Why ESG Can’t Be Completely Abandoned

T he backlash against the environmental, social, and governance movement — ESG — is accelerating. Recent months have seen a series of legislative and administrative actions at the state level designed to address ESG’s perceived harms.

While relatively few would argue that certain ESG priorities, such as climate change and diversity, should be completely ignored by investors, it is clear that the increasing influence of ESG in U.S. capital markets has had significant consequences. Goldman Sachs recently estimated that carbon-intensive energy projects had a cost of capital approximately 15 percentage points higher than clean-energy projects. The lack of competitive financing for new fossil-fuel production has driven inflation, undermined U.S. energy security, and constrained America’s independence to pursue security objectives.

While the Biden administration enthusiastically promotes ESG objectives through its regulatory agenda, the states are starting to offer their own solutions. At the heart of the pushback to the capital markets’ emphasis on ESG are actions by states like Florida and Arizona to prevent state retirement plans from considering ESG in investing decisions.

But a closer look at the divergent meanings of “ESG” suggests that a blanket prohibition is untenable. This is because there are two competing schools of ESG investing: one pursuing “impact” and another pursuing improved financial returns. This distinction is easy to overlook, but it makes all the difference when it comes to the actual impact of states’ recent actions.

ESG strategies that focus explicitly on real-world impact, such as raising the cost of capital for fossil-fuel production to reduce the potential effects of climate change, are clearly incompatible with both the traditional concept of fiduciary duty and current fiduciary law. While such “impact” investing is a viable strategy for individuals who explicitly prioritize impact over financial returns, states are rightly emphasizing that the U.S. Supreme Court made clear in Fifth Third Bancorp v. Dudenhoeffer that so far as tax-advantaged retirement plans are concerned, fiduciaries’ “exclusive purpose” is the pursuit of pecuniary benefits. Furthering unrelated social or political objectives is not permitted.

However, other ESG practitioners use ESG factors to assess material financial risks rather than to achieve particular non-pecuniary goals.  For example, ESG investors might argue that government regulation may favor an electric-vehicle manufacturer at the expense of a thermal-coal producer, suggesting an investment in the former would be more profitable than the latter. As Blackrock CEO Larry Fink’s most recent annual letter pronounces: “we focus on sustainability not because we’re environmentalists, but because we are capitalists and fiduciaries to our clients.”

This statement may seem surprising to some, but it is consistent with the core truth that essentially everything is pecuniary. Yes, even a company’s environmental conduct could affect its cost structure due to government regulation or consumer perception. Workforce treatment may impact the ability to attract talent. Indeed, literally every action a company takes can have a pecuniary impact. Thus, ESG factors can be legitimately considered when assessing risk and expected financial returns.

Many of ESG’s critics fail to seriously grapple with this argument, preferring instead to point to evidence that ESG investment strategies have generally underperformed traditional ones. But industry-wide performance data is not necessarily meaningful to whether an individual fiduciary focused on pecuniary return may properly apply ESG factors in investment decisions.

Indeed, a close read of states’ recent clarifications of fiduciary standards will reveal that consideration of ESG factors that are pecuniary in nature is still permitted under law.  This stands in contrast to the public pronouncements from elected officials, which suggest a prohibition on all consideration of ESG factors. The discrepancy is driven principally by the competing definitions of ESG and its evolving role in our markets.

As we parse out those definitions, the core public-policy challenge is to address ESG’s overbearing influence in our capital markets. This is caused not by mere consideration of ESG factors, but by excessive focus on ESG relative to other important risks like supply chain and energy security that have also traditionally been considered non-pecuniary. Rather than banning ESG flat out, policy-makers might consider how to restore proper balance to the consideration of all traditionally non-pecuniary factors, including ESG.

Publicly pronouncing that consideration of ESG factors should be ended or seeking to prohibit ESG under the dead end of restating existing fiduciary standards is not likely to achieve this end. Instead, states should instead seek to accelerate evolution of market practices by emphasizing that the proper exercise of fiduciary duties involves consideration of a broad range of potential factors that may have pecuniary impacts, recognizing that ESG factors are just a piece of the puzzle.

Similarly, states should make clear that other factors, like exposure to China, supply-chain resilience, and energy security are pecuniary factors that prudent fiduciaries may take into account. All these variables may have a pecuniary impact, and while fiduciaries should have to demonstrate how they weigh various factors, they should not be prohibited from considering any one area, including ESG.

Given the enormous inertia of the ESG movement — with more than $40 trillion in assets and enthusiastic support from the biggest asset allocators and managers — simply relying on the fiduciary standard is unlikely to correct capital markets’ ESG tunnel vision. Instead, states can help restore balance by emphasizing that prudent fiduciaries must consider all material pecuniary risks, while recognizing that some of those could fall under the ESG heading.