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How will Standardization be Achieved?

Daniel Murray • 27 June 2022
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How will Standardization be Achieved?

In ESG, achieving a type of standardization in reporting should not be a top-down-only approach where a regulatory entity dictates all the rules and protocols with strict specificity, without any input from the investment community. As an oversight body, the SEC’s mandates are well-intended, but oversight should not border on overreach.

A top-down approach may appear to be the best way to bring about standardization from a regulatory perspective, but this approach does not account for all the ESG materiality that investors will need to report on. The top-down approach assumes that investment strategies are all the same, thus any attempt to achieve standardization with strict, limited rules, and mandates will create operational burdens for investors and companies whose strategy cuts across asset classes, sectors, industries, and markets (emerging and otherwise) – as well as increased complexity and costs.

Role of an Oversight Body

The actions of an oversight body should incorporate considerations on the impact and effect parameters and guidelines will have on those companies required to comply, like establishing a list of indices that cover a broad spectrum of the investible universe. Those parameters and guidelines can then be used as the measure for a majority of asset classes, in addition to the necessary disclosures, to be in compliance with ESG and net zero emissions mandates.

Based on the current reporting mandates that are in place, a top-down approach may appear to be the best way to bring about standardization from a regulatory perspective, but this approach assumes that investor strategies are all the same. It does not account for all the nuanced investment strategies that investors will need to report on, including strategies that cut across asset classes, sectors, industries, and markets (emerging and otherwise).

So, how then do investors account for this, in terms of a proposed standardized reporting process that is based on strict, restrictive mandates?

The Current Standard

To date, the SEC has provided no indication of how it plans to accomplish a standardized ESG reporting process. Currently, most allocators who are ESG-'aware' tend to rely on asset managers to handle the ESG reporting on their behalf – allowing them to take a hands-off, bottom-up approach (where ESG reporting becomes the burden of the asset manager), with allocators having only general oversight.

In turn, although the bottom-up approach has worked so far for investors without a formal ESG policy and reporting process in place (the top-down method), this method of ESG compliance is far from standardized, as each asset manager operate with a wide latitude of what could be called a form of 'green-washing' their investments as being ESG-compliant.

So, should standardization be left up to managers to seek to standardize the current reporting processes that are being utilized among asset managers? And for that matter, how will standardized ESG reporting occur for investors and companies that operate globally in countries with differing or no ESG reporting standards?

Maximizing Top-Down and Bottom-Up

The more rational approach, to achieve a form of ESG reporting standardization, is a mix of both top-down and bottom-up approaches.

The top-down approach includes the SEC setting the parameters and guidelines (not fixed rules and mandates) within which reporting must occur for compliance, utilizing an approved set of indices that cover the varied investment strategies, industries, and asset classes against which materiality is determined. The bottom-up approach allows asset managers and companies who are currently reporting using the current non-standardized protocols, to achieve some level of standardization over time, as more and more companies work within the expanded ESG reporting parameters and guidelines.

There also needs to be a dynamic channel of communication between the SEC and companies whose strategies and operations may not fit cleanly into the reporting parameters and guidelines to afford full disclosure and compliance, so that they can present their cases for consideration by the SEC on acceptable ways to file their reports and disclosures that keep them in compliance.

Standardizing the ESG Reporting Process

The benefits of this open, two-way communication channel will minimize the need for asset managers to green-wash their reporting – and afford the SEC the opportunity to provide up-to-date guidance (not mandates) on acceptable ways to report, and to disclose on investments that do not fit cleanly into the established reporting guidelines and parameters.

In addition, the incorporation of top-down and bottom-up approaches with increased combination will allow asset managers to standardize their reporting within the specified parameters and guidelines, especially if an asset class or sector is not covered by a specific index such as the MSCI.

Over time, this will allow for greater standardization of the ESG reporting process across the board, without having to start over each time new rules and mandates are issued that present operational challenges, disruptions, and confusion.

Views expressed are based on feedback and sentiments from Advisory Board interviews and the sentiments of institutional investors.

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