Economy and Society: Pushback against ESG in retirement plans

ESG Developments This Week

In Washington, D.C., and around the world

Responses to Labor Department’s proposed rule encouraging ESG investments in retirement plans

On December 13, National Review’s Capital Matters carried a piece by Richard Morrison, a research fellow at the Competitive Enterprise Institute, critical of the Labor Department’s proposed rule regarding ERISA-governed retirement plans and ESG investments. Morrison is also the author of the recently published study, “Environmental, Social, and Governance Theory: Defusing a Major Threat to Shareholder Rights.” His case against Labor’s new rule reads as follows:

“One of the best policies enacted by the previous administration was a rule that made it clear to the people who manage pension funds that, when selecting investments, they need to prioritize returns for beneficiaries instead of pursuing their own political agendas. Unfortunately, Joe Biden’s Department of Labor is currently in the middle of repealing that rule. This effort, while obscure to the average American, is part of a much larger effort to redefine the world of saving and investing to permanently serve progressive policy goals. That should alarm not just conservatives, but anyone who wants to be able to enjoy a comfortable retirement someday.

As the 2020 Trump administration rule about pension fund investing reminded us, the law requires pension fund managers “to act solely in the interest of the plan’s participants and beneficiaries, and for the exclusive purpose of providing benefits to participants.” That’s it: nothing in there about staving off climate change, advancing gender diversity, or trying to drive tobacco companies out of business. Pensions should be dedicated to funding the retirements of workers, and that’s it — that’s the law.

In the interest of enforcing that law, the current rule was shepherded through the notice-and-comment process by former Secretary of Labor Eugene Scalia, and it reminded all of the relevant players of their responsibilities. It specifically warned them against the increasingly popular practice of using environment, social, and governance (ESG) factors to select investments, rather than traditional calculations of risk-adjusted return. Managers who did choose to include ESG factors in their investment decisions were expected to be able to demonstrate that these political considerations weren’t resulting in lower profits, but were only being used as a tiebreaker among options with otherwise identical expected returns.

But the same people pushing ESG-focused investing before the advent of the Trump rule are now promoting the Biden effort to repeal those safeguards. To the average reader, the language of the two rules will sound similar, but the difference is clear: Pension fund managers will now have a green light to use the retirements savings of beneficiaries to promote their own environmental and social policy goals. The language of the new rule actively encourages this, claiming that, for example, “Climate change is particularly pertinent to the projected returns of pension plan portfolios,” and encourages investment managers to emphasize the “long-term investment horizons” associated with pension plans in general. Is it impolite to ask whether workers retiring in five years really want their monthly checks to depend on what their plan manager is hoping the global average temperature will be in 2095?”

After explaining the details of the plans and what he sees as the implications of those details, Morrison concludes:

“If this Biden pension rule goes forward, we may be about to find out what happens when millions of American workers end up with “under-performing, but mostly profitable” pensions. It’s not going to be pretty.”

At the world’s largest stock-holder, ESG ratings are suspect

On December 16, Bloomberg continued its analysis of the investment practices at Norges Bank Investment Management, the world’s largest single holder of stocks. Bloomberg focused on how the management company/sovereign fund makes its ESG decisions and whether ESG ratings matter much at all in that process:

““We very rarely, if ever, use the ratings numbers,” said Patrick du Plessis, the global head of risk monitoring at Norges Bank Investment Management. 

NBIM, whose $1.4 trillion portfolio makes it both the world’s biggest wealth fund and the No. 1 investor in publicly traded equities, this week unveiled a tougher stance on assessing environmental, social and governance risk. Using a pre-screening tool, the fund will exclude benchmark stocks that would otherwise have made it into its portfolio, based on a series of ESG tests….

When deciding which stocks to avoid the fund examines everything from water use, to biodiversity to children’s rights. ESG ratings only come into the equation in the form of the raw data behind the headline figures provided by companies.

“What we do is that we de-aggregate” the ESG ratings data, du Plessis said in an interview on Tuesday. He and his team “get underlying data points, see where the various signals are, and incorporate that into our analysis.”…

The varying methodologies employed by the different ESG raters can sometimes result in seemingly unintuitive scores. Take BAE Systems Plc, whose involvement in the production of nuclear weapons means it’s blacklisted by the Norwegian wealth fund based on the advice of Norway’s ethics council. BAE is classified as an ESG leader by MSCI, which gives the company an AA rating. ISS gives BAE Systems a 10, which is the worst grade on its scale….

Du Plessis says investors using ESG ratings scores need to understand what they’re dealing with. He also suggested that currently, many aren’t using ratings appropriately.”

In the States and cities

Bloomberg reports on how ESG is being viewed in the municipal bond market

Municipal finance professionals are, according to one Bloomberg piece, expecting 2022 to be a banner year in their corner of the financial services world. Among other highlights, municipal financial professionals included the potential for huge deals on ESG debt financing among the factors they expect to make it a productive and profitable year. According to Bloomberg:

“For the municipal finance professional, the new year holds the promise of elephant-sized debt deals, a potential premium for environmentally friendly bonds and a bounty of securities sales spurred by the U.S. infrastructure bill. 

So say some of the top bankers in the $4 trillion market, where debt offerings have shown remarkable resilience in the second year of the coronavirus pandemic as state and local government coffers quickly recovered….

Bloomberg News surveyed the heads of public finance at the market’s top investment banks on notable trends of 2021 and their outlook for 2022. In the following Q&A, they highlight just how important the historic infrastructure package will be to their industry. And like all bond professionals, they consider the potential effect of the fastest inflation in decades….

How is ESG being viewed in the municipal bond market? 

Municipals may have been the original impact investing market, with governments selling debt for decades to improve water systems, fund affordable housing and public education. In recent years, bonds specifically branded with a “green” or “social” label have grown in prominence.

Bonds classified as ESG, for environmental, social or governance purposes, are a focus for both issuers and investors. “While there are currently no measurable or consistent pricing benefits, the ability for issuers to diversify their investor base may be beneficial long term,” Kiehn said. The impact of climate change could spur more debt sales as the need grows for improvements to water systems, flood control projects and resiliency efforts like seawalls, she said. 

Peck at Wells Fargo said they’ve seen a few instances of a “greenium,” that is, a relatively lower cost of capital, but overall, credit quality, liquidity and relative values are still the biggest price drivers. 

“While some transactions have seen a modest pricing benefit, the real advantage to issuers is exposure to a broader, more diverse group of investors,” he said. “This can result in an indirect pricing benefit by widening distribution.””

On Wall Street and in the private sector

Bank of America argues green debt will be key driver of ESG in 2022

And speaking of green bonds, Bank of America believes that green debt of all sorts (not just municipal bonds) will be one of the key drivers of ESG next year. There may be growing pains, the bank admits, but that won’t stop this burgeoning corner of the market, they argue:

“Bank of America Corp., the biggest corporate issuer of bonds tied to environmental, social and governance in the U.S., is predicting another big year for global sales of the debt.

Issuance of sustainable bonds from corporations and governments worldwide surpassed $1 trillion for the first time ever this year, more than double all of 2020 issuance. The market is poised to grow at a significant pace next year as well, according to Andrew Karp, head of global corporate and investment banking ESG advisory and financing solutions at BofA and Karen Fang, the bank’s global head of sustainable finance.

“Will ESG primary issuance market double again in 2022? We’re not making that prediction,” Fang said in an interview Monday. “But we do think it will grow very, very strongly given the momentum behind global net zero transition and investor demand.”…

Bank of America, for its part, has so far issued about $11.9 billion in different ESG debt labels since it started tapping the market — one of the fastest growing across fixed income — in 2013, making it the biggest issuer of the bonds among U.S. corporate and financial issuers….

Karp said he expects “ongoing growth” particularly in the sustainability-linked debt and the ability for a larger client base to access the market.”

In the spotlight

BlackRock-related ESG under the microscope 

This week, Bloomberg published a piece entitled “The ESG Mirage”, critical of the ESG practices and rationales embraced by MSCI, an index provider who is closely tied to BlackRock, and BlackRock’s single largest customer:

“For more than two decades, MSCI Inc. was a bland Wall Street company that made its money by arranging stocks into indexes for other companies that sell investments. Looking for ways into Asian tech? MSCI has indexes by country, sector, and market capitalization. Thinking about the implications of demographic shifts? Try the Ageing Society Opportunities Index. MSCI’s clients turn these indexes into portfolios or financial products for investors worldwide. BlackRock Inc., the world’s biggest asset manager, with $10 trillion under management, is MSCI’s biggest customer.

Sales have historically been good, but no one was ever going to include MSCI itself in an index of sexy stocks. Then Henry Fernandez, the only chairman and chief executive officer MSCI has ever had, saw it was time for a change. In a presentation in February 2019 for the analysts who rate MSCI’s stock, he said the company’s data products, the source of its profits, were just “a means to an end.” The actual mission of the company, he said, “is to help global investors build better portfolios for a better world.”

No single company is more critical to Wall Street’s new profit engine than MSCI, which dominates a foundational yet unregulated piece of the business: producing ratings on corporate “environmental, social, and governance” practices. BlackRock and other investment salesmen use these ESG ratings, as they’re called, to justify a “sustainable” label on stock and bond funds. For a significant number of investors, it’s a powerful attraction.

Yet there’s virtually no connection between MSCI’s “better world” marketing and its methodology. That’s because the ratings don’t measure a company’s impact on the Earth and society. In fact, they gauge the opposite: the potential impact of the world on the company and its shareholders. MSCI doesn’t dispute this characterization. It defends its methodology as the most financially relevant for the companies it rates.

This critical feature of the ESG system, which flips the very notion of sustainable investing on its head for many investors, can be seen repeatedly in thousands of pages of MSCI’s rating reports. Bloomberg Businessweek analyzed every ESG rating upgrade that MSCI awarded to companies in the S&P 500 from January 2020 through June of this year, as a record amount of cash flowed into ESG funds. In all, the review included 155 S&P 500 companies and their upgrades.

The most striking feature of the system is how rarely a company’s record on climate change seems to get in the way of its climb up the ESG ladder—or even to factor at all. McDonald’s Corp., one of the world’s largest beef purchasers, generated more greenhouse gas emissions in 2019 than Portugal or Hungary, because of the company’s supply chain. McDonald’s produced 54 million tons of emissions that year, an increase of about 7% in four years. Yet on April 23, MSCI gave McDonald’s a ratings upgrade, citing the company’s environmental practices. MSCI did this after dropping carbon emissions from any consideration in the calculation of McDonald’s rating. Why? Because MSCI determined that climate change neither poses a risk nor offers “opportunities” to the company’s bottom line.

MSCI then recalculated McDonald’s environmental score to give it credit for mitigating “risks associated with packaging material and waste” relative to its peers. That included McDonald’s installation of recycling bins at an unspecified number of locations in France and the U.K.—countries where the company faces potential sanctions or regulations if it doesn’t recycle. In this assessment, as in all others, MSCI was looking only at whether environmental issues had the potential to harm the company. Any mitigation of risks to the planet was incidental. McDonald’s declined to comment on its ESG rating from MSCI.

This approach often yields a kind of doublespeak within the pages of a rating report. An upgrade based on a chemical company’s “water stress” score, for example, doesn’t involve measuring the company’s impact on the water supplies of the communities where it makes chemicals. Rather, it measures whether the communities have enough water to sustain their factories. This applies even if MSCI’s analysts find little evidence the company is trying to restrict discharges into local water systems.

Even when they’re not in opposition to the goal of a better world, it’s hard to see how the upgrade factors cited in the majority of MSCI’s reports contribute to that goal. In 51 upgrades, MSCI highlighted the adoption of policies involving ethics and corporate behavior—which includes bans on things that are already crimes, such as money laundering and bribery. Companies also got upgraded for employment practices such as conducting an annual employee survey that might reduce turnover (cited in 35 reports); adopting data protection policies, including at companies for which data or software is the entire business (23); and adopting board-of-director practices that are deemed to better protect shareholder value (25). MSCI cited these factors in 71% of the upgrades examined. Beneath an opaque system that investors believe is built to make a better world is one that instead sanctifies and rewards the most rudimentary business practices.”