Markets or Regulators: Who Decides on ESG?

Environmental, social and governance investing (ESG) has become controversial, with conflicting discourse around ESG investing. One conclusion is that fiduciary duty prohibits ESG investing, while the other is that it mandates ESG investing. 

The concept originated at the United Nations in 2005 as a follow up to Socially Responsible Investments (SRI) and calls upon investment professionals to understand the implications environmental, social, and governance factors of their investments. Regulators are partially to blame, as The Department of Labor under the Trump administration initially said that ESG investing violates fiduciary duty, while under the Biden administration the Department has all but said fiduciary duty requires ESG investing. The final rule is still pending.

Part of the confusion is regarding the semantics surrounding ESG investing. The first uses factors that can improve risk-adjusted returns, while the second is that ESG can starve “bad” firms of capital, providing benefits to third parties, which is essentially rebrand of SRI. The confusion this has created is not good for financial markets or investors, in particular, it complicates the management of nearly $40 trillion in retirement savings.

Traditionally, the Employee Retirement Income Security Act (ERISA) dictates that until an individual receives a distribution, the fiduciary managing the individual’s retirement savings must consider only expected risk and return. Using ESG factors to assess risk and return can be permissible investment for an ERISA fiduciary, but a fund that uses ESG factors to advance collateral benefits is not as ERISA prohibits investing for social impact. “A governmental push for or against ESG investing will create regulatory uncertainty while variously freezing in place strategies that may stop working or freezing out strategies that may be beneficial.”

For more information see Max Schanzenbach and Robert H. Sitkoff “Markets or Regulators: Who Decides on ESG?”, Barron’s Economy & Policy, October 20, 2022.

https://lawprofessors.typepad.com/trusts_estates_prof/2022/10/markets-or-regulators-who-decides-on-esg.html