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Review & Outlook:
ESG Regulatory Landscape for Private Funds

By December 23, 2020May 5th, 2022No Comments

By Trysha Daskam

What we learned about ESG regulations and compliance in 2020

Private fund managers faced an endless array of challenges–both expected and unexpected–throughout 2020. One of these challenges is the growing interest in ESG and impact investing, and the increased demand for policies, practices, and processes that show how managers are taking sustainability considerations into account.

The past year has featured a historic amount of consolidation and harmonization towards common standards and best practices on ESG and sustainability. While we are still some ways away from a single universal standard, a defining theme of market developments in 2020 is an industry-wide shift from writing policies and developing processes towards putting those processes into action. In other words, fund managers that have begun to focus on ESG are increasingly expected to evidence their ESG commitments by taking tangible steps and implementing accountability mechanisms.

Enforcement on ESG is likely coming soon

The SEC signaled in 2019 and again in 2020 an intention to clamp down on greenwashing by more closely examining the labeling of ‘ESG’ funds. At the heart of the SEC’s interest in ESG is Rule 206(4)-7 of the Investment Advisers Act of 1940, which requires registered advisers to “adopt and implement written policies and procedures reasonably designed to prevent violation” of the Act. In other words, any investment fund using an ‘ESG’, ‘sustainable’ or similar label must have clearly outlined processes for implementing ESG considerations in both fund documents and investor disclosures. A firm trying to sell an ‘ESG’ product without the requisite investment processes and disclosures could find itself in the crosshairs of the SEC.

With a new Commissioner set to take the helm of the SEC in 2021, it would not be surprising if the agency soon looks to make an example of a firm as it relates to their ESG product, and the suitability of the product’s associated disclosures. Any such enforcement action would likely involve a hefty fine with the potential for other penalties. The best way to prevent this kind of outcome or heightened regulatory scrutiny in general is to closely examine fund documents and investor disclosures to ensure that there is no gray area around how a firm thinks about and practices ESG investing.

Moving towards harmonization with global standard-setters

Any enforcement actions the SEC takes won’t occur in a vacuum. There are several other financial regulators and standard-setters also looking to move toward a single shared standard on ESG and sustainability. This includes the European Commission, whose action plan on sustainable finance is set to go into effect in 2021. There are several important pieces of this plan, but two specific pieces worth highlighting here are the Sustainable Finance Disclosure Regulation, which is designed to inject more transparency into how the financial sector considers sustainability risks in investment decisions, and the Taxonomy Regulation, which establishes an EU-wide common language to identify to what extent economic activities can be considered environmentally sustainable. These regulations only apply to funds actively marketing to European investors but could have knock-on effects for fund managers primarily operating in the U.S.

Meanwhile, the PRI introduced a new reporting framework in November that raises standards for signatories and includes more stringent reporting and compliance requirements. The PRI also recently announced that starting in 2021 the organization would require its 3,500+ signatories to disclose “whether and how they engage with government officials and other policymakers to see if such lobbying efforts are in line with environmental and societal goals.”

While enforcement or assurance mechanisms for any of these regulations or standards are still mostly unknown, the history of financial regulation shows that enforcement will be gradually dialed up after an initial waiting period. This waiting period could last months or perhaps even years, but given the complexity of some of the requirements, it would behoove private fund managers to prepare for and move toward compliance in the near term. The PRI has already shown a willingness to cull its membership list, and it’s fair to expect other standard-setters will try to do something similar to give their efforts more teeth.

Climate risks take center stage

Many private fund managers may understandably feel overwhelmed by the growing list of regulatory and compliance requirements related to climate risk and mitigation. If it seems like there are constantly new standards and proposals being released, it’s because that is now the reality.

But for firms wondering where they should start, the clear answer is to focus on climate risks first and everything else second. That’s not to say that other sustainability risks and factors aren’t important (they are!), but regulators and standard-setters around the world have been intentional in communicating that disclosing climate risks will soon become mandatory, while other environmental concerns like biodiversity and water scarcity will come a bit later.

In the U.S., investors managing $1 trillion in assets wrote to Federal Reserve chair Jay Powell urging the central bank and other regulators to acknowledge that the climate crisis poses a systemic threat to financial markets and the real economy. In early September, the Commodity Futures Trading Commission, the U.S. futures regulator, issued a report that states climate change poses “serious emerging risks to the U.S. financial system,” and called for U.S. regulators to “move urgently and decisively” to confront them. And in December, the Net Zero Asset Managers initiative, which includes 30 asset managers representing more than $9 trillion in assets, announced a commitment to work in collaboration with clients to achieve the goal of net zero greenhouse gas emissions by 2050 or sooner.

Meanwhile, the UK recently announced that TCFD-aligned disclosures would be mandatory across the economy by 2025 with an interim deadline of 2023, following in the footsteps of New Zealand which made a similar announcement earlier in the year targeted at all listed issuers.

More countries will surely follow in the months and years ahead as they seek to take tangible steps towards meeting their net-zero commitments and targets. As a preemptive measure, every private fund manager should familiarize themselves with the TCFD recommendations and begin to develop processes for incorporating climate considerations across both their firm and their portfolio.

COVID-19 and BLM protests showcase importance of ‘S’ in ESG

Now more than ever, it is obvious that the ‘S’ in ESG is just as important as the other factors in fostering a productive and inclusive society. While we don’t expect financial regulators to mandate things like diversity quotas for investment firms and other companies, we do expect to see more announcements similar to NASDAQ’s recent proposed rule that would require each listed company to have, or explain why they do not have, at least two “Diverse” directors on its board. We also expect institutional investors to demand more disclosures focused on Diversity, Equity and Inclusion (DEI) issues. This means that any private fund manager seeking to raise or retain capital from institutional investors will need to give some careful thought to these issues and the best way to address potential investor concerns.

It is important to recognize that well-written policies are not a solution to increased demands on disclosures for everything from climate risks in the portfolio to the racial composition of an investment team. But policies can be an important step towards addressing regulator concerns and investor demands. Ultimately, every investment organization will need to put in place a plan for executing on specific goals and objectives, with accountability mechanisms built into the plan. Ideally, different policies and procedures should complement and reinforce each other as part of a comprehensive approach to addressing ESG and related issues.

In the short-term, the barrage of new requirements will force many investment firms to take a long, hard look at their operations and policies. But in the long-term, these policies and processes–and the ability of firms to execute on them–will separate the leading firms from those more interested in greenwashing and tokenism.

If you have any questions, please contact us at [email protected].