Pity our state public pension fund managers.
Imagine you’re one, charged with growing the retirement assets of millions of current and former public employees. As you evaluate different funds for investing the retirees’ money, you must balance your fiduciary duty of seeking the highest returns with consideration of material risk factors that could threaten those returns. A real estate investment fund, for example, might look attractive because of its five-year rate of return but you’re concerned about its exposure to properties that could be at increased risk of flooding perhaps exacerbated by climate change.
Recently, politicians in your state announced that you are no longer allowed to take “non-pecuniary” factors into account when making allocation decisions. Environmental factors—the E in ESG along with social and governance—such as climate change have been targeted by politicians as part of those non-pecuniary factors. You’ll be investigated if they determine that you deviated from pecuniary analysis. What do you do? On one hand, you need to take environmental-related challenges like flooding and its potentially heightened risk into account as something that could hurt returns. On the other, doing so could expose you to the threat of ruinous investigation.
Alternatively, imagine you’re a state pension fund manager, with the same responsibilities, in a state where ESG consideration in your allocation decisions has just been mandated by state government. You must maintain and increase investment returns at the same time that you pursue “ESG labor, diversity and environmental goals.” To fulfill this, you look around at various metrics and standards on offer for how to compare ESG operations at companies and principles at investment funds. What exists in the environmental space is fairly good, with some measure of standardization and comparability.
But when you turn to labor and diversity—included within ESG’s “S” factor—you hit a dead end. You find little definition, few comparable standards, and very little beyond corporate palaver. It’s hard to escape the conclusion of one academic analysis that ESG metrics, especially those in the S, are a subjective “compass without direction.”
This is the unfortunate situation that asset managers and investment officers all over the country find themselves in due to the hyper-politicization of ESG in recent months. There are canards on both sides of the debate. Use of ESG is not, as some on the right claim, an attempt to centralize the economy. Nor is it, as some on the left think, a means of overhauling capitalism. ESG is fundamentally a framework—a means of risk management—used by companies and investment funds.
Is it perfect? Not even close. There are legitimately substantive grounds for debate about ESG—definitions and measurement, for example. Too many companies and funds engage in virtue-signaling and greenwashing, exploiting measurement holes to adopt an ESG sheen, for which they can charge a premium.
If, as is currently expected, Republicans win the House of Representatives next month, they have promised oversight hearings on ESG. They will call the chair of the Securities and Exchange Commission (SEC) to testify, executives from the country’s largest asset managers, heads of state pension funds, state treasurers, and more. While it’s understandable that ESG has been turned into a campaign weapon this year, the potential change in congressional power offers an opportunity for what is needed most: ESG education.
When there are gaps in understanding and insufficient awareness of how ESG is used, misinformation (on both sides) fills the empty spaces. Republicans and Democrats around the country can agree that more ESG education is needed—it’s a complex topic. Some basic conceptual consensus will be needed.
Republicans need to accept that ESG is not inherently bad and isn’t going anywhere. Billions of dollars have been invested in ESG strategies, analysis, and disclosure, and nearly all S&P 500 companies report on some aspect of ESG. Democrats must accept that ESG is not inherently good given its subjectivity and as a result, remains a work in progress. There are many unanswered questions—maybe most importantly whether investors are adequately informed about the risks of lower returns in exchange for pursuit of ESG objectives.
In the next Congress, the two parties can and should commit to a joint ESG education campaign. So, call the asset managers, the standard-setters and raters, the state treasurers and pension funds. But do it in the spirit of learning. And keep in mind those pension fund managers, caught between an ESG rock and a political vice, who deserve our collective empathy.
