The Contentions Surrounding ESG Investing

One of the more recent investing trends that has gained a foothold in financial markets is Environmental, Social, and Governance (“ESG”) investing. The trend represents a shift in the investment community, focusing on how investments can help increase environmental, social, and corporate governance goals rather than unchecked profitability. While ESG investing has seen increased participation in the last few years, the trend is not without objection, both from industry peers and regulatory bodies alike.

The prominence of ESG investing cannot be ignored, as U.S. assets under management employing sustainable investment strategies increased 38% from 2016 to 2018, rising from $8.7 trillion to $12 trillion. (US SIF, Report on US Sustainable, Responsible and Impact Investing Trends 2018). The world’s largest asset manager, BlackRock, announced to clients earlier this year that “sustainable investment will be a critical foundation for client portfolios moving forward.” (BlackRock, Sustainability as BlackRock’s New Standard for Investing). BlackRock’s participation in ESG investing will add to the recent increase in investments, as 42% of institutional investors incorporated sustainability into their investment decision making in 2019, compared to 22% in 2013. (Callan Institute, 2019 ESG Survey).

But ESG investing has reached further than just institutional investors. As early as 2006, the United Nations began the Principles for Responsible Investing (“UNPRI”), where signatories use the UNPRI’s responsible principles to conduct investment decisions. (UNPRI, About). Since then, the UNPRI has grown to over 3,400 signatories, with 679 located in the United States, and over $70 trillion in combined assets under management. (UNPRI, Signatories).

However, despite its popularity, ESG investing still faces criticism. Perhaps most notably, the Department of Labor’s recent rule change now mandates that fiduciaries for private pension plans under the Employee Retirement Income Security Act (“ERISA”) must select “investment courses of action based solely on financial considerations relevant to the risk-adjusted economic value of a particular investment.” (Department of Labor, Financial Factors in Selecting Plan Investments). While the new rules do not prohibit plan fiduciaries from investment options with favorable ESG data, the amendments mandate that plan fiduciaries base their investment actions solely on pecuniary factors – that is, “a factor that a fiduciary prudently determines is expected to have a material effect on the risk and/or return of an investment based on appropriate investment horizons consistent with the plan’s investment objectives and the funding policy.” (Id.). Further, the new rule prohibits fiduciaries from selecting as the default investment option an investment that includes one or more non-pecuniary factors as that investment’s goals or objectives (in this case, ESG factors). (Id.). Put another way, in selecting investments, plan fiduciaries are mandated to focus on an investment’s return, and fiduciaries can only select an option based on non-pecuniary factors when multiple options prove indistinguishable based on investment returns. (Id.).

While the Department of Labor’s new rule may seem harsh on ESG investments, the trend still sees some pragmatic criticism from other regulators and investment institutions as well. For instance, while many see the upside that ESG investing can bring, some still see issues in blindly throwing investment dollars at a particular option based solely on an impressive ESG track record. William Nelson, Chief Compliance Officer at Mercer Advisors, notes that the world of ESG investing still has some growing to do, and that, for the time being, financial markets are still susceptible to “greenwashing,” the idea that companies or investment vehicles portray themselves or make representations to portray themselves as more serious about ESG than they really are.

William Nelson’s sentiments do not stand alone. Jay Clayton, Chairman of the Securities and Exchange Commission, expressed his own feelings on ESG investing earlier this year, stating that he remains skeptical that companies striving for the highest ESG “scores” will “facilitate meaningful investment analysis.” (Chairman Jay Clayton, Remarks at Meeting of the Asset Management Advisory Committee). Likewise, three Harvard Business School professors point out that high ESG scores can be an unhealthy mix of both “greenwash” and “whitewash,” where, for instance, a bank’s ESG score in reducing its own carbon footprint is not material to the bank’s economic performance nor its business. (Porter, Serafeim, Kramer, Where ESG Fails). The professors also point out that, for example, a bank’s participation in the issuance of subprime loan securities in the financial crisis would not have affected that bank’s ESG score despite the disastrous social consequences. (Id.).

Even still, the rising popularity of ESG investing is unlikely to see its peak. One study conducted by Merrill Lynch in 2017 concluded that high ESG scores proved to be the best indicator for predicting future earnings volatility, finding that companies with the highest ESG scores actually proved to have the least volatile future as far as earnings-per-share. (Bank of America, Merrill Lynch, ESG Part II: A Deeper Dive). The results of Merrill Lynch’s study lends great support to the big names that have come out in opposition to the Department of Labor’s rule, including BlackRock, Fidelity, and State Street. (Tim Quinson, Trump Plan to Block Green 401(k)s Stirs Fund Industry Fury). Fidelity Investments argued in the firm’s comment letter in response to the proposed rule, that the notion that ESG investments inherently sacrifice returns “are not well grounded or supported by much of the emerging data on ESG investing.” (Fidelity Investments, Comment Letter). Likewise, BlackRock commented that the proposed rule was overly burdensome, and that it would “interfere with plan fiduciaries’ ability and willingness to consider financially material ESG factors, regardless of their potential effect on the return and risk of an investment.” (BlackRock, Comment Letter).

In response, the Department of Labor walked back its hardline prohibition on considering ESG factors to be pecuniary, with the compromise of having such factors become a sort of tiebreaker. (Department of Labor, Financial Factors in Selecting Plan Investments). However, it is unlikely that neither BlackRock nor Fidelity remain satisfied with the Department’s rule. And, as William Nelson further notes, those firms that are smaller than the BlackRock’s of the world use guidance set by their industry leaders, and with the largest firms willing to put up a fight, the potential for litigious battles remains.