The Perversion of ESG Investing
As ESG Investing becomes increasingly politicised in the United States, we provide a breakdown of where such politicisation stems from, its impact on asset managers and what asset managers can begin doing to navigate this increasingly challenging landscape.
Benjamin Stone, Analyst
In the past year, we have observed the continued debate around Responsible Investing, and using ESG (Environmental, Social, Governance) factors in the investment process in particular. The discussion has become increasingly heated, particularly in the United States, where the polarised atmosphere that has been created is palpable. Anecdotally, we have heard cases of managers feeling the need to create two separate pitchbooks to avoid politicised debates about values, even though their investment process is the same. Political polarisation is nothing new in the United States, and as successive administration’s the Department of Labour guidance on the degree to which ERISA plans can account for ‘non-pecuniary’ or ESG factors has bounced back and forth, ESG investing was inevitably going to be drawn into the wider polarisation that has engulfed American politics. However, the ferocity and scale to which certain political figures are now criticising ESG investing is unprecedented, and this is also being accompanied by a litany of State level regulations seeking to limit the degree to which investment managers that manage public capital can account for such “ESG” factors in the investment process.
We believe that part of formulating an effective, cohesive response to such pieces of legislation is predicated on a clear understanding of the legislation itself and the misconceptions that underpin them.
We have assessed the recent anti-ESG legislation in certain US states and with this article, we hope to address common fallacies within the broader anti-ESG investing movement, whilst also offering some practical guidance for how impacted asset managers can navigate this increasingly difficult landscape.
Anti-ESG Legislation – A breakdown
According to our assessment, as of 5 September 2022, 18 different American states, nearly all of them classified as “red states”[1], have proposed or enacted different forms of anti-ESG related legislation. The typology of such legislation can be split into three main categories:
1. Anti-energy boycott acts;
2. Anti-firearms boycott acts; and
3. Wider anti-ESG acts.
We discuss these in depth below.
The anti-energy boycott act, also known as the Energy Discrimination Elimination Act, was drafted by the American Legislative Exchange Council (ALEC), an NGO providing draft bills that can be easily adapted and introduced by legislators in their corresponding states. At the centre of this legislation is that it prohibits boycotting energy companies, with ‘boycotting’ defined as “refusing to deal with, terminating business activities with, or otherwise taking any action intended to penalize, inflict economic harm on, or limit commercial relations with a company”. The key message of this act is that refusing to engage with a business “without an ordinary business purpose”, is what constitutes a boycott, with ‘ordinary business purpose’ being subsequently defined as when investing in such a company is “inconsistent with the governmental entity’s constitutional or statutory duties related to the issuance, incurrence, or management of debt obligations or the deposit, custody, management, borrowing, or investment of funds”. Only West Virginia further expounds upon this definition, stating that a “reasonable business purpose” is when one is:
Promoting the financial success or stability of a financial institution
Mitigating risk to a financial institution
Complying with legal or regulatory requirements
Limiting liability of a financial institution
In practice, this has resulted in States such as Texas publishing a list of firms they believe to be boycotting fossil fuel companies, with a subsequent requirement for State pension plans to divest from them. West Virginia will no longer engage in new business with five large financial institutions due to their alleged boycotting of the fossil fuels industry.
The anti-firearm boycott acts, like the Energy Discrimination Elimination Act, or Firearm Industry Non-Discrimination laws, commonly known as “FIND” laws, prohibit firms from entering governmental contracts if they are found to be discriminating against a firearm entity or firearm trade association. In this context, discrimination is defined as refusing to engage or terminating an existing business relationship with a firearm entity or firearm trade association. Again, there are caveats which relate to compliance with government policies or regulatory directives as well as “any traditional business reason […] not based solely on the customer’s status as a firearm entity”, which for asset managers, would likely relate to financial returns.
Beyond these two types of “anti-boycott” acts, which specifically target exclusions, three States also introduced / enacted legislation that aims to have a guide how ESG factors can be integrated in the investment process.
Florida
SBA Resolution – ESG states that the State Board of Administration’s investment policy must be “based only on pecuniary factors”, defined as something which is expected to have a “material effect on the risk and return of an investment”, and do not include the “furtherance of social, political, or ideological interests”. It states that the board cannot subordinate the interests of participants and beneficiaries through “sacrificing investment return or taking on additional investment risk to promote any non-pecuniary factors”.
Minnesota
Both acts H.F. 4574 and S.F. 4111 declare that investments should not have any “political affiliation; or any value-based or impact-based criteria, including but not limited to social credit scores or environmental, social, and governance credit factors". Interestingly, Minnesota does allow for investments with these “subjective standards”, if they are fully disclosed, explained to the investor and there is evidence that the investor has understood the additional risk being taken from such investments.
North Dakota
S.B. 2291 bans the consideration of “socially responsible criteria”, unless the state investment board can demonstrate that such an investment would provide an equivalent or superior rate of return compared to one that considered only traditional financial factors.
In practice, these acts are very likely to restrict impact investing, where asset managers are willing to sacrifice financial returns in order to achieve quantifiable, positive impact, although concessionary impact investing is currently restricted by fiduciary duty considerations. However, the extent to which this applies to managers engaging in ESG Integration remains to be seen. Even though ESG Integration is separate from impact investing, the way in which these two terms have been conflated may inadvertently affect asset managers who explicitly state they are accounting for ESG factors during the investment process.
What do these bills show?
From both the language within the legislation and general comments from proponents, it is clear that “ESG” is seen as the imposition of specific political values on businesses and how investments are made, and is considered antithetical to strong business performance and financial returns. This is made apparent from the constant reference to “traditional / ordinary business reasons”, with the emphasis on prioritising investment returns as the common thread for all pieces of legislation. Unfortunately, this ignores the fact that ESG factors have the potential to impact investment returns, which in simple terms, shows a lack of understanding of “ESG” itself. Yes, exclusions are a widely used responsible investment approach, but integrating ESG factors in investment processes is about better understanding risk and return characteristics.
Hypocrisy
Simultaneously, the bills highlight the hypocrisy of prescribing that the investment industry should invest in what is in the best interests of certain industries in the states, but disguising this under arguments of prioritising investment returns, which makes little sense. Investment professionals themselves are best suited to decide what they believe will maximise their returns.
Moreover, to act under the pretence that the legislation discussed is being implemented for the purpose of prioritising state beneficiaries’ financial returns is questionable. At the end of the day, these are protectionist acts, seeking to insulate industries that have strong connections to the local citizens. Although their language refers to what would normally be considered as the “business case”, and proponents of such legislation seeing themselves defenders of the free market, the reality is that their understanding of a free market does not seem to apply to an asset manager that chooses not to invest in an oil and gas company as it sees the inherent business model as unsuitable for their investment time horizon, and does not provide enough returns for the risk being undertaken. In the words of Bob Eccles, imputing “a political and social agenda to investors who, from a fiduciary duty perspective, believe that climate change poses a risk to the long-term returns of their portfolio companies”.
Taking a step back: What is “ESG” and how do investment managers use it?
As my colleague Christina Rehnberg highlights in her piece on “ESG Scepticism”, ESG “literally means Environmental, Social, and Governance – not a specific investment objective or set of values”. It is an acronym used to group together a series of traditionally “non-financial factors” that can influence the future value of a security. It is not, in the words of Ron DeSantis, a mechanism to “impose an ideological agenda on the American people through the perversion of financial investment priorities”. This could be true if the financial services industry prioritised impact over returns – but as we all know, this is not the case for the vast majority of investment products (otherwise ESG would not be facing the same backlash from those urging for more action on climate change).
For most asset managers, ESG information is a part of the mosaic of information used when evaluating an investment, and serves to bolster financial returns through highlighting additional risks or opportunities that an investment opportunity faces. The process of including such information is commonly known as “ESG Integration”, which research from Deutsche Bank’s 2021 ESG Survey shows to be the most popular form of responsible investment amongst asset managers.
ESG Survey – How would you define your ESG investment strategy? (n=366)
Source – dbDig Primary Research
Jon Hale, Global Head of Sustainability Research at Morningstar, states that asset managers are not driven by ideology, rather their focus is to make “prudent assessments of investment risks and opportunities, and most of them use […] ESG information to help them do that”. ESG integration does not preclude any investment.
If one wants a hypothetical example of how a manager may consider an “ESG” factor when making an investment decision, our ESG Scepticism piece provides an example of the many ways in which an asset manager may account for water scarcity when making an investing decision. For a summary of the academic evidence looking at how ESG factors are relevant for financial performance, NYU’s Stern Centre for Sustainable Business and Rockefeller Asset Management captures the current state well. They aggregated over 1,000 research papers examining the relationship between the ESG factors and financial performance, showing that 58% of papers found a positive relationship between ESG factors and corporate financial performance, whilst 59% of the papers found “similar or better performance relative to conventional investment approaches”.
Although there continues to be a debate around the exact relationship between ESG factors and financial performance, clearly, we can dispel the notion that the consideration of material ESG factors is somehow completely incompatible to generating financial returns, again, which is what the legislation implies. We agree that regulation plays a key role in creating more transparency around responsible investing and ESG integration, but it should not be used to prescribe an investment approach or impose a political agenda which constrains the investor and impedes them from meeting their fiduciary duty.
What can asset managers do?
Although exposing the inherent contradictions within these bills is necessary, doing so does not help the asset managers who are directly impacted by the legislation. Therefore, we suggest three steps that managers can begin looking to implement to combat the polarisation and spread of misinformation as it relates to responsible investing in the United States.
Get Everyone up to Speed: With much of the debate founded on a lack of understanding of what “ESG investing” actually is, and how ESG information is used in an investment process, it is essential to focus on knowledge building. Everyone within the firm, and more broadly the industry, should have a common understanding of what ESG means and should understand how ESG information is used in the fund’s own investment process. Being able to coherently articulate why the consideration of ESG factors are important and how they impact your investment process, is critical for demonstrating the value that they provide. To contribute to this, NPA will make publicly available, an ESG Glossary which helps breaks down the multitude of terms within the ESG space.
Formalise the Consideration of ESG Factors: Many managers will find that they are already implicitly accounting for ESG factors when making investment decisions, for example, governance being fundamental to all investments, or labour-related and pollution controversies being assessed before making an investment. However, what managers tend to lack is a framework that allows for the consistent application and documentation of this process. It follows that managers should work to formalise an ESG integration process in a manner that is proportional and consistent with their investment thesis, and which can be easily documented and defended, allowing one to demonstrate where exactly and how ESG factors have impacted the investment process and the outcomes of it. Doing so would make it much easier for managers to show that the reason an investment opportunity in an oil and gas company (or any other company for that matter) has been passed on was due to overall poor investment case, rather than blanket discrimination.
Collaborate: Although it may seem that the onslaught of regulation means that there is no appetite for ESG in certain States in the US, this is by no means true. A Morningstar study showed that support for 2021 ESG focused shareholder resolutions amongst US public pension funds “showed higher rates of support compared to general shareholders and [even] ESG-focused funds”. There are many avenues which asset managers can utilise to make their collective voices heard, such as becoming a UN PRI signatory and actively participating in their collaboration platform, engaging with industry bodies, collaborating with peers, participating in conferences and events, publishing research etc. In fact, the Responsible Investor notes that US-based managers are beginning to convene a working group, whilst State Democrat officials have also met to coordinate a response to this legislation.
Conclusion
It is unfortunate that how ESG factors are used in the investment process has been transformed into such a political topic and now sits at the forefront of the culture war in the US. Importantly, the integration of ESG factors in the investment process is by no means perfect, but it is simply not how these States have described it to be. I hope there comes a point where this particular debate shifts towards further transparency, improved data quality, innovation across asset classes and investment strategies, impact quantification etc, all of which is much more meaningful than driving political agendas and debating the basics.
Get in touch at info@northpeakadvisory.com if you would like to discuss this in more depth. We have written about the topic of ESG data and ESG skills, which you can read about in our Insights section. NorthPeak also offers online ESG training modules to support and build your teams ESG understanding and knowledge.