Does anyone have a concise definition of ESG? Anyone?
Neither do we. It’s one of the main sticking points for many 401k advisors and their plan sponsor clients when constructing investment menus with environmental, social and governance (ESG) factors in mind.
The DOL and similar regulatory bodies have made attempts at guidance to help sort it out (most notably in 2008, 2015 and just last month), but true to form with government “help,” it’s too often anything but.
Which is why we called George Michael Gerstein, Fiduciary Governance Group Co-Chair with legal powerhouse Stradley Ronon Stevens & Young. Gerstein has followed the issue closely and cleared much of the confusion during a presentation and panel at Fi360’s annual conference in San Diego in April.
He took some time to answer the most common questions he’s getting on the topic, and the red flags 401k advisors, sponsors and participants should watch for when entering the space.
- Is there, at this point, an accepted and specific definition of ESG investing? What does it actually mean?
To me, it means a fiduciary who treats an environmental, social and/or governance factor as tantamount to any other material risk factor in deciding whether to purchase, hold or sell an investment.
ESG is a big umbrella and covers such factors as climate change risk, board diversity, corporate governance and cybersecurity. People will sometimes refer to ‘ESG investing’ to mean impact investing, socially responsible investing or economically targeted investing, which are entirely distinct.
It’s unfortunate all of these different approaches to incorporating ESG factors get conflated because it muddies the water on the fiduciary duties.
I was recently on a panel in New York and polled the audience on whether they knew what ESG investing meant. Let’s just say no one was eager to step forward and hazard a guess because we all knew in that room at that time that there was widespread confusion over this terminology.
- What are the fiduciary duty issues associated with ESG investing?
It’s really important to know which approach to ESG you’re taking to fully answer the question. If it’s impact investing, then obviously the duty of loyalty is a big issue, along with prudence and diversification.
If it’s ESG investing based on my definition, then we’re looking at prudence issues, diversification and the need to ensure that the plan documents don’t prohibit the strategy. In terms of climate change risk, for example, I think we can get there on prudence grounds at this point based on the studies I am seeing.
At some point, the fiduciary risk will shift and pose a greater risk to those who don’t act to protect the plan in light of these better understood risks.
- Are ERISA plans the primary investors in ESG?
Nope. The more active U.S. institutional investors are foundations, endowments and governmental plans. Europe, in particular, is way ahead in terms of understanding and incorporation of ESG factors into the investment process.
Last I checked, the U.S. was considerably underweight in institutional investors and managers signing on to the UN Principles for Responsible Investment. I’ve heard a number of reasons why ERISA plans aren’t more active in this space, and all of them are valid.
One long-standing reason that the surveys have picked up is fiduciary concerns, but more and more fiduciaries are getting comfortable that fiduciary duties are not the roadblock they once were. In fact, that was once the top reason why ERISA fiduciaries did not incorporate ESG factors, but that’s not the case anymore.
- How are investors incorporating ESG?
There’s a wide range. Some are simply incorporating the factors in the investment policy statement and telling outsourced managers that ESG is important. Others are undertaking a screening of managers based on the managers’ own ESG credentials.
I’m not aware of a publicly-available product that helps investment committees screen managers, but there are solutions. Manager selection aside, most of the attention is on the screens, both positive and negative.
Fiduciaries should consider both, because the studies are mixed on what is the better approach. Divestment is a hot button topic now, though we’re seeing more of that outside of the ERISA space.
- Are there legal landmines associated with ESG investing?
Yes, but don’t all investment decisions have potential legal landmines? I don’t think ESG investing is any different, besides there being a steeper learning curve now. In 10 years, the risk will probably be equal to that of any other factor used in the investment process.
For now, it makes sense to ask a lot of questions and become familiar with the latest research and products. The benchmark products are particularly important. Documenting the decision will be vital, as confirmed by the Department of Labor.
Right around Christmas of last year, I was interviewed about a public spat between CalPERS and a trade group, which alleged that CalPERS’ investment process had been politicized. Fiduciaries should assume, in my view, that this same argument may be used against them.
But allegations of politicization should not discourage fiduciaries if they document why the decision is the right one for the plan and is based on ample evidence that the ESG factor either mitigates a material risk or otherwise repositions the portfolio to take advantage of ESG-driven market developments.
- We hear a lot about ‘shareholder engagement.’ What is happening there?
ESG shareholder engagement is largely popping up outside of ERISA plans, but it’s essentially where the institutional investor engages company boards directly via a proposal or indirectly via one-on-one meetings to change some behavior by that company’s board. It’s considered the primary alternative to divestment.
For example, many large managers are pressing numerous companies for better disclosures on climate change risk. SASB and UN PRI provide frameworks for managers in doing this. The FSB Task Force on Climate-related Financial Disclosures also provide a robust roadmap.
- Is the Trump administration turning its back on ESG investing?
Not really. There was much hullabaloo about the recent DOL guidance, but I think it, to a significant extent, reinforces what we all knew.
Some may have flashbacks to the 2008 Bush Administration guidance, which spooked some on the viability of ESG investing under ERISA, but I think the Trump Administration guidance is distinguishable and should not slow this rapidly developing area. There remains uncertainty over the role of ESG investing in a default investment option in a DC plan lineup.
The GAO just recommended that the DOL clarify its guidance in this area. As things stand, I think ESG-themed funds face an uphill battle as a QDIA, but incorporating ESG factors in the day-to-day investment process still seems okay to me.