We have seen a steady change in the business world over the last few years, away from the shareholder-focused approach of the last decades. Many investors now consider more than just a company’s bottom line and take into account environmental, social, and governance (ESG) issues. In 2020 alone, over $51 billion was invested in funds focusing on ESG, and some think that such assets could account for over a third of all assets under management by 2025.
Now it seems like the Labor Department is joining in. A new proposal forwards changes to the laws governing retirement funds, especially the Employee Retirement Income Security Act (ERISA). The proposed changes would make it easier for their managers to consider ESG issues in their investment decisions. But these changes, while undoubtedly a step in the right direction, are not as revolutionary as they might seem.
For starters, the Labor Department’s position is clear: the proposed changes are nothing new. Rather, they merely undo changes made by the previous administration and clarify preexisting standards for fund managers’ fiduciary duties. These managers had, have, and, under the new rule, will continue to have a duty to maximize long-term returns for the programs’ beneficiaries. They have never been and will not be permitted to sacrifice monetary returns for non-financial goals. While some, especially in the wake of the current pandemic, advocate for a stronger focus on other stakeholders, the Labor Department’s reaffirmation of this fundamental principle drives home the fact that fund managers are agents, investing money entrusted to them for the beneficiaries’ retirement.
However, what is new is the explicit language regarding the importance of ESG factors. The Trump administration changed the rules to require that the evaluation of any investment be based on “pecuniary factors.” This language made it unclear to what degree, if any, fund managers could consider ESG factors and had, in the words of the Labor Department, a “chilling effect” on integrating those factors into risk assessments. In contrast, last week’s proposal includes a section explicitly stating that evaluating the risks and returns of an investment often requires considering the potential economic effects of climate change and other ESG factors. The underlying idea is that ESG effects can be material risks, especially for the kind of long-term investment that characterizes retirement funds. Take, for example, the issue of climate change: part of maximizing investors’ value for payout in 30 years is making sure that the planet and a functioning society are around in 30 years, so the retirees can actually benefit from their investment. Higher short-term returns from environmentally damaging investments mean nothing if there’s nowhere to spend the money. The Labor Department has adopted the view that considering ESG factors is part of prudent risk assessment, management, and mitigation, and that considering those factors is in the long-term interest of the funds’ investors. In other words, the labor department wants fund managers to make informed investment decisions to guarantee lasting profitability, not to engage into ESG goals for their own sake.
While this might be a significant change for ERISA, in recent years this approach has already been gaining popularity within the academic world, but also with investors and corporations. In contrast to traditional, shareholder-focused, Milton-Friedman-inspired theories that encourage companies to ignore “externalities” like worker welfare and environmental issues, voices from all sides now demand that companies not ignore the needs of the world around them. In 2018, Larry Fink, CEO of Blackrock, the world’s largest asset manager, wrote in his annual letter to CEOs that companies should make “a positive contribution to society.” Similarly, in 2019, the Business Roundtable, an association of the CEOs of leading US-companies, published a statement saying that the purpose of a corporation is to benefit all stakeholders. While some argue that much of this is merely greenwashing, a PR effort to make the same investments look environmentally friendly and socially responsible, the broader trend towards the incorporation of ESG issues into business decisions is undeniable. Meanwhile, large investor initiatives like Climate Action 100+ and regulators around the globe keep increasing the pressure on companies, especially regarding environmental issues. Finally, consumers and employees are also increasingly interested in whether the companies they interact with or work for care about more than their bottom-line.
What the Labor Department is doing is, therefore, not bravely leading the way, but rather implementing something that is becoming common knowledge: that companies cannot ignore the world they are operating in any longer. Caring about ESG issues is good business practice, but, maybe even more importantly, ignoring them would be clearly shortsighted. However, while allowing fund managers to take those factors into account might not be revolutionary, it is nevertheless important, as it keeps the governing rules up to date with the emerging market standard. Only when fund managers can factor ESG issues in are they truly in a position to comprehensively assess potential investments and generate long-term profits for the coming decades.