Socially Responsible Investing – “Let the War Games Begin!”

Take-Away: Partisan politics has now entered  the world of investing, specifically socially responsible investing and environmental, social, and governance, or ESG, investment focused practices.

Background: In November, 2022, the University of Michigan announced that it will invest $300 million of its short-term working capital in environmental, social and governance- or ESG- investment practices. With that announcement, UofM President noted that ESG investments dovetail with the university’s priorities, including diversity, equity, and inclusion, stating: “Yet ESG investing and supporting small, local banks are among the many ways we can work more strategically and uphold our obligations to create a better and more just world.” MSU’s board has adopted a comparable approach to some of its fund investments. However, these decisions with regard to ESG investments by a university board of regents or trustees  would not be possible in a large number of states.

ESG ‘Debate:’ ESG-focused investing is more popular than ever, but recently it has also become a political ‘hot potato’ seemingly paralleling the divided politics of our nation. The federal government, President Biden, and some of the more liberal states have taken a strong pro-ESG stance. [New York, California, Illinois, Hawaii, New Jersey.]

At the same time, several conservative states have passed, or are currently considering, legislation that is intended to discourage or expressly prohibit state entities from working with companies and funds that practice ESG-focused investing. [Texas, Louisiana, Florida.] At least 23 states just in the past year have enacted laws, rules, or regulations that are intended to prohibit state investment vehicles from contracting with ESG-focused investors, claiming that ESG-focused investing improperly places political and social considerations above financial returns. Most of these anti-ESG laws and regulations require state entities to either divest from companies that are engaged in ESG-focused investing, or refuse them from entering into contracts with companies that are engaged in ESG-focused investing.

Observation: So much for a fiduciary exercising due diligence in its judgment when it comes to the selection of investments when the state Governor or the legislature tells the fiduciary what factors it must consider, or prohibits the fiduciary from exercising its own independent judgment. What happened to the Prudent Investor Rule?

Examples: In this ‘civil war’ among the states with regard to ESG-focused investing, consider the following examples:

Florida: Florida Governor Ron DeSantis has proposed legislation that would prohibit state fund managers from even considering ESG-related factors when they invest the state’s money.

Louisiana: A bill is pending in Louisiana that would prohibit the state’s pension funds from investing in companies that refuse to invest in, or do business with, energy companies. [Apparently sound investment decision-making by fiduciaries is irrelevant in Louisiana.]

Texas: In the past year Texas blacklisted ten major financial firms from securing state banking contracts because they were deemed by the Texas legislature to ‘boycott’ fossil fuel companies. One prominent asset manager was included on the blacklist despite its assertion that it oversees around $310 billion of investments in energy firms worldwide and oversees in excess of $115 billion in Texas alone. [I guess the Texas oil companies are not making enough, and they need to be protected.]

Illinois: Starting in 2020, Illinois signed into law a bill that directs state and local government entities that manage public funds to “develop, publish, and implement sustainable investment policies applicable to the management of all public funds.” The entities’ sustainable investment policies are directed to include “material, relevant, and decision-useful sustainability factors” for each public agency to “prudently integrate into its investment decision-making, investment analysis, portfolio construction, due diligence, and investment ownership in order to maximize anticipated financial returns, minimize projected risk, and fore effectively execute its fiduciary duty.” The relevant sustainability factors included in this legislation include: (i) consideration of a company’s corporate governance; (ii) leadership; (iii) environmental impact; (iv) social capital; (v) human capital; (vi) business model; and (vii) innovation factors.

New York: New York’s approach  requires divestment. It targets and requires state funds to transition their investments to review every 4 years their energy-sector investments and make appropriate adjustments to decrease exposure to climate-related investment risk by divesting from companies that fail to maintain certain standards. [I guess folks in New York believe in climate change.]

California: A bill is pending in California that would forbid the state pension fund’s board from approving or ratifying any fossil fuel investments or investments in other companies that “may have a negative impact on global climate, that scientific evidence has established as contributing to climate change, or that conflict with or undermine the commonwealth’s climate goals.” [Scientific evidence does not seem to carry much weight these days in Texas and Florida- annual devastating hurricanes are just part of the natural order of things, so just get used to it.]

Stuck in the Middle: Finding themselves the middle of this politization of investment decisions and philosophies are fiduciaries, including big-time  investment managers that operate throughout the entire country. Some larger fund managers that operate in both ‘red’ and ‘blue’ states, must now find themselves having to navigate a growing minefield of legislative trends and prohibitions that impact the now expanding field of ESG-focused investments. “Exposed’ to these rules are many companies that have affirmatively decided to incorporate ESG factors into their company missions, policies, governance, and management structures. How do they respond? In a couple of ‘red’ states, retribution has already been implemented, with billions removed from state funds because the investment manager failed to abandon (fast enough?) the ESG factors that it weighs in the investment funds that it manages.

ESG Advocates: The thrust of ESG-focused investing is the examination of sustainability-based metrics to assess financial opportunities. This growing trend is based upon a consensus that companies can only deliver sustainable long-term growth when they manage their resources prudently, treat their employees fairly, and act as responsible stewards with a perspective on the long-term viability of their surrounding environment.

ESG Opponents: As one example, Governor DeSantis proposed a Resolution that was approved by the State Board of Administration that prevents SBA fund managers from considering ESG factors when investing state resources and it requires fund managers to focus solely on maximizing investment returns on behalf of Florida retirees. Specifically, the Resolution requires state funds to limit their investments to companies that solely consider pecuniary, rather than political or social interests, when investing. “Pecuniary factors do not include the consideration of the furtherance of social, political or ideological interests.” [Yet politics precipitated Governor DeSantis’s Resolution but I digress.]

Conclusion: Sometimes when I read the news headlines, or listen the ‘talking heads’ on television, I feel like we now are fighting the Second Civil War among the states. Looking at the ‘competing’ ESG legislation, rules, resolutions from the states just in 2022 alone, my fears seem to be warranted. Sadly where it all ends, if it ever ends, I have no idea. It is just one more example of how divided we have become as a nation.