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ESG, investment tools, SEC, regulation

The SEC Cracks Down on Problematic Investment Tools

The securities regulator is taking a hard look at environmental, social, and governance standards.

Words: James David Spellman
Pictures: Sarah Dorweiler

The US Securities and Exchange Commission (SEC), the country’s securities regulator, recently began a long-overdue crackdown on questionable metrics that guide asset managers when screening whether companies adhere to environmental, social, and governance (ESG) standards.

SEC Chairman Gary Gensler’s efforts are part of President Joe Biden’s strategy to address climate change by cutting US carbon emissions in half by 2030. The Senate is still holding up Biden’s half-a-trillion dollar spending package for climate and clean energy technologies, and the Supreme Court has recently limited the Environmental Protection Agency ability to reduce greenhouse gas emissions. In light of these challenges, the administration needed to adopt a more incremental approach. Enter: the SEC. More than 3,400 comment letters have been filed, spanning the range from companies decrying the legal liabilities, costly burdens, and unclear guidance to environmentalists insisting the proposals need to address “environmental and climate justice.”

The SEC’s crackdown on ESG abuses is long overdue and the proposal is far more narrow than those underway or planned by the European Union. To understand the long-term implications of the proposed changes, it’s important to see how companies have been abusing the standards, and how rectifying this will also help the Biden administration implement its policies on climate change — albeit slowly, in small steps, and narrow in scope.


Since inception, ESG criteria have lacked rigor, making them prone to misuse if not misunderstanding. Methodologies vary widely, impairing comparison between evaluators’ different grades. Criteria are also entangled in the inevitable difficulties of using numbers to measure intangibles that may include human capital, the brand, intellectual rights, and managerial expertise — all major drivers of share values. Yet, where some see the glass as half-full, others may see it as half-empty.

The Biden administration must work to make ESG standards desirable, achievable, and profitable. The SEC’s recent regulations update is a small step in the right direction.

Government leaders might be tempted to shift the goalposts as new concerns occupy public consciousness, such as Russia’s invasion of Ukraine. This is a blessing and a curse; while modifying ESG standards needs to be in step with public demands, repeated shifts in priorities make compliance more difficult. And then there is the fudging by companies and measurers alike: the compromises or deceits called “greenwashing” and hiding the sins and exaggerating the good (the atonement). Philip Morris International is a good example of such problematic practices. The company advocates a “smoke-free future” and stresses improving agricultural labor practices but touts machines producing 20,000 cigarettes a minute. It has also promoted growth in cigarette and heated tobacco units as key drivers for higher earnings in 2021. Another worry is that companies may rationalize underperformance by hyping ESG investments.

The SEC’s proposal to address greenwashing is limited. Its rules aim to expand and sharpen companies’ disclosures — information that has “material impact,” meaning it would influence investors’ valuations — of climate-related risks and opportunities. The agency’s chair, Gensler, said the changes would result in “consistent, comparable, and decision-useful information” by mandating “consistent and clear reporting obligations” for companies. “A fund’s name is often one of the most important pieces of information that investors use in selecting a fund,” he said. If a fund markets itself as backing sustainable companies, then its holdings must match its claims.

Since the 1930s, the SEC has had an arsenal of anti-fraud regulations against disclosing false data or omitting information. In its first enforcement action involving ESG, the regulator charged BNY Mellon Investment Adviser, Inc. for “misstatements and omissions” and levied a $1.5-million fine. The investment bank didn’t review companies held in its funds but still scored their ESG accomplishments and failures. That enforcement action was followed in early June 2022 by a Bloomberg report that Goldman Sachs is under investigation by the SEC for investments that breach the ESG criteria promised in marketing materials.

The SEC’s actions are in step with the Biden administration’s top priority: reducing greenhouse gasses and transitioning the country toward sustainable energy while modernizing and expanding infrastructure.

ESG-focused investments are enormously popular. The flow of money into these funds is projected to set records this year. Global ESG assets may top $41 trillion by 2022 and $50 trillion by 2025, reaching one-third of projected total assets under management globally, according to Bloomberg Intelligence. Meanwhile, the number of funds marketing themselves as “green,” “sustainable,” and “low-carbon” multiplies. As of December 2021, there were 5,932 ESG funds, up from 4,153 at year-end 2020, Morningstar reports. Assets are concentrated in Europe, representing 81% of sustainable assets under management worldwide in December 2021, with the United States second, accounting for a 13% share.


Fund managers’ ESG strategies vary widely. Some focus only on those companies that have already achieved high ESG standards, such as small carbon footprints or “net zero.” Others back companies that hope to do better, using their clout as major shareholders to win seats on the board or force proxy votes that pressure management to change. Certain fund managers seek broad-based market exposure while others are extremely targeted. According to Morningstar, roughly 60% of the ESG funds are actively managed, but that share has been decreasing as passively managed funds pegged to ESG indexes continue to make gains. MSCI Inc. alone offers more than 1,500 equity and fixed-income ESG Indexes.

Issues over the indexes’ methodology and politics were highlighted with the skirmish in May 2022 between Standard and Poor’s and Tesla CEO Elon Musk. To justify removing Tesla from its ESG index, S&P cited claims of racial discrimination, crashes linked to Tesla’s autopilot vehicles, and inadequate details about both its low-carbon strategy and business conduct codes. In a retort, Musk tweeted that “Exxon is rated top ten best in world for environment, social, and governance (ESG) by S&P 500, while Tesla didn’t make the list! ESG is a scam. It has been weaponized by phony social justice warriors.”

In late May, police in Germany raided Deutsche Bank and its subsidiary DWS in response to a whistleblower’s claims that asset managers overstated the ESG records of DWS portfolios. A month before some of the bank’s offices were raided for money laundering, specifically a transaction involving the family of Syrian leader Bashar Assad. Deutsche Bank has denied the allegations. Some analysts believe more crackdowns are coming.

Looking at the ten constituents of the S&P 500 ESG Index shows Apple, Microsoft, Amazon, and two share classes of Alphabet to be the top five holdings. This highlights another issue. Does a screen for ESG matter if the same companies dominate equity funds generally? Is adding ESG to a fund’s name becoming meaningless as more and more companies align with ESG standards? To a large extent, fund managers have no choice but to invest in the largest companies. The scale of investment opportunities in unicorns to achieve a net-zero economy is far smaller than the money the managers can put to work. Bankers, too, are under pressure to match average market returns, or better, outperform. In the end, that means a portfolio dominated by the companies that have accounted for most of the gains in the S&P 500 or NASDAQ indices.

For investors, the ultimate test is the return they earn on their capital and whether that return equals, but preferably beats the market’s overall performance. Participating in what was the first meeting at the UN in 2008 between non-governmental organizations and Wall Street, I heard two prevailing points then. First, market forces are powerful in reducing dependence on greenhouse gases by channeling investment to technologies. In 1988, Senators Timothy E. Wirth (D-Colo.) and John Heinz (R-Penn.) emphasized the need to shift away from regulation-heavy policy to leveraging what drives capital markets in a pioneering report. And second, ESG strategies must deliver returns — dividend payments and appreciation in share price — at least comparable to market averages. Those concerns persist today.


Unfortunately, the returns are mixed, depending on how the deck is cut. Fidelity shows that half of ESG investments worldwide between 1970 and 2014 outperformed the market ― only 11% performed poorly. S&P back-tested its ESG index over ten years to show it had a similar historical risk/return profile to that of the S&P 500 and outperformed over the past year. During the peak of the COVID pandemic, more than eight of ten sustainable investment funds beat non-ESG portfolios, according to the world’s largest asset management firm, BlackRock. However, in each of these cases, the authors have skin in the game, profiting from their ESG products.

More sanguine is the study by researchers at the University of Chicago. They analyzed the Morningstar sustainability ratings of more than 20,000 mutual funds representing over $8 trillion in assets and concluded, “We do not find evidence that high-sustainability funds outperform low-sustainability funds.” A study from Columbia had similar findings, but also flags other concerns, including that the companies held in ESG portfolios have “worse track records for compliance with labor and environmental laws” compared to companies held in non-ESG funds. However, if corporate governance criteria are singled out, well-governed companies perform better than those poorly run.

The impact ESG funds have is also up in the air. The former head of sustainable investing at BlackRock, the world’s largest asset manager, bluntly said, “The major problem that I have is that even if they’re marketed correctly, they actually have no demonstrable impact.” Tariq Fancy sees CEO incentives being short-term in focus since leadership tenures are on average only a few years long and compensation is tied to meeting quarterly growth targets — a system that works against putting in place ESG strategies that may take two or three decades to bring results.

In other words, three realities determine how companies operate: how managers achieve share performance, how boards can provide maximum returns to their shareholders, and how companies can appease activist investors, who are ready to pounce on companies that don’t maximize shareholders’ wealth, at bay. Unfortunately, these are poorly tied to ESG standards that the companies are supposed to honor.


Nearly 1,000 companies have publicly announced they are voluntarily curtailing operations in Russia. Not to continue doing so has become counterintuitive, but as costs escalate and a recession takes hold, continued long-term ESG investments will be harder to rationalize or pursue if they can be shelved to ensure a company’s survival and arrest a sharp downfall in share prices. But those constraints shouldn’t derail companies’ ESG commitments.

For investors, consumers, and policymakers, holding companies’ feet to the fire through greater disclosure obligations that are aggressively enforced will move companies to help rescue our habitat and maintain inclusive and just workplaces. Incentives — including tax cuts and public financing — that reduce risks and increase returns are powerful forces in molding economies’ consumption patterns and resource dependencies. Policies must be multifaceted, blending regulation with incentives. But investors have a responsibility too: to view ESG investing with the same skepticism and due diligence they do for any use of their capital. As Gensler warned, the ESG label as it stands today may be deceptive.

Building on small wins will reinforce ESG’s credibility and impact. Rushing to change the goalposts will only enhance cynics’ dismissal of ESG as a fashion, not an enduring investment principle like value investing that Benjamin Graham and David Dodd pioneered in the 1930s. In other words, the Biden administration must work to make ESG standards desirable, achievable, and profitable. The SEC’s recent regulations update is a small step in the right direction.

James David Spellman is principal of Strategic Communications LLC, providing counseling on government affairs strategies. He holds an M.Phil. from Oxford University in International Relations.

James David Spellman

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