The Politicization of ESG Investing
Credit: Vecteezy
In the U.S., pension fund managers and elected officials of several states are taking diametrically opposed and partisan political positions as to whether it is permissible or appropriate for public pension managers to consider environmental, social, and governance (“ESG”) factors in their investment decisions and analyses. The respective ideologies on each side of this political divide are also manifested in related activities in which various states take pro- or anti-ESG positions in administering state financial matters unrelated to pension funds (e.g., regarding fossil fuel or firearms companies), including a recent announcement by the Florida chief financial officer that the state will begin divesting $2.0 billion worth of assets currently under management by BlackRock, Inc. (“Blackrock”), the world largest asset manager, based on Blackrock’s views and policies regarding ESG investing.
The intervention of partisan politics into the administration of pension investments is not limited to state public pension funds. With respect to private sector employee retirement plans (typically corporate plans) subject to the federal Employee Retirement Income Security Act of 1974, as amended (“ERISA”), the United States Department of Labor (“DOL”) under President Biden adopted a new rule in November 2022 (Prudence and Loyalty in Selecting Plan Investments, 2022, the “2022 DOL ESG Rule”) rescinding a prior Trump administration rule that some stakeholders claimed has had a “chilling effect” on ESG investments. The 2022 DOL ESG Rule does not apply to state pension funds, which are exempt from ERISA rules, but, based on historical practices, it will likely influence consideration of ESG factors in state pension investment decisions and alter to some degree the political rationales driving the current political divide on pension fund ESG investing.
The fundamental economic question presented is whether the inhibition of ESG investing for political rather than economic reasons by public and private sector pension plans are impediments to optimally efficient market-driven capital flows and allocations (i.e., regulatory friction). A preponderance of studies on the performance of ESG oriented investments suggests that indiscriminate exclusion of ESG investment strategies by pension fund trustees has the potential to hinder rather than enhance the financial performance of their funds (Whelan et al., 2021; Friede et al., 2015) and, therefore, impair the financial returns to plan participants. In addition, with regard to environmental and social impact, it follows logically that this regulatory friction could impair the scale of potential positive impacts that might be otherwise facilitated by ESG investments relating to critical environmental and social issues such as carbon emissions; employee diversity, inclusion and welfare; resource conservation; and others.
The Evolution of ESG Investing
The consideration of ESG factors in investment decisions by pension plans is not new. Brett Hammond and Amy O’Brien identify what they call a “pre-modern” era of ESG investing, roughly ending in the early 1980s, during which investor interest in non-financial operations of the corporations in which they invested was focused primarily on governance issues, leaving it to governments and union activism to regulate concerns about the environment and employee and consumer protection. At the dawn of what Hammond and O’Brien call “the modern era of ESG investing,” in the late 1970s and early 1980s pension investor concerns for social and environmental topics evolved into what became known as socially responsible investing (“SRI”) (Hammond & O’Brien, 2021, p. 20). By the 1990s public pensions joined other investors and stakeholders as activists on hot button issues such as apartheid in South Africa, child labor, tobacco, alcohol, and the prevention of environmental calamities such as the Exxon-Valdez oil spill, eventually spurring a corporate social responsibility (“CSR”) movement to pressure corporations to consider their responsibility for the negative externalities of their operations (Hammond & O’Brien, 2021).
On a separate trajectory from CSR, a global sustainability movement began in the 1980s with the United Nation’s Brundtland Report (entitled “Our Common Future”) which sought to reconcile economic development globally with the protection of social and environmental balance. In a much quoted phrase the report defined sustainability as “development that meets the needs of the present without compromising the ability of future generations to meet their own needs” (World Commission on Environment Development, 1987, §1.3). This has been adapted over the last three decades in the private sector into corporate sustainability, defined by scholars as an intentional strategy to create long-term value through improved social and environmental impact (Grewal & Serafeim, 2020). Grewal and Serafeim note that corporate sustainability differs from CSR in that the latter is often not integrated into strategy and consequently implemented only at the margins of the business.
In 2004 the investor perspective on financially material aspects of corporate sustainability coalesced under the term ESG as famously used in a United Nations report entitled “Who Cares Wins: Connecting Financial Markets to a Changing World” issued by a coalition of 20 major financial institutions with combined assets then under management of more than $6.0 trillion (United National Global Compact). The focus of the report was a series of recommendations targeting different financial sector actors (e.g., institutional investors, fund managers, buy-side and sell-side research analysts and investment consultants) which sought to address how to integrate ESG value drivers into financial market research, analysis and investment. This might be said to be the birth of ESG as distinguished from the SRI that had previously prevailed.
From a pension plan fiduciary perspective, this evolution to the current state of ESG investing is important as there is no persuasive argument that retirement plan fiduciaries in the U.S. can legally, through their investment decisions, promote social and environmental outcomes at the cost of harming the long-term financial returns of plan beneficiaries. As discussed below, the law is clear on this — they cannot (Schanzenbach & Sitkoff, 2020a; Cavaliere et al., 2021). Rather, the principal issues often obscured by the currently highly partisan political environment and thus in need of greater clarity are (a) to what extent are ESG factors appropriate to consider in furthering optimal financial outcomes for plan beneficiaries; and (b) when is it appropriate for plan fiduciaries to consider collateral social or environmental benefits, even when returns can reasonably be anticipated not to be impaired.
ESG Investing Under ERISA
Globally, ESG investing has grown as much as tenfold in the last decade (Kline, 2021). The market research firm Morningstar, Inc. recently estimated that total assets in ESG-designated funds totaled $3.9 trillion (Reuters, 2021). More broadly it is estimated that money managers apply ESG criteria for about $12.0 trillion in assets, whether or not in funds styled as sustainable or ESG (Aubrey et al., 2020). However, according to the DOL’s 2021 rule proposal (Prudence and Loyalty in Selecting Plan Investments, 2021, the “2021 DOL ESG Rule Proposal”) in 2020 only three percent of corporate employee retirement plans offered any ESG investment choice to its plan participants (p. 57297, citing the 2020 63rd Annual Survey of Profit Sharing and 401(k) Plans, Plan Sponsor Council of America). By contrast, it has been estimated that public pensions apply ESG criteria to more than half — at least $3.0 trillion — of all assets in public pension funds. The difference in scale of ESG investing is attributable in part to private sector plans adhering to stringent interpretations of ERISA’s prudence and loyalty fiduciary tests (Aubrey et al., 2020, p. 3).
In December 2020, shortly before the end of the Trump administration, the DOL issued a regulation (Financial Factors in Selecting Plan Investments, 2020, “2020 DOL ESG Rule”) challenging ESG investing. The 2020 DOL ESG Rule required ERISA plan fiduciaries to make investments decisions based solely on financial considerations relevant to the risk-adjusted economic value of a particular investment or investment course of action, but the DOL under the Biden administration announced it would not enforce the 2020 DOL ESG Rule, noting concerns that it “has had a chilling effect on appropriate integration of climate change and other ESG factors in investment decisions” (2021 DOL ESG Rule Proposal, p. 57275).
Aubrey et al. acknowledge the uncertainty caused by the back and forth of DOL regulation and guidance as the political winds shift (summarized in part in Figure 1 below), but note that even though DOL rules do not apply to state pension plans, the DOL guidance prior to the 2020 DOL ESG Rule had an indirect impact on public plan behavior by legitimizing the role of ESG factors in investment decisions. This interplay between ERISA law and state pension fund behavior possibly foretells renewal of momentum in favor of ESG investing by state pension funds following the effectiveness of the 2022 DOL ESG Rule on January 30, 2023. This momentum is also likely to be propelled by the tremendous growth in ESG investing globally and a rapidly consolidating ESG ecosystem of data providers, rating agencies, framework developers, assurers, coalitions and initiatives, standard setters (voluntary and mandatory) and other actors influencing how companies report ESG information.
Anti-ESG Actions in Certain States
At least 19 states have announced or taken various steps designed to limit or discourage various kinds of ESG investing at the state level through new regulation or legislation. For example, the Governor of Florida has proposed legislation for the 2023 legislative session that would prohibit the Florida State Board of Administration (SBA) fund managers from considering ESG factors when investing the state’s money and require SBA fund managers to only consider maximizing the return on investment on behalf of Florida’s retirees (Executive Office of the Governor, State of Florida, 2022). The Governor also announced that he will propose an update to the fiduciary duties of the SBA investment fund managers and investment advisors to clearly define the factors fiduciaries are to consider in investment decisions, which are not to include ESG factors (Lichtenstein et al., 2022, p. 4).
A new law adopted in Idaho in 2022 prohibits public entities using an investment agent from considering ESG characteristics in a manner that could override the prudent investor rule of Idaho state law when selecting investments(An Act Relating to Disfavored State Investments, 2022). More specifically, in Kentucky, the state attorney general has opined that ESG investment practices are inconsistent with Kentucky law on the fiduciary duties of investment management firms to public pension plans (Lichtenstein et al., 2022, p. 7). The opinion concludes that ESG investment practices that “introduce mixed motivations” to investment decisions are inconsistent with Kentucky law governing fiduciary duties of investment management firms.
Other anti-ESG initiatives target financial firms that exclude financing or making investments in fossil fuel or firearms companies. For example, Texas passed legislation in 2021 requiring the listing and possible divestment of financial institutions that are determined to have ceased financing fossil fuel energy companies and in West Virginia, the state treasurer designated five commercial banks that were found to have boycotted energy companies as “Restricted Financial Institutions” which will exclude the designated bank from future banking contracts with the state (Forrester, J. et. al., 2022).
The attorneys general of 19 states — Arizona, Arkansas, Georgia, Idaho, Indiana, Kansas, Kentucky, Louisiana, Mississippi, Missouri, Montana, Nebraska, Ohio, Oklahoma, South Carolina, Texas, Utah and West Virginia — sent a letter in August 2022 to BlackRock claiming that Blackrock was putting its “climate agenda” ahead of the best interests of beneficiaries in certain ESG oriented retirement funds. The letter implicitly contains a critical assumption that Blackrock’s approach to energy investments is inconsistent with optimizing financial returns:
“Whether mixed motives arise from a desire to save the world or attract investment from European or left-leaning pension funds, is ultimately irrelevant to the legal violation. Investors have wide latitude over their own money, but our state pensions must be invested only to earn a financial return (Brnovich et al., 2022, p. 2).”
The assumption in the letter that ESG investments seek to do something less than earning an optimal financial return is significant because it allows for no possibility that ESG investing might be fully consistent with fiduciary duty to maximize returns, even if in some cases it results in collateral environmental or social benefits. Moreover, as some commentators suggest, fiduciary duty might in some cases require that financially material ESG factors be a mandatory consideration for pension plan trustees (Cavaliere et al., 2021; Sandberg, 2010).
There can be no doubt that the anti-ESG movement is currently fueled by partisan politics. The New York Times reported on the results of an investigation in which it found that much of the anti-ESG investing movement is being led by Republican state treasurers supported by a “complex web of conservative groups linked to the fossil fuel industry” in a coordinated effort “to thwart climate action at the federal and state level” (Gelles, 2022). Proponents of the anti-ESG movement, however, claim they are responding to an inappropriate pro-ESG agenda of the political left. For example, an ESG page on the Utah state treasurer’s website states that “ESG is a political score that, intentionally or not, can result in market participants using economic force to drive a political agenda” and that “Treasurer Oaks is committed to pushing back against ESG” (Utah State Treasurer, n.d.).
The anti-ESG proponents have broadened their attacks on ESG investing beyond the argument that trustees violate their fiduciary duty when they act with mixed motives. Although in a recent Wall Street Journal Op-ed, former Attorney General William P. Barr and Yale Law School professor Jed Rubenfeld accused the “Big Three” asset management firms (State Street, Vanguard and BlackRock), which they note have collectively more than $20 trillion of assets under management, of using their “vast economic clout to push a social and political agenda that many Americans don't support and never voted for. It's a usurpation of their political rights” (Rubenfeld & Barr, 2022).
Pro-ESG Actions in Certain States
Since 2019, at least 15 states have taken steps to favorably integrate ESG considerations in law and regulation. The first of these to be enacted requires state and local governmental entities in Illinois that manage public funds to consider materially relevant sustainability factors, including, but not limited to: (1) corporate governance and leadership factors; (2) environmental factors; (3) social capital factors; (4) human capital factors; and (5) business model and innovation factors (Illinois Sustainable Investing Act, 2019).
In 2021, Maine enacted first-in-the-nation legislation prohibiting investment by the Maine Public Employee Retirement System in the 200 largest publicly traded fossil fuel companies and to divest from those companies before 2026 (An Act To Require the State To Divest Itself of Assets Invested in the Fossil Fuel Industry, 2021). Similar legislation is pending in Vermont and California and, although not currently pending, such legislation has been considered in Virginia and Hawaii (Lichtenstein, et al., 2022). In Hawaii, the investment policy statement of the state’s Employees’ Retirement System encourages “responsible investing,” defined to include areas of concern that are central factors in measuring sustainability and ethical impact in a company or business (Lichtenstein et al., 2022, p. 4)
In 2022, the Massachusetts state treasurer announced that the state’s governing pension board had created an ESG committee to assist the fund to promote ESG labor, diversity and environmental goals “while still maintaining — and even increasing — returns” (Office of the Massachusetts Treasurer, 2022, p. 1). The treasurer’s announcement also stated that the fund’s voting guidelines had been amended to require the fund to vote against any director at a company that is not aligned with the 2015 Paris Climate Agreement and the Climate Action 100+ initiative.
Legislation enacted in 2022 requires the Maryland State Retirement and Pension System board to address climate risk management in its investment policies and to report annually on the level of its climate risk across its investment portfolio (State Retirement and Pension System-Investment Climate Risk-Fiduciary Duties, 2022).
In 2021, the New York State Teachers’ Retirement System announced that it would cease further investment in 20 oil and gas holdings and thermal coal reserve companies and divest from $66 million worth of thermal coal holdings (Lichtenstein et al., 2022). Also, seven states — Connecticut, Massachusetts, Nevada, New Jersey, New York, Pennsylvania, and Rhode Island — have announced or taken action since 2019 requiring or intended to require divestment from firearms or ammunition companies (Lichtenstein et al., 2022, pp. 3-14).
In addition, in apparent response to the burgeoning anti-ESG movement, the New York City comptroller and 12 Democrat state treasurers — from California, Colorado, Delaware, Illinois, Maine, Massachusetts, Nevada, New Mexico, Oregon, Rhode Island, Washington and Wisconsin — have formed a pro-ESG investment organization under the name “For the Long-Term” and condemned on their website the blacklisting by other states of certain asset managers offering ESG investment choices (For The Long-Term, n.d.).
Fiduciary Duty
Prominent supporters in the legal community of the anti-ESG movement state that pension trustees risk violating their fiduciaries duties if they permit their funds to engage in ESG investments because “the sole interest rule requires investment fiduciaries to act to maximize financial returns, not to promote social or political objectives” (Rubenfeld & Barr, 2022). In a seminal law review article published in February 2020 and a follow-on summary article published in October 2020, however, legal scholars Max Schanzenbach and Robert Sitkoff analyze in considerable depth legal issues at the intersection of fiduciary principles and ESG investing in the U.S. and opine that a trustee or other fiduciary who reasonably concludes that use of ESG factors will provide risk and return benefits should have no hesitation in using those factors, “provided that the trustee is solely motivated by that conclusion” (Schanzenbach & Sitkoff, 2020b, p. 47). Moreover, they conclude that SRI — which they define as “investing for moral or ethical reasons or to benefit a third party” (Schanzenbach & Sitkoff, 2020a, p. 389) — more than likely breaches fiduciary duty, while “risk-return ESG” (discussed further below) is “permissible but not mandatory” (Schanzenbach & Sitkoff, 2020b, p. 47; Schanzenbach & Sitkoff, 2020a, p. 448).
Schanzenbach and Sitkoff take a middle course between two conflicting views of pension fiduciary duties previously set forth. John Langbein and Richard Posner (1980) viewed skeptically the permissibility of SRI investing under ERISA because ERISA bans investments for any purpose other than seeking optimal risk-adjusted returns (Langbein & Posner, 1980). In contrast, Benjamin Richardson (2007) took a favorable position with respect to then nascent field of ESG investing, citing an appeals court holding that trustees do not breach their fiduciary duty of loyalty when the costs of considering social impact are de minimis.
Schanzenbach and Sitkoff refer to ESG investing motivated by moral or ethical purposes or for the benefit of a third party (i.e., essentially the same as SRI) as collateral benefits ESG (Schanzenbach & Sitkoff, 2020b, p. 43). They distinguish collateral benefits ESG from risk-return ESG (i.e., “to improve risk-adjusted returns”) and note that “American trust fiduciary law generally prohibits collateral benefits ESG, but risk-return ESG can be permissible” (Schanzenbach & Sitkoff, 2020b, pp. 42-43). Unlike prior DOL guidance which was overruled by the 2020 DOL ESG Rule, Schanzenbach and Sitkoff reject the use of ESG factors as tiebreakers when trustees are presented with two otherwise identical investment decisions. They view “mixed motives” as violative of the sole interest rule under ERISA and don’t believe that trustees can consider collateral benefits to break a tie between two choices with identical return and risk profiles (Schanzenbach & Sitkoff, 2020a, pp. 408-411).
In contrast, the 2021 DOL ESG Rule Proposal noted that “[c]ontrary to the perception created during the promulgation of the [2020 DOL ESG Rule], the Department does not view collateral benefits as being presumptively illegal” (p. 57279) and ESG might be a legitimate collateral benefit for consideration (pp. 57278-57279). The proposed rule commentary stated that fiduciaries are not prohibited from selecting investments based on collateral benefits other than investment returns provided that the trustees do not accept reduced returns or greater risks associated with the collateral benefit (pp. 57278-57279). The 2022 DOL ESG Rule restores the tiebreaker standard so that if a fiduciary fairly concludes that competing investments offer equal financial return prospects over the appropriate time horizon, collateral benefits may be considered.
Since 2005, the United Nations has published a series of reports asserting that as a general matter ESG investing is consistent with fiduciary duties globally (Sandberg, 2010). The first report, known informally as the “Freshfields Report” and issued by the United Nations Environment Program’s Finance Initiative, summarized fiduciary law globally relevant to the issue and concluded that embedding ESG factors into an investment decision is clearly permitted and possibly required (Sandberg, 2010). The report endorsed on legal grounds the concept of using tiebreakers when two choices otherwise identical on a risk-adjusted return basis are presented. In addition, the report noted that it should be mandatory for ESG factors to be considered when ESG considerations are found to be material to a company’s financial performance (Sandberg, 2010, p. 146).
A follow up report to the Freshfield Report — entitled “Fiduciary Duty in the 21st Century” — concluded that fiduciary duty is not a barrier to investing sustainably and, instead, that a failure to consider relevant and material ESG factors as drivers of long-term value creation is actually a failure of fiduciary duty. Other legal scholars find that whether or not ESG factors should be a mandatory consideration for pension plan trustees to be an open question, noting that the still-evolving and currently uncertain nature of ESG attributes and the manner in which fiduciary duties have evolved piecemeal through common law, trust law and federal and state statutory law (Cavaliere et al., 2021, p. 21).
The literature reviewed above illustrates that pension fiduciary law is not static. It is unlikely, however, that in the foreseeable future U.S. federal or state law will allow pension plans to make investments in which returns are sacrificed in favor of potential environmental or social benefits. Nonetheless, as suggested above and discussed below, a trend is developing in certain pro-ESG states in favor of regulation or law mandating consideration of ESG factors in pension fund investment decisions when returns are not expected to be impaired (Lichtenstein et al., 2022).
Also, turning collateral benefits analysis on its head, there is new research looking at the negative consequences that might arise from spurning ESG considerations in state finance decisions. Daniel Garret and Ivan Ivanov studied the economic impact of anti-ESG regulation in Texas that prohibits certain state entities from contracting with banks that have specified pro-ESG policies. Due to “significantly fewer bidding underwriters and higher bid variance, consistent with a decline in underwriter competition,” the authors estimated the less advantageous circumstances resulted in a detriment of between $302-$353 million of additional interest payments on state borrowings in the first eight months the new restrictions were in place (Garret & Ivanov, 2021, p. 1). This is significant because it illustrates how adding regulatory impediments to the free flow of capital can result in collateral detriments, possibly including adverse impacts on returns. This study suggests the possibility of adverse consequences resulting from regulatory friction that can be suffered by pension plans not investing in sustainable investments that have earned a place on economic grounds.
ESG and Financial Performance
Research on the financial performance of ESG investing are decidedly mixed. A large meta-study of more than 1,000 peer reviewed articles published between 2015 and 2020 finds that a majority of the studies surveyed conclude that ESG investing is more likely than not to be financially beneficial (Whelan et al., 2021). A previous study combining the results of more than 2,000 primary studies also found positive evidence of financial benefits from ESG investing (Friede et al., 2015).
The Whelan paper notes that analysis of the relationship between consideration of ESG criteria and financial performance is difficult because of inconsistent terminology and nomenclature and most studies fail to distinguish between material and immaterial ESG factors (Whelan et al., 2021, p. 3). This had led to widely diverging individual research results. For example, a study of funds that used negative screening to exclude companies with poor ESG performance found a positive benefit of ESG investing (Verheyden et al., 2016). An earlier study that looked at portfolios positively screened for ESG factors among companies found a positive correlation of such portfolios to stock performance (Kemp & Osthoff, 2007).
By contrast, other studies have found that companies with low ESG scores had higher returns (Ciciretti et al., 2019); companies with better ESG scores had lower market valuations (Marsat & Williams, 2019); and ESG-styled funds have lower returns (as much as 43.9% lower over ten years as compared to an S&P 500 index) (Winegarden, 2019). With regard to the Winegarden study, which the DOL cited in the 2021 DOL ESG Rule Proposal, Blackrock characterized it in a comment letter as flawed in that not all the ESG funds evaluated by Winegarden were broadly diversified U.S. equity funds and the investments studied included global clean technology-related companies with significant exposure to international and emerging markets or were concentrated in one or two industries (Blackrock, 2021). Blackrock concluded: “Because of this dataset mismatch, Winegarden’s comparison of the selected ESG funds against the S&P 500 does not isolate how incorporation of ESG data affects performance” (Blackrock, 2021, p. 2).
Because there are thousands of published studies on the general topic of the financial performance of SRI and ESG funds, it is appropriate to assign less weight to studies that focus on the relationship between ESG investing without regard to the financial materiality of the factors considered (as is common in studies of SRI investing) in favor of studies that focus on whether ESG investing that prioritizes material ESG factors can reasonably be expected to enhance (or at least not impair) fund financial performance, as required under state and federal trustee fiduciary duties. These studies substantiate arguments in favor of ESG investing based on financial materiality regardless of the presence of collateral social and environmental benefits.
For example, Porter et al. (2019) state there is no conclusive evidence that socially responsible screens of company positions on various sustainability ratings lists outperform market averages but that “there is compelling evidence that superiority in identifying and harnessing social and environmental issues relevant to the business can, over time, have a substantial economic impact on companies and even industries.” An earlier study by Eccles et al. (2014) distinguished between “high sustainability” versus “low sustainability” public companies based on whether or not companies had environmental and social policies embedded into their strategies; high sustainability companies studied were those that had a substantial number of such policies and low sustainability companies were those that had none of those policies. Tracking the selected companies over an 18 year period, the study concluded that the high sustainability companies significantly outperformed the low sustainability companies both in terms of financial results and market appreciation of their stock (Eccles et al., 2014). A subsequent 2015 study found that companies with strong ratings on material sustainability issues have better future performance than firms with inferior ratings on the same issues, while companies with strong ratings on immaterial issues did not outperform (Khan et al., 2016).
The Data Driven and Rapidly Consolidating ESG Ecosystem
The evolution in ESG investing has been accompanied by exponential growth in the amount and types of data available for ESG investors to consider. The number of public companies publishing corporate sustainability reports grew from less than 20 in the early 1990s to more than 10,000 companies by 2019 and nearly 90% of the Fortune Global 500 had set carbon emission targets in 2018, up from 30% in 2009 (Grewal & Serafeim, 2019).
In a 2021 comment letter regarding the 2021 DOL ESG Rule Proposal, Blackrock stated that as ESG data has become more accessible, the firm has developed a better understanding of financially relevant ESG information, and ESG funds that incorporate financially relevant ESG data have become more common. BlackRock noted that its systems for ESG analysis have access to more than 2,000 categories of ESG metrics from various ESG data providers, and concluded that because of the greater volume of ESG-related disclosures by companies and third party ESG vendors, together with advancements in technology, “the use of ESG data to seek enhanced investment returns and/or mitigate investment risks has become more sophisticated” (Blackrock, 2021, p. 3).
Much of the ESG data available to investors historically has been obtained through voluntary cooperation by companies either in answering survey questionnaires or in publishing sustainability reports based on one or more of dozens of frameworks and reporting standards created by various non-profit organizations active in environmental and social causes.
Voluntary disclosure of SRI and ESG information over the past three decades has been highlighted by the development of several key reporting standards and frameworks. The development of the Global Reporting Initiative (“GRI”) in the 1990s as a standard reporting framework for CSR reporting was a major step in promoting reporting focused on ESG issues material to the company and the company’s external impacts on outside communities and the planet. The Task Force on Climate-Related Financial Disclosure (“TCFD”) created in 2017 by the G20’s Financial Stability Board, and widely adopted around the world, recommends disclosure regarding climate-related governance, strategy, risk management, and metrics and targets specific to the risks to a company presented by climate change. In the U.S., the Sustainability Accounting Standards Board (“SASB”), modeled on the Financial Accounting Standards Board which oversees generally accepted accounting procedures in the U.S., was formed in 2011 with a focus on ESG factors material to a company on an industry-by-industry basis. SASB has developed standards for 77 industries that identify and measure financially material, decision useful, and actionable ESG factors important to long-term value creation.
In 2014, the European Commission (“E.C.”) adopted a financial directive (E.C. Non-Financial Reporting Directive) that requires certain large companies to disclose information on the way they operate and manage social and environmental challenges. The directive was intended to help investors and other stakeholders evaluate the non-financial performance of large companies and encourage these companies to develop a responsible approach to business. It applies to large public-interest companies with more than 500 employees (approximately 11,000 companies across the European Union (E.U.)) and requires information related to environmental and social matters, treatment of employees, human rights, anti-corruption, and board diversity (European Commission, 2014). Supplementing the E.C. Non-Financial Reporting Directive, in 2019 the E.C. published new climate reporting guidelines for companies that integrate the TCFD’s recommendations (European Commission, 2019).
To address shortcomings in the E.C. Non-Financial Reporting Directive, on November 10, 2022, the European Parliament substantially increased mandatory sustainability disclosure requirements by adopting a new Corporate Sustainability Reporting Directive which requires detailed and prescriptive disclosure on sustainability matters in the annual financial statements of all large and listed E.U. companies and E.U. subsidiaries with at least two of the following three attributes: more than 250 employees; revenue of more than €40 million; and total assets of more than €20 million; more than 50,000 companies are expected to be covered by the new requirements (European Parliament, 2022).
In 2010, the U.S. Securities and Exchange Commission (“SEC”) issued guidance to reporting companies on disclosure of material climate-related risks that should be disclosed under existing SEC disclosure rules (Securities and Exchange Commission, 2010). Finding that disclosures under this guidance were insufficient, the SEC on March 21, 2022 proposed new rules (The Enhancement and Standardization of Climate-Related Disclosures) to require companies filing reports and securities registration statements with the SEC to provide detailed information about their handling of climate-related risks and opportunities, including climate-related governance, strategy, risk management and metrics and goals based on the TCFD framework. The proposed rules will also require companies to measure and disclose greenhouse gas (“GHG”) emissions in accordance with the GHG Protocol methodology, the most widely known and voluntarily used international standard for calculating GHG emissions. The SEC proposal notes that several jurisdictions have already adopted disclosure requirements in accordance with the TCFD’s recommendations, including Brazil, the E.U., Hong Kong, Japan, New Zealand, Singapore, Switzerland, and the United Kingdom (The Enhancement and Standardization of Climate-Related Disclosures for Investors, 2022, p. 21415).
Figure 2: Consolidation of ESG Ecosystem created by AuditBoard, Inc.
More broadly, as depicted in Figure 2, there is a rapidly accelerating consolidation of the most internationally significant sustainability disclosure frameworks and standards. Last fall, the International Financial Reporting Standards (IRFS) Foundation — which administers the IFRS financial accounting standards that are used in most jurisdictions other than the U.S. — announced the formation of a new International Sustainability Standards Board (“ISSB”) to develop a comprehensive global baseline of sustainability disclosure standards.
In 2022, the ISSB completed the consolidation of: (a) the Climate Disclosure Standards Board, an international consortium of business, environmental and social NGOs that offered companies a framework for reporting environment and social information with the same rigor as financial information; and (b) the Value Reporting Foundation (“VRF”).
The VFR itself was formed by the merger in 2021 of the Integrated Reporting Framework (“IIRF”) with SASB. The participation of the IIRF in the ISSB is noteworthy in that IIRF has promoted the adoption of integrated reporting by putting into monetary terms and combining non-financial ESG data with traditional financial information in company reports.
Taken together, this consolidation of the ESG ecosystem and the continued enhancement and standardization of ESG data and analyses should enable future investment and academic research to more precisely evaluate when ESG factors are relevant to the creation of long-term value, which in turn can facilitate more confident pension fund ESG investment decisions.
New Regulation Addressing the Greenwashing Problem of ESG Funds
In addition to this massive and widespread regulatory momentum to require greater volume, consistency and reliability of corporate ESG disclosures, there is also increasing regulation of ESG funds in financial markets designed to mitigate “greenwashing” where the potential social and environmental benefits of a fund’s ESG investment strategy are overstated or even nonexistent (Cremasco & Boni, 2022).
In Europe, a Sustainable Finance Disclosure Regulation (“SFDR”) effective in 2021 requires E.U. investment firms to disclose their approach to the consideration of ESG factors in their investment decisions and to make disclosures for investment products that do not take into account ESG factors. The SFDR sets forth disclosure categories into which financial products must fall, ranging from funds which address ESG risks but have no sustainability goals (Article 6 funds); funds which promote ESG characteristics (Article 8 funds); and “impact” funds with intentional and measurable sustainability objective (Article 9 funds) (Cremasco & Boni, 2022).
The SEC has pending proposed rules applicable to investment firms that are also intended to combat greenwashing (Enhanced Disclosures by Certain Investment Advisers and Investment Companies, 2022). The proposed rules provide that only funds with an ESG purpose would be permitted to label themselves as such, and a new set of mandatory disclosures for ESG-focused funds are intended to enable outside parties to confirm whether a purportedly ESG-focused fund is in compliance with its stated investment purpose. Similar to the SFDR, the SEC new rules would create three categories of ESG funds: “Integration Funds,” which would be required to describe how ESG factors are incorporated into their investment process together with non-ESG factors; “ESG-Focused Funds,” which would identify ESG factors as a significant or principal consideration, thus requiring more detailed disclosure; and “Impact Funds,”that seek to achieve a particular ESG impact, requiring disclosure on how the fund measures progress towards the stated objectives (Enhanced Disclosures by Certain Investment Advisers and Investment Companies, 2022).
Categorization of ESG funds on a standardized basis under new European and U.S. fund regulations can be expected to significantly mitigate the problem of inconsistent terminology and nomenclature noted by Whelan, et al. (2021) as to what is and isn’t fairly categorized as an ESG investment.
Conclusions
The immense amounts of corporate sustainability data that is becoming increasingly available in more standardized fashion, together with greater clarity on the attributes of what is or isn’t an ESG fund under new investment fund regulations, should enable public or private pension funds to more easily determine whether any particular investment labelled as ESG would be consistent with their fiduciary duties. Based on a fair reading of the duties imposed on trustees as outlined in the literature reviewed, the rigor and standardization of emerging mandatory sustainability disclosure, and the objectives of ESG (as opposed to SRI) investing, it is clear that ESG factors that are considered financially material are appropriate to consider in furthering optimal financial outcomes for plan beneficiaries.
It can also be anticipated that over time ESG factors predicated on financial materiality will become increasingly indistinguishable from other economic considerations in investment analysis and decisions. Moreover, the red state/blue state divide is turning purple in some states. For example, notwithstanding legislative action in Texas requiring the listing and possible divestment of financial institutions that are determined to have ceased financing fossil fuel energy companies (Forrester, J. et al., 2022), the Teacher Retirement System of Texas announced in 2021 that it will consider ESG factors in its investment decisions (Nasdaq, 2021). In Kansas, it was recently reported that investment advisers to the Kansas Public Employees Retirement System’s warned the fund’s board of trustees that requiring or banning investment in certain companies based on political ideas regarding energy policy, climate change or the carbon economy could undermine financial performance of the fund’s $24.8 billion portfolio; the advisers also warned that transferring portfolio management duties from current investment management companies, including BlackRock, to an in-house model could also harm the pension fund’s performance (Carpenter, 2022).
As ESG investing further matures, states which have targeted ESG investing for apparent political reasons — for or against consideration of ESG factors or ESG-styled investment choices — can be expected to come under increasing pressure to recalibrate their positions. In the end, pension fund managers should be unencumbered in making non-partisan investment decisions in the best financial interests of plan beneficiaries. This should certainly include consideration of financially material ESG factors when that is reasonably expected to potentially enhance returns. Also, even when potential financial benefits are uncertain, pension managers should be able to make investment decisions and offer plan participants investment opportunities that might result in collateral positive environmental and social impacts as long as returns are reasonably anticipated not to be impaired.
References are attached.
About the Author:
David Cifrino, a Senior Editor of the Social Impact Review, was a 2021 Fellow and 2022 Senior Fellow in Harvard’s Advanced Leadership Initiative. David is also Senior Counsel at the law firm McDermott Will & Emery LLP where he is a co-founder of the firm’s ESG, Impact and Sustainability practice group. This article does not constitute legal advice.