Financing 1.5°C: In a Booming ESG market, the SEC Has Some Questions

The US Securities and Exchange Commission (SEC) recently made headlines by launching a formal investigation into ESG (environmental, social, and governance) investment products offered by DWS Group, Deutsche Bank AG’s asset management division. The investigation sent DWS shares tumbling more than 12 percent, demonstrating the real-world consequences of a long-burning question in the sustainable finance community: what does ESG really mean?

As demand for investments offering ESG benefits continues to rise, federal regulators have found significant deficiencies in the implementation of ESG strategies as advertised in investors’ portfolios. To help address this issue, the SEC recently established the Task Force on Climate and ESG Issues—the group now responsible for spearheading the DWS investigation—with an explicit mandate to combat greenwashing amid record levels of capital flows into ESG investments.

In short, financial regulation and climate action are increasingly intersecting in the United States. The SEC is looking behind the curtain of ESG investing practices more intensely than ever. It is important, therefore, to understand the SEC’s perspective as a regulator focused on protecting investors. With that in mind, we can make sense of what’s driving the agency’s recent actions and preview the future of US ESG markets.

The ESG Enigma

The concept of ESG has always been confusing. A recent report by InfluenceMap found that over 70 percent of 593 ESG funds were misaligned with the goals of the Paris Agreement. On one hand, these statistics are alarming. On the other hand, nothing about the label “ESG” promises Paris alignment.

Nonetheless, “ESG” is commonly reduced to just “E” (for “environmental”), used interchangeably with “sustainable” or even “climate-aligned” finance. Yet, zooming in on the environmental aspect of ESG alone is a mysterious exercise. Does it signify investment in low-carbon assets? Does natural gas count? Or is it investments that protect waterways? Or that conserve plant biodiversity?

Different interpretations of E, S, or G investments may have merit. The bottom line is that investors seeking to allocate capital in a way that supports various net-zero or sustainability commitments would very much like to know whether investment opportunities with ESG labels match their investing priorities.

Looking under the Hood

SEC Chair Gary Gensler, for one, thinks “investors should be able to drill down to see what’s under the hood of [ESG] funds.” Gensler is promoting a “truth in advertising” approach, aiming to facilitate enough transparency through regulation that investors can discern the substance underlying ESG labels and investing strategies.

Take the SEC’s “Names Rule,” which requires that at least 80 percent of a fund’s assets match what the fund’s name would suggest. To borrow Gensler’s example, a “high-yield bond fund” should disclose evidence that at least 80 percent of the underlying bond assets are below investment grade. Unlike ESG, high-yield bonds have a well-understood definition. The SEC may not yet be defining “green,” “climate-aligned,” or “ESG,” but Gensler’s remarks indicate that the agency may soon compel definitions and criteria used by fund managers marketing ESG products.

The SEC is in charge of promoting fair and efficient markets, ensuring investors have what they need to evaluate investment opportunities and allocate capital as suits their needs and risk preferences—a mission in line with improving transparency around ESG investing. The agency’s mandate may not mention climate, but as Gensler put it, “what investors want changes over the decades.”

What’s Next for ESG?

Investor and advocacy communities are closely monitoring the SEC’s review of climate-related public disclosure requirements, a process happening in parallel to the SEC’s consideration of recommendations around fund managers’ disclosure of ESG criteria and underlying data.

Another relevant and recently proposed SEC rulemaking would require funds to disclose their proxy voting records, including those related to climate and other ESG issues. The proposed rule would improve investors’ ability to hold investment managers accountable, especially those who, rather than shed or avoid polluting assets, intend to support or compel change through active ownership. The strategy has the potential to effect change in the real economy, but it will only work when paired with robust transparency and accountability to distinguish marketing from genuine intent.

No matter which road the SEC takes, investment funds and products without a robust strategy to back up ESG, sustainability, or climate-alignment claims are clearly living on borrowed time. The provision of honest and transparent information is a cornerstone of the SEC’s “fair, orderly, and efficient markets.” Plus, many investors welcome these regulatory steps. Clearer regulatory guidance can support, simplify, and accelerate implementation for financial institutions with climate commitments, establishing a clear market for climate-aligned finance and paving the way for capital allocation in line with a 1.5°C future.

Meanwhile, RMI’s Center for Climate-Aligned Finance will be here to help. We support financial institutions in better understanding their role in the transition, including how to develop and implement climate strategies that propel 1.5°C-aligned change in the real economy, not just within their portfolios. Although the SEC seems to be laying groundwork in the right direction, it will ultimately be up to investors to reorient capital into alignment with a net-zero world.