Fans of ESG might be in for a rude awakening as their rhetorical dream becomes a mandatory reality.
Politicized investing, especially of the â€œenvironmental, social, and governanceâ€ (ESG) variety, has experienced some regulatory pushback during the last year, but the incoming Biden administration is widely expected to reverse course and accelerate in the opposite direction come January. While many ESG advocates claim that their philosophy of investing is a market-driven phenomenon, itâ€™s likely to get its biggest state-sponsored boost to date. It remains to be seen, though, whether fans of â€œenlightenedâ€ capitalism will ride this wave or be submerged by it.
This year, the Trump administrationâ€™s Department of Labor â€” which has responsibility over pension funds covered by the Employee Retirement Income Security Act (ERISA) of 1974 â€” published two important rules related to politicized investing. The first rule restated ERISAâ€™s longstanding expectation that plan managers must make investment choices for plan beneficiaries solely with an eye to financial return (with one limited exception) rather than with regard to any â€œsocially responsibleâ€ considerations, although plans that allow beneficiaries to self-direct their retirement savings are allowed to include ESG-themed funds as an option, if, in essence, those goals can be achieved without sacrificing financial return. The second rule applied to pension-fund managers voting on corporate shareholder resolutions on behalf of their beneficiaries, and it similarly reinforced that investment returns rather than politics should guide their decisions.
Unfortunately for American retirees, Team Biden is widely expected to ignore or actively undermine the enforcement of both of those rules. Because formally repealing a published regulation can be time-consuming and legally complex (as the Trump administration found out on more than one occasion), it will be much easier to simply publish a new interpretation of what the rules mean. Jon Hale of Morningstar predicted in November that â€œthe Biden [Department of Labor] will look at ways to clarify if not reverse the [ESG pension-fund] rule. We expect subregulatory guidance such as FAQs and advisory opinions to help bring things back toward the old status quo.â€
One can do a lot with â€œsubregulatory guidance,â€ or â€” as my colleague Wayne Crews likes to call it â€” â€œregulatory dark matter.â€ Suffice it to say that any system under which a new rule that says â€œXâ€ can immediately be reinterpreted by the next administration as saying â€œnot Xâ€ is not going to inspire a lot of confidence in the rule of law or provide the regulatory certainty that investors supposedly crave.
But redefining the ERISA pension rules may be the least of our worries. Biden has said that he considers climate change â€œthe No. 1 issue facing humanity,â€ and climate has long been the most prominent of the many issues that fall under the ESG umbrella. Former secretary of state John Kerry will be the administrationâ€™s â€œclimate envoyâ€ and will have a seat on the National Security Council. Biden has also nominated former Environmental Protection Agency Administrator Gina McCarthy to be â€œclimate czar,â€ a position that, according to NPR, will involve â€œlead[ing] an office or policy council akin to the Domestic Policy Council.â€ Senator Tom Udall (D., N.M.) explained to the New York Times last month that the new administration wouldnâ€™t have just the traditional environmental regulators working on the issue, but rather, â€œitâ€™s going to be a whole government approach.â€
Biden has also endorsed the Green New Deal, calling it â€œa crucial framework for meeting the climate challenges we face.â€ His campaign, however, was much quieter on what such a framework would cost Americans. A 2019 study by my Competitive Enterprise Institute colleague Kent Lassman and Power the Futureâ€™s Daniel Turner shows that actually implementing the Green New Deal would generate costs of $70,000 per U.S. household in the first year alone. Costs in a state such as Alaska, which is currently more dependent on fossil fuels, would be closer to $100,000 per household. This would be great for anyone selling solar panels to the government, but disastrous for the nation.
More specifically on finance, Bidenâ€™s campaign called for â€œrequiring public companies to disclose climate risks and the greenhouse gas emissions in their operations and supply chains.â€ But what counts as a climate risk? ESG advocates for years have claimed that disclosing and divesting away from fossil fuels is simply a smart investment strategy driven by market forces and a desire to avoid holding stranded assets. But the main reasons investors are steering away from oil and natural gas is because of politics, not market demand. Organizations such as the UN-sponsored Principles for Responsible Investment have been trying to frighten investors for years with the ominous-sounding â€œInevitable Policy Response.â€ This is the claim that â€” sooner or later â€” governments around the world will make it toxic or legally impossible to invest in traditional energy sources, so everyone with capital to allocate better get on the climate-activism train now. Thatâ€™s no more a market phenomenon than deciding to sell off your distillery investments as the nationâ€™s 36th state is about to ratify the 18th Amendment.
From an industry perspective, the irony of all this political pressure is that ESG investing is supposedly already a spectacular success. Virtually every news-media think piece on the phenomenon claims that it is gaining momentum, blowing up, or â€œa sizzling sector.â€ But this is mainly because its fans have been able to throw those three letters around with no definition or binding guidelines as to what they actually mean. The expectations for what qualifies as an ESG investment are so loose that some of the movementâ€™s true believers have turned to denouncing it. Social Capital founder and CEO Chamath Palihapitiya, for example, made headlines around the world when he called the world of ESG investing a â€œcomplete fraudâ€ back in February.
Federal policy-makers under the Biden administration may be about to upset that comfortable world of no hard definitions, however. Fund managers and analysts who were happy to celebrate the burgeoning trillions of dollars of ostensibly ESG-aligned investments might find themselves chagrined and surprised when they suddenly get defined out of compliance. The easy virtue to be had from â€œsocially responsiblyâ€ investment, in which one doesnâ€™t even need to divest from profitable oil stocks to be a leader in climate finance, may finally be ending. Years of keynote speeches and Davos workshops by industry leaders on the need to take climate change seriously are coming home to roost. Letâ€™s hope the ESG boosters donâ€™t get whiplash arguing against new rules that would actually do so.