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ESG regulations and compliance monitoring

Published on September 19, 2023 by Mary Fernandez , Rakesh Jamdhade and Tilling Suniya

Environmental, social and governance (ESG) factors have become a major area of focus for regulators, investors and companies. As investor demand for more ESG-focused investments has increased, companies have become more conscious about climate-related impact on the environment, society and business and have started to offer ESG-focused products. Large regulators such as the Securities and Exchange Commission (SEC) and the Financial Conduct Authority (FCA) are, however, becoming increasingly concerned about companies “greenwashing” products – misleading investors with their claims – and are requiring transparency from financial market participants (FMPs) on their ESG investment strategies.

Accordingly, the SEC proposed amendments to regulation governing ESG disclosures in May 2022, increasing disclosure requirements for funds and advisors marketed as ESG-focused.

Funds and advisors are now required to provide more specific disclosures based on their ESG strategies in fund prospectuses, annual reports and advisor brochures. Funds also need to disclose their greenhouse gas emissions statistics based on their investments. Any funds claiming to have an ESG impact would need to provide details on how they plan to have an impact and a summary of the progress on this front.

The amendments mandate that funds with proxy voting disclose information on their voting practices in relation to ESG-related matters and any information obtained at ESG-related meetings. This would require ESG reporting of census-type data on Forms N-CEN and ADV Part 1 A that are used by funds and advisors, respectively.

The rule would apply to certain registered investment advisors and companies, advisors exempt from registration and business development companies. The SEC expects these changes to promote dissemination of consistent and reliable information on ESG funds and advisors to investors.

These amendments are expected to come into effect this year. In anticipation of this, most large firms have already begun disclosing some of the information required. However, publicly traded small- and mid-cap firms are likely to struggle with compliance, as they lack the required resources needed to meet the guidelines. Some are also concerned about the additional costs of compliance and reporting.

Fund managers and advisors have identified several other drawbacks in implementing ESG-related amendments. ESG disclosures differ for funds and advisors operating in different jurisdictions due to the absence of universally accepted disclosures. Moreover, the lack of standardisation in reporting due to varying methodologies and criteria makes it difficult to compare and analyse different sets of data. It is important to educate investors on ESG to establish mutual understanding of disclosures and their requirements. Imposing penalties for non-compliance may encourage investors, fund managers and advisors to take policies more seriously.

FMPs draft investment policies or set up committees to help them meet such regulatory requirements. However, these do not necessarily mitigate risk of violation, misleading/false claims and reputational risks. FMPs should also focus on the following:

  • Having checks in place to validate ESG policies and procedures to be followed by portfolio managers

  • Having a team in place to conduct a gap analysis between internal ESG policies and regulatory requirements

  • Living up to their claims in offering documents such as memoranda and prospectuses

  • Assessing what can be improved to ensure increased compliance in terms of ESG investments

To ensure this, they would need to have compliance monitoring in place, to avoid regulatory fines and reputational risk.

Compliance monitoring is an important component of FMPs’ second line of defence, as it assesses the effectiveness of compliance with laws, regulations and policies (internal and industry standards). Such review could generate early warnings of actual or potential compliance problems, identify areas where training or internal controls can be strengthened and, most importantly, mitigate legal, regulatory and reputational risks.

How compliance mitigates risk inherent in ESG funds

Internal ESG policy The compliance function must test whether internal ESG policy is integrated with the ESG investment process. If the policy states that as part of due diligence the firm is required to send ESG checklists to clients, the compliance function should verify the factors included under each pillar. If the policy states that certain businesses and sectors are on the exclusion list, the compliance function should ensure processes are in place to prevent ESG funds from investing in such companies and sectors.

ESG checklists and questionnaires – Portfolio managers assess the ESG risk of companies based on checklists and questionnaires. The compliance function must ensure that factors included in ESG checklists and questionnaires are aligned with internal regulatory requirements and the firm’s policy on ESG funds.

Pre-investment screening and due diligence – This is one of the most critical steps in the investment process. The compliance function should test the accuracy of screening and the due diligence process to ensure investments are made in companies with less ESG risk.

Disclosures – Regulators require FMPs to disclose ESG information that is material to investors on their websites and in reports, regulatory filings and voluntary filings such as United Nations Principles of Responsible Investment. The compliance function must test the authenticity of disclosures by validating the data reported.

Article 8 or 9 funds – Funds that promote environmental or social characteristics are classified as article 8 or light-green funds. Funds that have sustainable investment as their objective are classified as article 9 or dark-green funds. The compliance function should test these funds’ portfolio allocation to assess whether they are investing as they claim in their prospectus.

Portfolio and country allocation – The idea behind allocation is to have a positive ESG impact while generating competitive financial returns. The compliance function must verify that allocations are assigned to companies, sectors and countries according to ESG risk scores.

This structure would help the ESG compliance-monitoring function prepare quality assurance testing and ensure the firm’s internal frameworks, investment process, policies and procedures meet all the regulatory requirements.

How Acuity Knowledge Partners can help

We deliver unparalleled ESG compliance and monitoring solutions. As a trusted partner, we take the complexity out of navigating ESG regulations, providing tailored managed services. We work closely with your organisation, ensuring seamless verification of internal ESG policies, meticulous data validation and authentic disclosures. We help conduct pre-investment screening and due diligence, and help you make well-informed decisions that align with your sustainability goals.


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About the Authors

Mary Ann Fernandez is a Senior Associate and has been associated with Acuity Knowledge Partners for four years. At Acuity Knowledge Partners she is part of the corporate and forensic compliance team and is part of the operational due diligence team for a client. She is a graduate who specialized in Finance and Accounting and holds a Bachelors degree from Christ University, Bangalore.

Rakesh Jamdhade has over 11 years’ experience of working with Investment firms for Compliance department. His expertise spans across Trade surveillance and ESG compliance monitoring. Prior to joining Acuity, he was associated with BNP Paribas and Accenture. He holds a Master’s degree in Business Administration, specializing in finance. At Acuity Knowledge Partners, he is part of Corporate and Forensic Compliance team and specializes in Best Execution, Fair allocation and ESG monitoring.

Suniya has 9+ years of experience in Corporate Compliance. She has previously worked with State Street Global Advisors. She is an Analytical and detail-oriented professional, focused on making sure products meet all relevant domestic and international regulatory requirements. With methodical and objective with good judgment and sound critical thinking and problem-solving abilities. At Acuity Knowledge Partners she is part of the Corporate Compliance team and specializes in Marketing and Advertising Reviews. Suniya is an BALLB graduate from Bishop Cotton Women’s Christian Law College, Bangalore University.

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