companies where he is invited to provide training have already set up groups in this area, and some are inviting ESG experts to be on their audit committees and board of directors. 

ESG has been a selling point for more investors, especially younger ones. “These proposals ultimately were released to seek enhanced transparency and really help ESG-conscious investors gain greater clarity about their holdings,” said Hodge. “We know that consumers, customers and individuals — the next generation — are very much focused on ESG considerations, particularly climate change, so the ultimate goal is to ensure investment decisions are consistent with the name of a fund and the investors’ expectations.”