Opponents Of New ERISA ESG Guidance May Inadvertently Prove DOL’s Point
This past June, the Department of Labor (“DOL”) released new guidelines regarding the proper use of incorporating Environmental, Social, and Governance (“ESG”) factors in determining the investments within a retirement plan covered by ERISA.
This hasn’t gone over well with ESG advocates.
Aron Szapiro, director of policy research for Morningstar MORN , recently wrote, “The rule is a bad idea that would take away important options from retirement investors and deny them access to the best analysis on mitigating ESG risks.”
The Morningstar analyst believes “the Labor Department’s approach would put up barriers to considering this ESG information that many professional investors and asset managers view as material, worsening outcomes for ordinary investors saving for retirement.”
He adds, “many participants want investment options that match their values. To the extent that plans can offer funds that support these values without sacrificing returns.”
But does the DOL’s new guidance explicitly restrict ESG investments to the extent Szapiro states?
“The proposed DOL guidelines do not seem to argue the point that material environmental, social and governance issues may positively or negatively impact financial performance,” says Meredith Jones, head of the global ESG practice at Aon AON in Nashville. “Rather, the guidance seems focused on ensuring investors focus on materiality and financial performance and do not use ESG packaging to invest in ways that may not be fiduciarily sound.”
In essence, the DOL has merely restated what ERISA has consistently demanded of retirement plan fiduciaries: always place the best interest of the plan participant ahead of all else. That best interest, by the way, is not necessarily what the plan participant wants. It’s the plan fiduciary’s duty to make sure the participant’s actual financial needs are addressed, even if the participant wishes to subordinate those needs for non-financial matters.
“The DOL’s proposed regulation reminds fiduciaries that ESG criteria cannot be prioritized ahead of the financial merits of the investment,” says Margaret C. Hiller, Director of Institutional Services at The Advisory Group of San Francisco, LLC in San Francisco. “However, if a fiduciary can show that the ESG option is equivalent or superior to its non-ESG peers when evaluated on financial criteria such as expenses, risk factors and historical rates of return, the investment is permitted.”
Despite the plain language of the DOL’s new rule, some insist ESG factors have been completely removed from consideration, even if ESG factors show they can produce better investment returns. In fact, if this can be shown, then the DOL has no problem with ESG-based investing.
“Under the proposed guidelines, the DOL allows ESG investing, but it essentially eliminates the social or environmental impact component as a measurement driver for investment decisions and values investments solely on financial returns,” says Craig Jonas, CEO of CoPeace in Denver. “There is some evidence, however, that ESG investments are in some cases outperforming non-ESG investments. The takeaway from this is that ESG investments can provide competitive returns which would satisfy DOL guidelines.”
Hold on to your seat. This is where things begin to get dicey.
Before we get there, though, it’s important to recognize ESG is an investment theme. As a measure of potential return measurement, it’s just like plant-based meat, cloud-based apps and the coronavirus vaccine. There’s no reason to believe they can’t produce above average performance for companies that are a part of any of those stories.
In the lexicon of securities analysts and academic researchers, however, ESG components are considered “non-financial” factors when it comes to determining the investment attractiveness of a stock. In other words, they do not represent quantitative numbers found in a company’s balance sheet or income statement.
Yet the fact is, there’s a market for ESG-based products, including investment products. Indeed, many ESG rating agencies, including Morningstar, have emerged in recent years to address this demand.
And therein lies the problem. This problem goes well beyond anything the DOL says or does. It cuts to the very heart of the ESG premise.
There is no consensus on what “ESG” means.
A new working paper out (“ESG Rating Disagreement and Stock Returns,” R Gibson, P Krueger, P Steffen Schmidt, Swiss Finance Institute Research Paper No. 19-67, European Corporate Governance Institute—Finance Working Paper No. 651/2020) is meant to address this matter directly. It says, “Given the complexity of measuring a firm’s non-financial or ESG performance, the validity of these ratings has been debated critically.”
How critical is the disparity between ESG rating agencies, especially compared to financial rating agencies? The Swiss researchers found “the correlation for the overall ESG ratings is 0.46 on average, which is much lower than average correlations between credit ratings issued by Moody’s MCO and S&P. According to Berg et al. (2020) correlations among those two credit rating providers exceed 0.99.”
This isn’t merely an academic exercise. You see it in the headlines you read every day about specific ESG factors. There is widespread disagreement, especially among experts, on the future direction and impact of these factors. The DOL appears to be calling out this uncertainty and the risks associated with it.
“By introducing the concept of ‘objective standards’ in the ESG investment decision-making,” says Jones, “the guidance could call into question some blanket investment prohibitions sometimes found in ‘sustainable’ investment funds. For example, the wholesale avoidance of fossil fuels within an investment portfolio could be judged as failing this test as current research disagrees on things like when demand for fossil fuels will peak as well as the impact of divestiture on portfolio returns. Unless the investor can document that these types of investment decisions will result in ‘economically indistinguishable’ performance, ESG or sustainable investment products with inconclusive supporting research or with values overtones might be best avoided.”
The Swiss Finance Institute paper twists the usual thinking when it comes to ESG analysis in a way that produces a surprising result. By focusing on the meaning of this variance in ratings, the researchers make the claim that “while many papers have studied the relation between stock returns and the first moment of ESG ratings (see, for instance, Friede, Busch, and Bassen 2015 and references therein), our paper is the first to systematically examine the stock return consequences of the second moment of ESG ratings, i.e., disagreement about a firm’s ESG performance.”
In doing so, this paper may have found a suitable way to incorporate ESG into investment decisions, but only if you break it down between the specific components of E, S and G.
It turns out, at least according to this working paper, the more disagreement there is on environmental factors, the better the future performance of the stock. On the other hand, the more disagreement there is on social and governance issues, the worse the future performance of the stock.
As with most ESG studies, there’s not enough there to produce a definitive causation, so you (and the researchers) are left to speculate as to the true reasons for these results.
Morningstar’s Szapiro argues, “Investors themselves increasingly want access to ESG investment options, either because they want to mitigate ESG risks or because they want to align their investing with their values—without giving up returns.”
This is precisely what the DOL’s guidance allows. Yet, if ESG advocates continue to maintain that ESG trumps financial returns, aren’t they therefore making the case that prioritizing non-financial factors like ESG is not in the best interest of plan participants?
“ESG investing in retirement plans has grown significantly over the years, and the unspoken truth is that most plans that utilize ESG investments chose the investments specifically for their ESG criteria,” says Hiller. “Fiduciaries often compare ESG investments against other ESG investments when making their selection, but the DOL has made clear that this comparison does not satisfy the requirements—ESG is a nonfinancial benefit, not an asset class. Those who have interpreted the proposed regulation as a prohibition of ESG investments are implying that ESG investments have been selected specifically for their ESG parameters—an implication that underscores the DOL’s concern and the reason for the proposed regulation.”
Doesn’t that prove the DOL’s point?