A Setback for ESG Investing?

Environmental, social and governance (ESG) investing is one of the fastest growing areas of asset management in the world.  Assets in ESG funds rose to $95 billion in 2017, a 60% increase from the prior year according to Morningstar.  ESG investors proactively search to fill portfolios with companies which focus on promoting social issues like board diversity or climate change.  This a nuanced change from social responsible investing (SRI) which creates negative screens for funds to eliminate investment in companies engaged in activities deemed harmful for society, such as selling tobacco or firearms.

The US Department of Labor (DOL), however, wants to know whether ESG factors are economically relevant to an investment strategy or whether they are used merely for political aims.  The DOL oversees the management of 401(k) plans, and it periodically issues guidance on how companies offering such plans must act as fiduciaries – the most recent guidance, issued in April, warns employers that they cannot place their own social goals ahead of their fiduciary duties.  The report says:

“Fiduciaries must not too readily treat ESG factors as economically relevant to the particular investment choices at issue when making a decision. It does not ineluctably follow from the fact that an investment promotes ESG factors, or that it arguably promotes positive general market trends or industry growth, that the investment is a prudent choice for retirement or other investors. Rather, ERISA fiduciaries must always put first the economic interests of the plan in providing retirement benefits.”

Furthermore, the guidance explicitly advises that employers do not make ESG funds as part of their default plans. It also cautions against investment managers from getting involved in shareholder issues or starting proxy fights.  The guidance does, however, allow for ESG investments to be a part of 401(k) platforms as long as the ESG-themed fund does not result in a platform from forgoing a non-ESG themed investment opportunity.

So, why does this matter?

In theory, weighting portfolios more heavily with ESG companies will create a positive feedback loop.  For example, strong demand for a company’s debt or equity will lower its cost of capital, allowing it to pay lower interest rates, freeing up cash for investment in R&D, sales, marketing, etc.  This will give the company an advantage over those without high ESG ratings and will improve its relative financial performance, creating more demand for its debt and equity.  If trillions of assets are allocated to ESG-focused companies, all companies would be under tremendous pressure to improve their own ESG matters.

In the DOL’s defense, the feedback relies on ESG investors gambling that the companies can improve their performance with more capital aimed at social benefits.  SRI investors, historically, could say with a straight face that negative screens of risky, harmful assets were in the best interest of the investor, as well as society.  Standardizing ESG measurements and making the link between ESG factors and financial performance will be a key to proving that ESG investing produces economic benefits first.  And this presents an opportunity for those who have developed skills at the intersection of finance and the environment.

Finance can and will be a powerful tool in combating global environmental challenges.  For now, investors will have to not only support ESG businesses with their passive investments, but they will have to proactively make every day, consumer- decisions based on ESG principles.  This will eliminate any political argument revolving around ESG funds. They simply will perform better.

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