What is ESG Integration?

According to the United States Securities and Exchange Commission (SEC), ESG Integration is an investment strategy that considers “one or more ESG factors alongside other, non-ESG factors in investment decisions.” “ESG” stands for Environmental, Social, and Governance criteria which form a framework for understanding a company’s relationship with ESG issues. “Integration” refers to the level of commitment to using ESG criteria in an investment strategy. The SEC, which regulates the US Securities industry, released a proposed rule on May 25th, 2022 that intends to bring clarity to the mass of ESG funds, investment products, and strategies now on the market. The proposal segments the spectrum of ESG investment strategies into three categories: ESG Integration, ESG-Focused, and a subset of ESG-Focused called Impact.

The SEC cites a lack of transparency, misleading marketing around ESG strategies, and a “lack of consistent, comparable, and reliable information” that can “create a risk that a fund or adviser’s actual consideration of ESG does not match investor expectations.” Many of the ideas in the proposal serve either to increase disclosures on ESG methodologies or to standardize the way information is disclosed so that an investor is better equipped to compare products. Investors’ ESG preferences vary, and this proposal aims to help investors identify products that best align with their preferences.

What counts as ESG? The SEC has opted not to define the term, leaving it up to individual funds and advisers for ESG strategies to describe what they mean when they call themselves ESG. In doing so, it avoids the burden of being the authority on a contentious term and facing the backlash from those who would no longer fit the mold. The purpose of the proposal is to help investors make more informed decisions when it comes to investing in ESG products.

ESG Integration

Of the three strategies, ESG Integration is the least committed to the environmental, social, and governance issues that so far have defined the field of socially conscious investing. ESG factors can be material to an investment analysis, so a strategy that systematically includes an ESG factor can be considered Integration.

An ESG Integration fund does not have to look at every ESG issue or use ESG criteria for every decision. These factors are not the primary reason fund managers might select or exclude a security for an ESG Integration fund. In a scenario where a sustainable choice might be bad for returns, this type of fund may not sacrifice returns, on principle.

Proposed Changes

The SEC proposes minimum disclosure requirements so that “any fund that markets itself as ESG” will “provide sufficient information to investors to support the claim.” In a layered disclosure model, ESG Integrated funds will be subject to the loosest disclosure requirements. This is so that ESG factors, which are secondary factors in the funds’ investment decisions, are not overemphasized with a disproportionately detailed description.

With the proposed rule, an ESG Integrated fund will have to “summarize in a few sentences how the fund incorporates ESG factors into its investment selection process, including what ESG factors the fund considers.” The information will be placed in fund prospectus summaries or general fund description sections, alongside information about investments, risks, and performance. Another proposed change is that, if an Integration Fund considers the greenhouse gas emissions of portfolio holdings, they must describe the methodology of how they do so and their source of data. Disclosures would use a standardized machine-readable format, the Inline eXtensible Business Reporting Language (“Inline XBRL”) which serves to make comparisons easier across funds.

The regulatory hurdles are light compared to other categories of ESG strategies. ESG-Focused funds, which center their strategy around ESG considerations and sometimes actively engage with issuers, face more stringent disclosure requirements. This is to substantiate their commitment to ESG factors in their strategies. Impact funds must do the same to show how exactly they aim to make an impact on a specific cause.

For ESG Integration funds, the additional transparency might be an important change as the category lies in the gray area between full ESG and non-ESG strategies. This group would be subject to lower disclosure requirements because the grouping itself indicates that a fund or adviser does not prioritize ESG considerations. This can help resolve fears around greenwashing and add legitimacy to those in the ESG-Focused category or its Impact subcategory who may legitimately aim to invest sustainably. Overall, ESG Integrated funds are the least committed group and will be represented as such.

Future regulation

The SEC asks: is this the right approach? The framework, if adopted, will redefine the parameters in which ESG funds and advisers operate. Still, it is clear that the SEC is not out to narrow the definition of ESG. While they invite feedback throughout the proposed rule, the SEC appears to focus its intentions on better transparency for the investor.

What we know is that a new framework for ESG products will be noted across the securities industry in the US and internationally. We have yet to see whether the SEC will adopt ideas brought to them in commentary on the proposed rule. In any case, the proposed rule is an important development in how we may talk about ESG in the future and in how investors will be able to select funds and strategies that align with their objectives.

Published on July 1, 2022.

References

Matt Orsagh, James Allen, Justin Sloggett, Anna Georgieva, Sofia Bartholdy, Kris Douma. "Guidance and Case Studies for ESG Integration: Equities and Fixed Income." 2018. CFA Institute. <https://www.cfainstitute.org/-/media/documents/survey/guidance-case-studies-esg-integration.pdf>.

Matt Orsagh, Justin Sloggett, Anna Georgieva. What is ESG Integration? 25 April 2018. <https://www.unpri.org/fixed-income/what-is-esg-integration/3052.article>.

United States Securities and Exchange Commission, Enhanced Disclosures by Certain Investment Advisers and Investment Companies about Environmental, Social, and Governance Investment Practices (May 25, 2022, Release No. 11068, 34-94985, IA-6034, IC-34594, File No. S7-17-22).

About the Author

Kristina Bjorksten is an Operations Analyst at Humankind Investments, whose ambition is to make companies more sustainable and enhance the quality of life for humankind. She gained her industry experience at a broker-dealer and brings fresh ideas and an international lens to her role. She studied economics, earning her Master’s in European Economic Studies from the College of Europe and her Bachelor’s in Economics from UC San Diego.