An Introduction To ESG Integration: Understanding The SEC Classification

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The ESG integration incorporates one or more ESG with non-ESG factors in investment decisions. The SEC, on the other hand, regulates the US securities industries and brings clarity to ESG funds, market strategies, and investment products. The SEC released a proposal in 2022 that categorizes ESG investments into integration, focus, and impact.  The proposal aims at helping investors to make more informed decisions when investing in ESG products.

Read on for an introduction to ESG integration and SEC classification in the sections below.

An Introduction To ESG Integration

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According to SEC’s proposed rules on integration funds, the ESG factors are non-determinants when including or excluding a particular investment portfolio. If adopted in an introduction to ESG integration, the SEC proposed rules would require the following:

  • Categorization of registered investment funds into an ESG fund type
  • Disclosures on how the funds incorporate Environmental, Social, and Governance factors in their investment strategies
  • Annual fund summaries to reveal additional ESG information
  • Registered advisers to reveal their ESG practices
  • ESG disclosures be in a machine-readable data language structure
The SEC Classification

The impact of the SEC’s proposed rules depends on the ESG fund types and application to the fund’s investment decisions. These funds include the following:

The Integration Fund

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The integration fund considers one or more ESG factors with non-ESG factors where the ESG factors are not more significant than the rest in the investment selection process. Of the three funds, the integration fund portrays the least commitment to ESG issues defining ethical investment. This fund does not look at every issue or utilize the ESG criteria in every decision.

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The ESG-Focused Fund

An introduction to ESG integration reveals certain gaps in the integration fund. To deal with the limitations, the SEC proposed the ESG-focused fund to substantiate more commitment to ESG factors in strategies. The ESG-Focused fund focuses on one or more ESG factors as a main consideration in selecting investments and engagement strategies with the companies it invests in.

The ESG-focused fund has lower disclosure requirements as it does not prioritize ESG considerations. This feature helps to resolve greenwashing fears and legitimizes those in ESG-focused categories. However, ESG-focused funds engaging with issues through other means than proxy voting will disclose information on the KPIs of their engagements. The disclosure will include the percentage or number of issues the fund has held its engagement meetings.

The ESG Impact Fund

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While inviting feedback throughout its proposed rules in an introduction to ESG integration, it is clear that the SEC’s intentions aim at better transparency for the investor. If adopted, this framework will define the operating parameters of the ESG funds and advisers.

The ESG impact fund seeks to attain a specific ESG impact or more. In the proposed SEC rules, an impact fund will need to summarize the fund’s progress upon achieving impacts in quantitative and qualitative terms. The fund will also identify the key factors affecting its ability to achieve the specific effects annually.

The Bottom Line

If the above-proposed rules are adopted, this will mark the first time the SEC requires disclosure of specific aspects of the investment processes by sponsors. Failure to comply could place a fund in the SEC’s crosshairs. Therefore, fund advisors should start reviewing their compliance programs on investor disclosures, ESG practices, and policies to ensure consistency with their representations and disclosures.

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