What is the current state of regulation for ESG fund disclosure in the Canadian market?
What are some of the challenges faced by investors around existing ESG practices?
What should regulators do to help investors deal with these challenges?
What advice can be given to asset managers developing or enhancing their ESG investment strategies?
What is the ideal future in terms of the regulation of ESG investments?

This article is a Q&A on environmental and social governance (ESG) in Canada.

What is the current state of regulation for ESG fund disclosure in the Canadian market?

There are currently no specific ESG regulatory requirements in Canada. However, in January 2022, the Canadian Securities Administrators (CSA) published a notice setting out their guidance on how existing non-ESG-specific securities regulatory requirements apply to ESG-related investment fund disclosure.

The approach that the regulators have taken is interesting. Instead of producing something specific to ESG, they are relying on some of the existing rules that are available to govern in this area. It is important for industry participants to understand that the guidance, since it is based on existing regulatory requirements, is in effect with immediate application, even though it just came out in January 2022.

The guidance is quite extensive. It is 25 pages long and broad in its scope, covering:

  • investment objectives and fund names;
  • disclosure of fund types;
  • investment strategies disclosure;
  • proxy voting and shareholder engagement policies and procedures;
  • risk disclosure;
  • how a fund discloses its suitability for investors and how it impacts a fund's continuous disclosure;
  • sales communications and ESG-related changes to existing funds; and
  • some ESG-related terminology.

The purpose of this CSA notice is to provide fund managers in Canada with relevant and practical guidance to enhance the ESG-related aspects of their funds disclosure documents. The real goal is likely to prevent greenwashing by reminding fund managers that a funds description of its ESG strategies must be written using plain language, and when ESG-related terms are used, the fund manager should provide a clear and comprehensive explanation of those terms.

An interesting aspect about the CSA notice is what type of fund it applies to. It says it applies to investment funds, such as retail mutual funds and exchange traded funds, especially those that have ESG in their objectives or names, but also those that just mention an ESG strategy as a part of the fund. Interestingly, it even applies to funds that do not have any ESG strategies at all, or nothing in their names or objectives, because it specifically says that those types of funds should also consider whether there are any material ESG-related risk factors that are applicable to them and disclose those risk factors.

The aspect that is unclear is whether the CSA intended the guidance to apply to pooled funds or hedge funds offered under an operation and maintenance. The guidance in the CSA staff notice does not specifically state that it is intended only for retail prospectus-qualified funds. However, all of the existing requirements discussed in the notice are those that relate to retail prospectus funds. From this, it can be inferred that the CSA staff notice is primarily intended for retail funds.

The notice does say that staff encourage investment funds, investment fund managers and portfolio advisors to review the notice. Based on past experience, when the Ontario Securities Commission and other regulators conduct compliance audits of registrant firms that manage pool funds or hedge funds, they do often look to existing CSA staff notices for retail prospectus-qualified funds as a guide as to what they would expect to see as a best practice.

Therefore, it will be important for all investment funds managers to look carefully at this notice and get policies and procedures revised to ensure it is followed quickly.

What are some of the challenges faced by investors around existing ESG practices?

It should first be noted that ESG is a big deal for investors these days, and that is why regulatory guidance is coming out on the topic. In November 2020, a report from the Responsible Investment Association showed that retail-responsible investing mutual fund assets had increased by 36% over the past two years. The CSA also speaks to this: they indicate that the value of sustainable funds was C$18 billion at the end of the first quarter of 2021, which represented a 160% increase from 2020.

In response to this interest from investors in ESG investing and sustainable investing, fund managers are starting to deliver the product. The CSA noted in its notice that there were 156 sustainable funds in Canada at the end of March 2021. This is likely why ESG investing is getting some attention by the regulators.

In terms of challenges for investors, there are a couple of challenges. First, investors want clear, consistent and comparable disclosure to help them choose an ESG fund. Although this may sound simple, the situation is made more complex by the fact that different investors may have different reasons for wanting to choose an ESG fund. Some investors may want to consider how an ESG objective or strategy could impact actual investment performance. They may think that, for example, climate change presents a big risk, which could impact their investment, so they want to make sure, for performance reasons, that that risk is being taken into account.

Some investors may want to align their investment with moral values or principles, and some investors may want their investing power to affect positive change for the planet or their communities.

In this regard, the real challenge for investors is that, in order to make their investment decision, they need a lot of information and disclosure on the ESG strategies that are becoming available to them in increasing amounts in the marketplace, how they compare and contrast, and how they can align with what their investment objectives are.

The second challenge is that, once investors do choose an investment product, they really want to make sure that the fund is delivering on its ESG strategy. For years, investors have wanted to make sure that, when they choose an investment product, it delivers on its performance objectives. Often, funds line up against performance benchmarks, and investors want reporting on:

  • what the fund has done to increase its performance;
  • how has it changed; and
  • how is it performing against the benchmark.

A related challenge is that investors want their fund managers to show them what their ESG strategy is and how they are delivering on that strategy. Sometimes, there are benchmarks to deliver on the strategy, such as carbon emission objectives. Investors want to see measurable goals and that their investment choice is meeting those measurable goals.

What should regulators do to help investors deal with these challenges?

The CSA notice is a great step forward. It clarifies the regulatory expectation of the level of disclosure that is required for ESG strategy, and it is going to step up the game a bit. A fund that uses one or more ESG strategies, either as a principal strategy or part of its investment selection process, is going to be required to provide disclosure about the ESG-related aspects of its actual selection process and the strategies. In addition, if the strategies include identifying any ESG factors used, they have to explain the meaning of each ESG factor in plain language and how those factors are evaluated and monitored.

Specifically, if targets for specific ESG-related metrics are used (eg, carbon emissions), funds will now be required to disclose those targets as part of their investment strategies and also to report on them in their ongoing continuous disclosure documentation.

Another interesting aspect is that, if a fund uses proxy voting as an ESG investment strategy, the prospectus is required to provide clarity about how the voting rights attached to the fund's portfolio securities will be used to further the fund's ESG-related investment objectives.

This CSA notice is going to go a long way to help investors make their investment decisions and meet the challenges they have been having in that regard.

What advice can be given to asset managers developing or enhancing their ESG investment strategies?

A first step is to become very familiar with the notice, which is quite comprehensive. A next good step is to conduct an audit of their existing investment products by looking at existing disclosure in the prospectus, but, importantly, also looking at what the marketing material and the website say. Once an audit of all the disclosure has been done, the products should be categorised into how they fit into the notice. Are they an ESG fund, namely a fund that is really focused on ESG and the objective or name? Are they just a fund that uses ESG strategies and hence still subject to many of the aspects of the notice? Or are they really a fund that is not in the ESG space at all?

Once the products have been categorised, asset managers should step back and ask whether this is really how they do want their products to be categorised from an ESG perspective. The notice does provide a lot of guidance to fund managers on how to make changes to existing products involving ESG disclosure and strategies.

For new funds, a point to note is there should probably be implementing processes, namely new processes to consider whether ESG factors will be incorporated into the fund's objectives and strategies.

As a final step, asset managers should look at existing policies and procedures, especially related to sales communications, including the website, and consider if the ESG disclosure meets the guidance from the regulators, and what policies and procedures they need to put in place to make sure that happens.

What is the ideal future in terms of the regulation of ESG investments?

It is expected that ESG-focused products in Canada will increase and that there will be better disclosure for investors. But the one remaining issue that will likely be a focus in the next three to five years is continuing to build on having consistent terminology. Terminology in the ESG area has become a substantial issue.

The CSA notice did include some new terminology, such as the ESG fund, which is a fund focused on ESG and its objectives and name. They have also introduced a new terminology called "ESG strategy fund", which is a fund that only has ESG as part of its strategy. But the CSA did not set any other terminology in the notice. All that the CSA requires in the notice is that a fund's description of the ESG strategies must be written in plain language.

However, the CSA did include a callout in the notice to encourage investment fund managers to develop common ESG-related terms and definitions that will enable investors to better understand ESG-related funds and make informed decisions about them.

Continuing to come up with consistent terminology in the ESG space will likely be a focus over the next few years. One thing to note is that that process is already underway – in fall 2021, the Chartered Financial Analyst Institute released its ESG disclosure standards for investment products. There is also an upcoming release to be issued by the Canadian Investment Funds Standards Committee regarding its framework for the identification classification of ESG funds. All of these initiatives will contain descriptions that will likely help the industry start to align on common language and definitions for ESG investment products.

For further information on this topic please contact Lynn McGrade at Borden Ladner Gervais LLP by telephone (+1 416 367 6000) or email ([email protected]). The Borden Ladner Gervais LLP website can be accessed at www.blg.com.