Economy and Society: State pension funds draw scrutiny for ESG

Economy and Society is Ballotpedia’s weekly review of the developments in corporate activism; corporate political engagement; and the Environmental, Social, and Corporate Governance (ESG) trends and events that characterize the growing intersection between business and politics.

ESG Developments This Week

In Washington, D.C.

Congress, the SEC, and disclosure

The Competitive Enterprise Institute’s Senior Fellow Richard Morrison published a roundup of congressional pushback against the proposed SEC rule mandating public company disclosure of environmental and sustainability data. The recent update is as follows:

“Skeptical members of Congress have begun weighing in on the Securities and Exchange Commission’s (SEC) recent climate disclosure proposal, and their objections are significant. Earlier this week, letters went out from Republicans in the House and Senate urging the SEC to table or withdraw the new rule, which the agency initially released on March 21. The deadline for the public to submit comments on the proposed rule, “The Enhancement and Standardization of Climate-Related Disclosures for Investors,” is May 20, 2022.

The letters from House and Senate members cover similar territory, and include the following objections:

  • The SEC does not have statutory authority to issue this rule.
  • The rule would violate First Amendment protections against compelled speech.
  • Existing SEC regulation and guidance already cover relevant risk disclosures, including climate-related risks.
  • The rule would change the definition of “materiality” for the worse.
  • The proposed rule is a backdoor attempt at substantive climate legislation.
  •  The SEC does not have the technical expertise to evaluate the required submissions.
  • The rule will be extremely costly to firms and shareholders.
  • Small companies, not normally subject to SEC requirements, will be swept up under this rule.
  • This is the worst possible time for such a regulation, given inflation, high energy prices, and concerns about long-term economic growth….

Our nation’s lawmakers have decided that new laws in this area—and new powers for the SEC—are not needed and should not be approved. Members of Congress did not “forget” to authorize this approach; they made an affirmative decision not to do so….

Individual members of Congress are moving even further along with legislation that would stop the SEC from promulgating this proposal. As I wrote about earlier this week, Rep. Beth Van Duyne (R-TX) and a dozen co-sponsors recently introduced the Stopping Excessive Climate Reporting Act (H.R.7355), which would stop the SEC from requiring climate change and greenhouse gas disclosures, but leave companies free to share whatever such information they believed was material to shareholders and potential investors.

This increasing skepticism in Congress of environment, social, and governance (ESG) investing dovetails perfectly with policies that governors and legislators are advancing at the state level.”

SEC flexes its enforcement muscle

While most of the recent attention on the SEC involves its plans to mandate new disclosures, the rest of the Commission continues its day-to-work, including its enforcement division, which recently laid out its priorities for the rest of the year. Those priorities include stepped-up policing of ESG:

“On 30 March 2022, the Division of Examinations (the Division) of the U.S. Securities and Exchange Commission (SEC) released its examination priorities for the 2022 fiscal year. The Division highlighted five “significant focus areas”: (1) private funds, (2) environmental, social, and governance (ESG) investing, (3) standards of conduct (including satisfaction of fiduciary duty), (4) information security and operational resiliency, and (5) financial technology and crypto-assets. In addition, the Division identified core programmatic areas for registered investment advisers (RIAs) and broker-dealers as cornerstones of its examination program.

Collectively, the priorities reflect the overarching goal of the Division—and the SEC as a whole—to continue to incentivize managers to provide accurate and complete disclosure to investors, and to maintain fulsome and tested compliance programs, particularly with respect to newly emerging approaches to investment management and the risks they may pose….

Consistent with prior pronouncements, task force initiatives, and other recent regulatory actions by the SEC and its staff, the Division will focus on ESG-related advisory services and investment products, highlighting in the priorities the lack of standardization in ESG investing terminology, variability among the approaches to ESG investing, and the extent to which RIAs and funds seek to effectively address legal and compliance issues with new lines of business and products (which RIA and fund efforts, in the Division’s view, may not be sufficient). By reviewing RIAs’ portfolio management processes and practices, the Division will focus on whether RIAs and registered funds are accurately disclosing ESG investing approaches and ensuring continued accuracy of such disclosures. This is again consistent with the SEC’s demonstrated interest in ESG disclosures, including from an enforcement perspective, as indicated by recently reported investigations by the SEC’s Division of Enforcement regarding this issue.

In addition, the Division will examine whether client securities are voted in accordance with proxy voting policies and procedures and with client ESG-related mandates conditioning investments in a company on the strength of its ESG program. Finally, demonstrating the Commission’s concerns over “greenwashing” (i.e., exaggerating the extent to which an investment program marketed as ESG-focused actually invests in assets that achieve ESG goals), the Division will consider whether RIAs have overstated or misrepresented in their marketing materials the extent to which ESG factors are considered in portfolio selection.”

In the States

State pension funds draw scrutiny for ESG

On April 15, The American Conservative published a long piece by Kevin Stocklin, a writer and film director, on the issues of ESG and what analyst Stephen Soukup has described as woke capital in pension funds, specifically state pension funds. Stocklin and the experts he cited make a case against the practice of ESG in pension funds:

“State pension fund managers who have declared that they will include environmental and social justice goals in their investment decisions collectively control more than $3 trillion in retirement assets and include the five largest public pension plans in the U.S. Among them are The California Public Employees Retirement System (CalPERS), California State Teachers Retirement System (CalSTRS), the Teachers Retirement System of Texas, New York City pension funds, New York State Common Retirement Fund, Maryland State Retirement and Pension System, and the New York State Teachers Retirement System.

Perhaps their most high-profile success came in June 2021, when CalSTRS, CalPERS, and NY State Common Retirement Fund joined three of the world’s largest asset managers, BlackRock, Vanguard, and State Street, in voting to elect clean-energy advocates to the board of Exxon and divert its investments away from oil and gas and toward alternative fuels. All of these pension fund and money managers except Vanguard are members of Climate Action 100+, an initiative dedicated to making fossil fuel companies “take necessary action on climate change.”

But state officials are starting to question what they see as a misappropriation of public money, and whether climate and social investing is actually delivering any benefit in return….

“States are recognizing that the financial system is being weaponized against industries that are the life blood of a lot of heartland states,” said Jonathan Berry, former regulatory head at the Department of Labor and a partner at Boyden Gray. “Pension plan proxy votes are often being used against both the economic and political interests of a lot of government workers.”

Derek Kreifels, CEO of the State Financial Officers Foundation, said corporate executives often confide to him that “they hear from folks on the left on a daily basis. Up until the fall of last year, they rarely heard from those of us who were right of center.”

Kreifels said it takes time to explain to people how their retirement money is being used to promote a progressive agenda. “But once you do, frankly people are pretty outraged by it.”

In an attempt to de-politicize their pensions, state officials are working to hold fund managers personally liable if they misuse retirees’ money. Last week, a conference of state officials, working through the American Legislative Exchange Council (ALEC), crafted model legislation that compels state pension fund managers to invest solely according to financial considerations. It also prohibits fund managers from voting the shares owned by the pension fund “to further non-pecuniary or non-financial social, political, ideological or other goals.”

If pension fund managers “use politically based investing that costs pensioners their return on investments,” said ALEC Chief Economist Jonathan Williams, “people need to be held accountable.” Maximizing returns becomes more critical in light of what ALEC reports is a $5.8 trillion shortfall in states’ ability to pay their pension obligations.

A study by the Boston College Center for Retirement Research in October 2020 found that for state pensions, ESG investing reduced pensioners’ returns by 0.70 to 0.90 percent per year. It attributed much of this underperformance to ESG fund fees, which were on average 0.80 percent higher than non-managed funds for the same asset type.

“Before this explosion of ESG investing,” said Jean-Pierre Aubry, co-author of the study, “most asset management firms were being squeezed in terms of fees” because investors were opting for low-fee “passive” index funds rather than pay asset managers to try to actively to pick winners and losers. ESG, he said, “just seems like a repackaging of active management.”

In addition, an April 2021 report by researchers at Columbia University and London School of Economics found that companies in ESG funds have “worse track records for compliance with labor and environmental laws, relative to portfolio firms held by non-ESG funds managed by the same financial institutions,” and that ESG ratings are driven more by companies’ public statements than by what they actually do….

Regarding “stakeholder capitalism,” an August 2021 study at the University of South Carolina and the University of Northern Iowa found that “the push for stakeholder-focused objectives provides managers with a convenient excuse that reduces accountability for poor firm performance.” Specifically, the report found a correlation between CEO’s underperformance and how vocal they were in supporting more nebulous, less quantifiable ESG goals.

“The original promise of ESG is that you could do well by doing good; it turns out you do less well, and you’re not doing any good either,” said financial analyst and author Stephen Soukup. “So the basic promise of ESG is a fraud on both ends.””

In the spotlight

Study: Investors know little about ESG, including potential downsides

According to a Barron’s story published on April 12, a recent study shows that despite the attention it has received over the last several years, retail investors still know little about ESG investing:

“Environmental, social, and governance, or ESG, investing is a hot trend, but retail investors are unfamiliar with the approach and have a hard time explaining what it means. About one in four people believes the acronym stands for “earnings, stock, growth,” according to a new study.

“Retail investors don’t understand ESG investing—only 9% say that they have ESG-related investments, and the familiarity with the concept is not as high or as broad as some of the coverage on the topic of ESG investing might suggest,” says Gerri Walsh, president of the FINRA Investor Education Foundation, which conducted the retail investor survey with NORC of the University of Chicago.

Only 24% of the 1,228 investors surveyed could correctly define ESG investing, and just 21% knew what the letters in ESG stood for. 

Walsh says the finding is “both surprising and concerning.”…

Survey respondents indicated that financial factors are the most important consideration when making investment decisions, including whether an investment has the potential to earn high returns, the amount of risk it entails, and the associated fees. Environmental factors were the least important. ESG investors, however, are highly motivated by ESG factors, especially the environment, according to the survey.

Most non-ESG investors don’t hold ESG-specific investments because they are unfamiliar with the concept. “It just doesn’t occur to them,” Walsh says. “There’s an education gap and a knowledge gap about what ESG investing is.”…

When it comes to ESG funds’ performance, a plurality (41%) of investors believe that returns for companies that prioritize their impact on the environment and society will be the same as the broader market while 14% expect ESG investments to outperform the market.”