ESG Investing: The good, the bad and the ugly

The increasing degree to which ESG (environmental, social and corporate governance) factors are being considered in choosing investments raises a number of difficult issues, particularly in the context of retirement funds.

ESG investment is commonly defined  as using environmental, social and corporate governance factors to evaluate companies and countries on how far advanced they are with sustainability.  Once enough data has been acquired on these three metrics, they can be integrated into the investment process when deciding what equities or bonds to buy.

The debate is not completely new.  A half century ago, there was much debate about the “social responsibility” of businesses and conservative economist Milton Friedman stirred considerable controversy by publishing an essay in The New York Times entitled “The Social Responsibility of Business Is To Increase Its Profits” in which he argued that maximization of shareholder value was the highest corporate goal   Basically, Mr. Friedman was opposed to investments unrelated to the direct corporate mission and believed that shareholders should simply decide for themselves what philanthropic causes they wanted to support.

To be clear, no one is saying that individual investors should not take personal moral or ethical values into consideration in making investment choices.  Pro-life investors have every right not to invest in abortion drug providers, vegetarians need not put money in meat producers and gun control advocates can certainly forego weapons manufacturers. And these principles obviously apply to avoiding investment funds which have objectionable companies as components.

Still, ESG investing certainly has its detractors.  In a recent opinion piece in the Wall Street Journal, businessman and investor Andy Kessler points out that some purported funds are not ESG enough (accused of “greenwashing”), while others charge exorbitant fees (5 to 15 times more), while making relatively  few changes in investment mix from standard index funds.  Mr. Kessler cites a report by  University of Colorado professor Sanjai Bhagat, writing in the Harvard Business Review, that makes four important points about ESG: 1) ESG funds have underperformed; 2) companies that tout their ESG credentials have worse compliance records for labor and environmental rules; 3) ESG scores of companies that signed the U.N. Principles of Investment didn’t improve after they signed, and financial returns were lower for those that signed; and 4) companies publicly embrace ESG as a cover for poor business performance.

But while private investors can decide what they wish to do with  ESG investments, much harder questions arise in the context of retirement plans that are vehicles for retirement savings. Under ERISA, the governing law, these are to be invested for the “exclusive benefit” of participants and beneficiaries.  Previous guidance of the Department of Labor, which administers ERISA, has gone back and forth on permissibility of ESG type investments,  but 2020 regulations issued under the Trump Administration stated that only pecuniary factors could be considered in evaluating plan investments and that only in rare instances could a decision be made to break a tie among  investment alternatives in favor of an ESG investment.

The Biden Administration, however, seems to be moving the needle toward ESG investments.  It issued a proposed regulation in 2021 widely viewed as opening the door for more socially conscious investments.  The regulation noted that a fiduciary’s considerations may include climate change, governance and enforcement practices.  This year, the Department of Labor issued a request for Information discussing possible required disclosure by plan fiduciaries on climate related risks in their investments.  The obvious implication is that plans might feel pressured to include these type of investments, whether warranted or not.

It is true that nowadays most retirement plan participants are in 401(k) plans, in which the employee chooses among a menu of employment options, unlike the old days when employers made investment decisions for defined benefit plans. Nevertheless, I believe that the primary goal should be maximizing the employee’s long term retirement security and a go-slow approach is certainly appropriate for ESG investments.

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