How can asset owners and asset managers navigate the ESG labyrinth in the US? We survey the state of ESG regulations and evolving parameters of the public debate.
How can asset owners and asset managers navigate the ESG labyrinth in the US? We survey the state of ESG regulations and evolving parameters of the public debate.
May 2023
Introduction
The application of environmental, social and governance (‘ESG’) criteria to investments has always been contentious. However, the ESG debate in the US has expanded significantly in recent years, from one that historically focused on relevance and materiality (how to measure subjective ESG factors and whether they could help investors minimize exposure to risks or identify securities expected to enjoy more sustainable growth1) to one much more concerned about the inclusion of ethics and values (specifically political leanings) into investments.
Two broad camps are forming, albeit with subtly different priorities beneath the surface.
In this paper, we examine what has become a labyrinth for asset owners and asset managers. We survey both the burgeoning thicket of regulations that pertain to ESG and the evolving parameters of the public debate, and illuminate the implications for asset managers and owners. While it can seem that approaches to ESG across the US are becoming ever-more diffuse, we will show that in fact two broad camps are forming, albeit with subtly different priorities beneath the surface.
Summary of Current Regulatory Regimes
Part of this topic’s complexity stems from who has regulatory oversight of the assets in question. In the US, there are three primary bodies that regulate the assets to be managed.
The Securities and Exchange Commission (‘SEC’)
The SEC has oversight of protecting investors in the capital markets through investing directly and indirectly through mutual funds and retirement accounts. The SEC’s core mandate is, “….to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.” In order to accomplish this, the SEC places great emphasis on fund disclosure and mis-selling:
“To achieve this, we require public companies, fund and asset managers, investment professionals, and other market participants to regularly disclose significant financial and other information so investors have the timely, accurate, and complete information they need to make confident and informed decisions about when or where to invest.”2
SEC Commissioners are appointed by the President to five-year rolling terms, with one Commissioner’s term ending every year. To keep the organization non-partisan, a maximum of three of the five Commissioners may come from the same political party. While the goal is to be non-partisan, the President does name the SEC’s Chair, who is the Commission’s top executive and typically sets policy direction. This can lead to dueling speeches and commentaries on ESG from Commissioners; most obviously, Commissioners can and do release dissenting statements on decisions.
Given the proliferation of ESG and climate-related investment strategies, this is a growing area of interest for the SEC. The pertinent language, however, dates back to the SEC’s adoption in 2007 of a new anti-fraud rule under the Investment Advisers Act of 1940. The rule’s spirit can be summarized as: “say what you do, and do what you say.” Given these rules the SEC can address greenwashing concerns under existing rules without the need for new ones.
With disclosure a priority, the SEC’s most recent guidance on ESG specifically came in May 2022. This proposed that ESG funds be classified into one of three categories:
- ESG Integration: “ESG factors may be considered in the investment selection process but are generally not dispositive compared to other factors when selecting or excluding a particular investment.”
- ESG Focused: “[These funds] focus on one or more ESG factors by using them as a significant or main consideration in selecting investments or in engaging with portfolio companies.”
- ESG Impact: “Impact strategies generally seek to target portfolio investments that drive specific and measurable environmental, social, or governance outcomes.”
The SEC expects funds to demonstrate their alignment with these criteria through more specific and detailed disclosures in their prospectuses, annual reports, and marketing materials. For example, an environmental strategy should disclose its portfolio’s greenhouse-gas emissions, impact funds should describe the specific outcomes they seek to achieve and summarize their progress towards them, and funds that emphasize engagement as an ESG approach should be transparent on their voting record and meetings with company management.
Even leaving aside anti-ESG voices, criticisms have been leveled at the SEC’s proposed categorizations. For example, the requirements are very broadly defined and do not align well with other international proposals, such as those from the EU and UK (discussed further below).
The Department of Labor (‘DOL’)
The DOL’s purview in overseeing ESG investing relates to its oversight of retirement plans, including defined-benefit pensions and defined-contribution schemes such as 401(k) plans. It sets policies that guide the management of Employee Retirement Income Security Act (‘ERISA’) pensions, which are mostly corporate plans. However, the DOL does not oversee state and local-sponsored pension plans; these are governed at the state level, ultimately by the state legislatures (as addressed in the next section).
Rules can change from administration to administration.
Unlike the SEC, the DOL is a political body whose leadership is set by the executive branch. Rules can therefore change from administration to administration, although the department’s permanent staff is more stable and so new policies can take time to come into effect.
The most important current DOL rule on ESG was announced in November 2022. This explicitly permits the consideration of ESG factors in the investments of retirement accounts, removing the previous ‘pecuniary’ statement that investment decisions must be based solely on pecuniary, or monetary, factors and not subordinate the interests of participants to non-pecuniary (i.e. ESG) factors. This rule also allows ESG to be considered in proxy voting.
This policy reversal did face opposition in Congress, however. In late February 2023 and early March 2023 respectively, the House and Senate approved a measure that would have overturned the DOL bill that authorized the incorporation of ESG in investment accounts. On 20 March 2023, President Biden used his first veto of his administration to reject this measure and uphold the new DOL rule. Even prior to this, the rule had become a political football: the DOL introduced it under President Obama, President Trump rescinded it, and now President Biden has re-established it.
State Legislators
While the DOL oversees corporate defined-benefit and defined-contribution plans, state and local pension plans are overseen at the state level – typically by governors, state legislators and attorneys general. These officials can set policies that are handed down to the organizations that oversee those pension plans. These policies can be very specific to the goals of that state’s elected offices and are generally outside the purview of the SEC and DOL. Setting specific policies is typically easy when the legislative bodies in a state are controlled by the same political party.
ESG Regulations in Non-US Jurisdictions
In the European Union (‘EU’), the primary ESG policies are the Sustainable Finance Disclosure Regulation (‘SFDR’) and the EU Taxonomy. SFDR, which came into effect in March 2021, seeks standardized and transparent disclosure of how ESG principles are applied, with fund categories known as “Article 6” for those that do not integrate ESG, “Article 8” for those that promote social and/or environmental characteristics without that being a core objective, and “Article 9” for those that have a sustainable investment objective. The EU Taxonomy lists economic activities accepted by the EU as environmentally sustainable, helping to clarify what investments can be included within ESG strategies. SFDR has materially changed the European fund landscape, in our view, as asset managers reclassify funds to meet strong demand for ESG-oriented strategies. However, there was a rash of downgrades by fund managers in late 2022 as regulators offered stricter guidance on the Article classifications over fears of greenwashing.
In the UK, funds are primarily regulated by the Financial Conduct Authority (‘FCA’), which also prioritizes transparency and trust in ESG disclosures and labelling but does so under its core mandate of consumer protection.3 The FCA’s Sustainability Disclosure Requirements (‘SDR’) explicitly target ‘greenwashing’ by introducing requirements and restrictions on the use of sustainability-related terms in fund naming and marketing. Final guidance is not yet set, but SDR is expected to come into effect in 2024.
In Asia, the main financial hubs of Japan, Hong Kong, and Singapore each have different climate and ESG disclosure rules. Japan’s Financial Services Agency has proposed an obligation on locally listed companies to provide ESG information on their businesses and has declared it will take action against “malicious” greenwashing practices by funds, although it does not plan to adopt European-style fund labels. Hong Kong’s Securities and Futures Commission (‘SFC’) has told ESG fund managers to conduct periodic assessments and reporting on their ESG credentials, and maintains a public register of ESG funds. Singapore’s central bank has instructed retail ESG funds to disclose how their strategy and selection metrics apply ESG criteria.
The main battlefield for ESG in the US is at the state and local level, where ESG policy has become very values-oriented.
The Current Landscape in the US
The main battlefield for ESG in the US is at the state and local level, where ESG policy has become very values-oriented, driven by governors and state legislators. This reflects both the widening gulf between traditionally pro- and anti-ESG regions, as discussed further below, and the greater likelihood of passing legislation when one like-minded party controls a state’s executive and legislative functions, in contrast to the more structurally divided federal government. As set out above, state officials can most directly affect pension plans for local public employees, which can be a substantial asset base.
As mentioned, we see two broad camps emerging on ESG investments. The divergence can be seen clearly on a map (Figure 1). There are two subdivisions within each category:
- Those focused on certain industries, i.e. promoting divestment in certain industries like tobacco or targeting entities that boycott certain industries like fossil fuels;
- Those focused on incorporating ESG factors into investment policy and proxy voting.
Interestingly, there are no states that are neutral on the topic, which indicates the polarization on this topic.
Figure 1. Trends in ESG Investment Across States
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Source: Bloomberg and Ropes & Gray LLP; as of 7 March 2023.
Figure 2 breaks the four categories down on a total asset-weighted basis, and we see that states taking action to promote ESG either through restrictions or incorporating ESG into policy manage 30% more pension dollars than those seeking to restrict ESG. Divestment strategies have the most AUM, followed by states that restrict the use of ESG factors. States targeting entities that boycott certain industries manage the third-most assets, followed by those actively promoting ESG in investment policy and voting.
Figure 2. Total State Pension Assets by ESG Actions
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Source: National Association of State Retirement Administrators; as of FY 2021.
Furthermore, alliances are forming between different states in these camps, often led by attorneys general. On the pro-ESG side, for example, attorneys general from 16 states plus the District of Columbia wrote to four key Congressional committee leaders in November 2022 to argue that “environmental, social, and governance issues are material factors that can affect returns”.4 This was a direct response to an August 2022 letter from 19 other state attorneys general that claimed ESG was attempting to “force the phase-out of fossil fuels, increase energy prices, drive inflation and weaken the national security of the United States”.5
In addition, earlier this year 27 state attorneys general formed a coalition claiming the DOL’s ESG rule violates ERISA, and separately 21 state attorneys general warned that proxy advisers’ ESG engagements and votes “may interfere with your ability to honor your legal obligations”.6
While alliances are coalescing, individual states still maintain their own different interpretations of how to incorporate their values in investment policies.
Yet while such alliances are coalescing, individual states still maintain their own different interpretations of how to incorporate their values in investment policies. For its part, the National Association of State Retirement Administrators (NASRA) has taken a neutral stance that has focused on fiduciary duty.7
NASRA does not have a position specifically on ESG. NASRA’s resolution 2019-02, – Support for Strong Fiduciary Standards in Retirement System Investments, states, in part, that NASRA:
- Supports strong fiduciary standards set in law by state and local governments and supports investment strategies for which the paramount goal is the financial security of pension fund assets.
- Opposes any attempt, either implicitly or explicitly, to direct or influence state and local government retirement system investments that circumvent the trustees’ fiduciary responsibility.
Pro-ESG Policies in States – Illinois as a Case Study
Illinois passed the Sustainable Investing Act (PA 101-473) in 2019, and it took effect on 1 January 2020. The law requires that all state and local government entities holding and managing public funds should “integrate material, relevant, and useful sustainability factors into their policies, processes, and decision-making.” The Act defines sustainability factors as including data and indicators that relate to corporate governance and leadership, the environment, social capital, human capital, and business models and innovation. It was framed by Illinois authorities as providing “a more complete view of an investment, its past performance, and its future potential” given that “sustainability factors have a material impact on business performance and long-term shareholder value”. The Act asks affected bodies to update their investment policy to include the consideration of sustainability factors, integrate sustainability factors into investment practices, and speak to external fund managers about how they apply these principles.8
Anti-ESG Policies in States – Florida as a Case Study
On 19 April 2023, Florida’s state legislature passed the Government and Corporate Activism bill. This obliges investments of state money to adhere to a “pecuniary factor” that explicitly “does not include the consideration of the furtherance of any social, political, or ideological interests”.9 Florida Governor Ron DeSantis signed the bill into law on 2 May 2023.10 This followed the enactment of Florida’s State Pension Initiative in August 2022. The Initiative directed the state’s fund managers to invest state funds “in a manner that prioritizes the highest return on investment for Florida’s taxpayers and retirees without considering the ideological agenda of the environmental, social, and corporate governance (ESG) movement”.11 A month earlier, DeSantis proposed amending the state’s Deceptive and Unfair Trade Practices statute to prohibit “discriminatory practices by large financial institutions based on ESG social credit score metrics”.12 In December 2021, Florida also reclaimed proxy voting authority from fund providers to “ensure that the decisions made by these civil servants on behalf of the people of Florida are in accordance with the voters’ values as expressed through the democratic process rather than blindly in lockstep with the ESG mania taking hold of Wall Street and Washington”.13
Implications for Asset Owners
There are different ways that ESG matters can influence asset owners.
Investment Policies
We see two primary means by which ESG factors can affect investment policy specifically. The first and easiest to implement is through exclusion lists. Exclusion lists can be pro- or anti-ESG, and based on the values and policies of the asset owner reflecting its pension beneficiaries. For example, values-based exclusions could restrict investments in tobacco companies or explicitly demand the inclusion of fossil fuels.
The second measure is from a policy perspective, where the investment objective of the mandate could require strategies to address climate change or ban any expression of ‘woke’ capitalism (however defined), for instance.
Proxy voting is becoming an ESG battleground.
Proxy Voting
Proxy voting is becoming an ESG battleground, as interested parties seek to use their share ownership to support or oppose specific policies at corporations. How an equity ESG fund can reflect its objectives in its voting decisions, however, remains an open question. As mentioned, 21 state attorneys general wrote in January to two large proxy advisors – firms that help asset managers evaluate and process corporate voting – alleging that the consideration of anything other than “the economic value of the investments” when voting could be in breach of their contracts with their states. On the other hand, the pro-ESG camp feels that ESG shareholders must change corporate behavior on environmental, social and governance issues in order to protect Americans’ retirement savings.
Pecuniary versus Non-pecuniary
What constitutes a pecuniary matter can be very subjective. For example, it is possible to argue that many ESG issues – modern slavery, excessive executive compensation, or seeking to mitigate climate risks – have direct financial implications for companies. However, it must be acknowledged that these consequences can be distant and hard to quantify, whereas actions taken today can have a much nearer-term negative effect on profits. There are also many factors that affect asset prices and attributing risk-adjusted returns to any single factor, especially those as nuanced as ESG, is a dangerous game.
ESG has become politically charged in the US in recent years, making it difficult for asset managers develop their own ESG approach while navigating the values of different stakeholders including their underlying investors.
Implications for Asset Managers
ESG has become politically charged in the US in recent years, making it difficult for asset managers to develop their own ESG approach while navigating the values of different stakeholders including their underlying investors. As a general rule, both asset managers and the investment boards overseeing state and local pension assets prefer fewer constraints over their investment universe, given the flexibility of larger opportunity sets and risks of incurring tracking differences, and tracking error, to benchmarks. The additional constraints also require more thresholds to be monitored and reports to be produced.
In addition to increased political complexity, asset managers face greater pragmatic and operational challenges as a result. For example, managers must maintain and adhere to multiple restriction lists and multiple proxy-voting policies. At Man Group, across our managers, we vote on approximately 70,000 proposals per year (Figure 3). This creates a substantial administrative burden: thousands of candidates for board appointments must be parsed and considered, and resolutions are often phrased in non-intuitive ways (for example, yes/no votes on climate policies don’t always correspond to support/opposition). It can therefore be helpful to work with a specialist proxy-voting advisor (as referenced above), although we believe their guidance must not replace internal proxy expertise. So while we do use a proxy advisor at Man Group, we have voted against their advice approximately 4.5% of the time.14
Figure 3. Number of Proposals on which Man Group has Voted
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Source: Man Group; as of 31 December 2022.
Commingled funds also present challenges in this respect. Asset managers may have investors in commingled pools who have different restriction lists, investment objectives and proxy-voting policies. While it is nearly impossible to satisfy clients with different restrictions and objectives in the same pooled vehicle, we have made advances in applying different proxy policies within the same commingled fund to try to satisfy investors’ different value sets. Otherwise, costs will increase and returns decrease if asset managers have to run smaller pooled vehicles with fewer assets and higher administrative burdens.
Reporting on ESG matters is another challenge. This goes beyond the mere gathering of the data in the first place. Although standardization and best practices are developing, there remains no clear consensus on how to measure various ESG metrics. To take just one example, carbon emissions can be counted in various different ways; a technique based on what are known as Scope 1, 2, and 3 emissions is becoming more common for portfolio reporting, but much of these data are based on estimates and there are questions on double counting and other aspects of the process.
One emerging trend is a conversation within the anti-ESG camp on whether the perceived advantages of their stance outweigh the costs of constraining the choice of investment strategies.
The Current State of Play
Cost/Benefit Analysis
It is important to note that this is not simply a Democrat/Republican issue. One emerging trend is a conversation within the anti-ESG camp on whether the perceived advantages of their stance outweigh the costs of constraining the choice of investment strategies. For example, an anti-ESG bill in Indiana was moderated in February after state pension officials estimated that it could cost retirees approximately $7 billion over 10 years; the head of the state pension fund in Kansas has warned that anti-ESG measures could reduce investment returns by $3.6 billion. The executive director of the Texas County & District Retirement System has suggested that mandatory anti-ESG requirements on investments could cost $6 billion over a decade.15 In some cases, the pleas from pension-management officials have scaled back the anti-ESG measures in states like Indiana and Kansas.16 However, other states like Florida and West Virginia have pushed original anti-ESG measures through state legislatures.17 18
These constraints are also manifest in municipal bond underwriting, where the decrease in the number of underwriters due to their pro-ESG corporate policies was estimated to increase interest expense by several hundred million dollars.19
Amid this ongoing debate, we believe asset managers should remain engaged in the discussion and focus on two priorities: first, meeting clients’ specific needs; and second, maximizing clients’ risk-adjusted returns based on those specific needs. An open dialogue is critical since the asset manager is best positioned to know how the clients’ preferences will impact the investment strategy in which they are invested.
Conclusion
On ESG, as on many other issues, the United States appear to be becoming disunited. It is now a polarizing topic, with the many different jurisdictions in the US each taking a different view. Look more closely, however, and it becomes clearer that the parties are split rather than splintered. Unions are emerging, broadly between pro- and anti-ESG camps but with a great deal of nuance in individual states’ priorities beneath the surface.
A recent trend seems to be attempts to quantify the implementation and impact of these important decisions to make sure they square with the fiduciary duty of those responsible.
This bifurcation affects asset owners and asset managers alike. We believe both need to work together to:
- Define how to represent the values of the constituents in the assets being managed;
- Set and monitor investment policies;
- Agree voting and engagement approaches;
- Measure the results of these decisions.
Across all these elements of the ESG discussion, a recent trend seems to be attempts to quantify the implementation and impact of these important decisions to make sure they square with the fiduciary duty of those responsible. We look forward to working with all those involved to forge consensus and establish best practices.
1. For analysis of ESG as it relates to investment performance, readers can refer to this summary of the literature or this discussion by the Man Group Academic Advisory Board.
2. www.sec.gov/about/what-we-do
3. Investment Week, 6 December 2022.
4. Pensions & Investments, 21 November 2022.
5. TAI CIO, 9 August 2022.
6. Pensions & Investments, 18 January 2023.
7. www.nasra.org/esg
8. www.illinoistreasurer.gov/Local_Governments/Sustainable_Investing_Act For further detail on the experience of Illinois, Man Group spoke to Rodrigo Garcia, the former CFO of the Illinois State Treasury, in this podcast.
9. www.flsenate.gov/Session/Bill/2023/3/ByVersion
10. www.reuters.com/business/sustainable-business/desantis-signssweeping-anti-esg-legislation-florida-2023-05-02/
11. www.flgov.com/2022/08/23/governor-ron-desantis-eliminates-esg-considerations-from-state-pension-investments/
12. flgov.com/2022/07/27/governor-ron-desantis-announces-initiatives-to-protect-floridians-from-esg-financial-fraud/
13. www.flgov.com/2022/08/23/governor-rondesantis-eliminates-esg-considerations-from-state-pension-investments/
14. Source: Man Group; as of 31 December 2022.
15. Bloomberg Law, 28 March 2023.
16. Fund Fire, 25 April 2023.
17. Pensions & Investments, 19 April 2023.
18. West Virginia Record, 13 March 2023.
19. fnce.wharton.upenn.edu/wp-content/uploads/2022/07/Paper5_Garrett.pdf
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