The benefits and drawbacks of ESG investing have taken the centre stage in US politics, where a fierce debate has resulted in policies that will ultimately affect the finances of private citizens.
- The US Republican establishment claims that ESG investing is a ‘woke’ approach that imposes liberal views on the financial system.
- By definition, however, it is a capital markets-based investment approach looking to maximise risk-adjusted returns.
- Although the political battle is affecting corporate decisions, sustainable investing is unlikely to disappear.
What constitutes ESG investing?
ESG stands for environmental, social and governance. While they are not financial factors, they are being applied by investors to analyse risks and opportunities in the medium- to long-term. Essentially, ESG investing is a capital markets-based investment approach looking to maximise risk-adjusted returns.
These risks could be financial, such as the pricing of externalities increasingly being implemented by governments; related to supply chain risk, due to a growing demand for resources causing price increases; and the overall system risks posed by inequality to functional societies, unrest and conflict. As such, investors can access as much information as they need to allocate capital most efficiently and in terms of their own risk appetite, for the highest, most stable return on investment.
In the US, companies are not required to include these metrics in their financial reporting, although legislation is moving towards that direction. Indeed, the US Securities and Exchange Commission is expected to finalise a rule on climate disclosures in Spring 2023, which will impose the inclusion of non-financial data into corporate reporting.
What is the criticism in the US against it?
The Republican establishment has been attacking ESG as a ‘woke’ approach, and one that is trying to impose liberal values on the investment system. There is concern that applying these metrics to pension funds will hurt the finances of US citizens, as the investments will be done based on political motives rather than maximising financial returns. As such, the argument seems to be that fiduciary duty should trump interest in ESG, even though it presents financially material risks.
In an open letter, an anti-ESG alliance of 18 Republican states wrote: “We as freedom loving states can work together and leverage our state pension funds to force change in how major asset managers invest the money of hardworking Americans, ensuring corporations are focused on maximizing shareholder value, rather than the proliferation of woke ideology.”
“Retirees, already suffering from the reckless fiscal policies of the Biden Administration, will continue to experience diminished returns on the investment of their hard-earned money while the corporate elite continue to use their economic power to impose policies on the country that they could not achieve at the ballot box.”
How did it all start?
Sustainable investing has been a relatively niche area until around a decade ago, but increasing awareness around risk has led to a shift in the financial system. With companies engaging in ESG initiatives and investors demanding it, the trend has continued beyond the debate on its positives and negatives.
Because US federal agencies have been slower to propose rules in this area than their European counterparts, much of the activity on the ESG front remains the subject of private ordering in response to stakeholder demands, rather than regulatory requirements – even if regulation is coming.
According to Edward Threlfall, manager for strategy & transformation at MorganFranklin Consulting, the debate has heated up in the US for three main reasons.
Firstly, the country is made up of 50 states with their own local economic drivers, which may not be aligned with ESG values. “[It] can just be a hot topic, for example, if you’re in a state where historically the economy has been driven by fossil fuels… The rise of ESG investing can just create maybe some unease potentially from the constituents of those areas,” he says.
Secondly, even though many large investment managers have taken a stance on ESG, they still hold stakes in companies that are not aligned with these values, posing a contradiction which opens the door for a discussion.
Finally, there are several firms that invest with the sole purpose of generating excess capital returns and, since ESG investing is relatively new, are still unclear on how it will play out from this perspective.
“ESG can be a polarising term, in the sense that people hear it and jump to maybe certain conclusions,” adds Threlfall. “I do think that with respect to how a lot of US companies are looking at ESG, they are getting more targeted with terminology or focusing on specific aspects of ESG, like sustainability, for example, as like a subset of the environmental component. And I think that does change the narrative a little bit, when you’re thinking about ESG investing, and you’re also thinking about how companies perceive ESG.”
What has the ESG debate led to?
The situation continues to evolve. Around 20 states have enforced actions restricting the use of ESG factors. The most radical example is Texas, which has directed its state agencies to divest from a list of investment companies that allegedly promote ESG causes and “boycott” energy stocks – an important point, considering that the local economy is heavily reliant on oil and gas.
Beyond the policy action, 18 Republican states also formed an alliance to fight a rule that allows pension managers to consider ESG risks, after President Joe Biden vetoed a proposed resolution to overturn that rule.
What are the consequences of these actions?
There is limited literature estimating the financial repercussions of these anti-ESG measures, with mixed views on the matter. Beyond the direct costs to local governments and private citizens, however, there is already a wider impact on the market.
According to a study by Wharton Business School professor Daniel Garrett and Federal Reserve economist Ivan Ivanov, the anti-sustainable investing law in Texas raised costs to the public by as much as $532 million in its first eight months.
This analysis was then used in a separate study conducted by Econsult Solutions, which was commissioned by The Sunrise Project, on behalf of As You Sow and the Ceres Accelerator for Sustainable Capital Markets. The researchers found that taxpayers in Kentucky, Florida, Louisiana, Oklahoma, West Virginia, and Missouri could have faced upwards of $708 million per year in additional interest charges on municipal bonds, had they implemented the anti-ESG laws that were being proposed at the time of the analysis.
This is because the legislation would force state treasurers to boycott major banks and asset managers that historically have bid on municipal bond issuances. As a result, less competition between finance firms for these bonds would cause higher interest rates.
In addition, the anti-sustainable investing directives and legislation risk serious economic harm to state and local citizens in other ways. This could affect state and local treasury functions, pension investment performance and government banking functions.
Both studies focused only on the municipal bond market, suggesting that the implications of these laws could spread much further.
A March 2023 study on funds banned by Texas, however, found that the anti-ESG legislation did not turn into meaningful action. Firstly, the banned funds are largely indexers with a tilt slightly away from energy stocks, even though their energy exposure is nonzero and economically significant; secondly, the three Texas public pension plans whose data are available do not invest higher amounts in the energy sector than do the banned funds; finally, the impact of the Texan ban on the fortunes of BlackRock (NYSE:BLK), the only American fund manager in the sanctioned list, “is neither statistically nor economically significant”.
“The Texan law is unlikely to make a meaningful difference to state pension funds’ energy exposure and risk-return characteristics or to ESG funds’ fortunes and investing strategy. Thus, the legislation appears to be political posturing and may serve no other purpose,” the researchers concluded.
What now for ESG in the US?
According to analysis by Goldman Sachs, the trend of increasing ESG flows reversed in 2022 in North America due to debates around the intentions, approaches and impacts of ESG products. The analysts said that they are “healthy and indicative of the increasing relevance and ongoing maturation of ESG-related products”, suggesting that the market is reaching a certain level of maturity.
The political debate is far from over, however, and in many cases it is spilling into the corporate world, with large businesses avoiding taking a stance and rejecting climate proposals altogether to avoid political scrutiny – at least from one side. Nonetheless, an investor survey by HSBC found that sustainability is expected to become mainstream during this decade, while many investors have already taken positions which show that ESG and sustainability are affecting both their positioning and their strategies.
As such, it seems reasonable to think that, over time, ESG will become the de facto investment approach due to its considerations of risks and opportunities, as well as the looming consequences of global warming.