Senators ask Treasury for additional climate finance regulation

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.

Senators ask Treasury for additional climate finance regulation

The Treasury Department released guidelines on September 19 aiming to promote net-zero finance. The next day, six left-leaning senators, including Bernie Sanders (I-Vt.) and Elizabeth Warren (D-Mass.), sent a letter to Treasury Secretary Janet Yellen encouraging her to enact additional financial regulations related to climate and carbon emissions. 

In a letter sent to the Treasury last week, Democratic senators Warren, Martin Heinrich, Edward Markey, Sheldon Whitehouse and Jeffrey Merkley, as well as Sanders, an independent, welcomed the department’s work on the issue so far but called for “added urgency” given increasing risks.

The Treasury should act now – including through its role as head of the multi-regulator Financial Stability Oversight Council (FSOC) – to address systemic risks becoming evident in a crash in coastal property values, insurance market failures, and uninsurable wildfire risks, they said.

“As climate financial impacts grow, the Climate Hub and Treasury must pursue with added urgency all available measures to address the climate crisis and its threat to the stability of our financial system,” the senators wrote in the Sept. 20 letter, which was first reported by Reuters. …

The senators called on Treasury Secretary Janet Yellen and newly appointed climate counselor Ethan Zindler, a climate and clean energy research executive, to do more to protect the U.S. economy from what Yellen has described as the “existential threat” posed by climate change. …

The senators welcomed the Treasury’s new voluntary principles for “net-zero” financing commitments, but said there were gaps in the guidance and that the department should make clear all large financial institutions should have a credible transition plan.

They also repeated earlier calls for stronger Internal Revenue Service enforcement of rules on political activity by nonprofit organizations, citing efforts by special interests to fuel climate change denial, and investigations into how such funding could be obstructing more action on the climate crisis.

SEC Name Rule could hinder ESG, analyst argues

As we covered in this newsletter last week, Reuters reported that the Securities and Exchange Commission’s newly revised Name Rule now “requires that 80% of a fund’s portfolio matches the asset advertised by its name.” Analyst Jon McGowan argued in a Fobes piece published September 26 that the rule could harm the returns of ESG funds:

The Securities and Exchange Commission recently announced a rule requiring environmental, social, and governance funds to be 80% aligned with the funds stated goals. This could reveal a long-held secret of ESG funds: to be competitive, they are packed with more profitable investments that are not green. …

The increased interest in ESG caused fund managers and businesses to adjust their practices. This sudden shift raised concerns of greenwashing, or the exaggeration of environmentally friendly initiatives to appear greener than they actually are. A new term, climate washing, has recently developed that is specific to the exaggeration of climate change initiatives.

Greenwashing for marketing purposes, while misleading, rarely met the standard of a regulatory violation. However, when greenwashing is directed at investors it could violate financial regulations and fall under the authority of the SEC. The SEC recently fined Deutsche Bank’s investment arm, DWS, $19 million for “materially misleading statements” relating to greenwashing in ESG funds. However, enforcement is problematic as the threshold for what constitutes greenwashing was not previously defined.

That changed when the SEC announced a new rule that requires ESG funds to match at least 80% of their portfolio with the stated goals of the fund. This new rule came just weeks after the SEC issued a round of subpoenas to an unknown number of fund managers relating to their ESG fund practices. …

Fund managers are placed in a precarious position of trying to offer environmentally friendly funds, while also meeting their fiduciary duty to maximize returns. In doing so, they are forced to offset the underperformance of sustainable investments with investments in companies that are high profit, but contrary to the green goals. The result is funds that are not truly green, but greenish.

The new SEC rule will force fund managers to limit that practice to 20% of the fund. The unsettled question is how that will impact returns. ESG funds already underperform compared to traditional funds, the 80% rule may make them no longer a viable investment.

On Wall Street and in the private sector

Big Three asset managers close ESG funds

With American ESG funds continuing to experience outflows and with financial services executives increasingly looking to distance themselves from the term ESG, some of the world’s largest asset management companies—including two of the Big Three passive firms—are shutting down some ESG funds and returning capital to the funds’ investors:

BlackRock Inc. and other money managers spent years rolling out sustainable funds, seeking to capitalize on surging interest in ESG investing. Now they’re abandoning an increasing number of those products in the US amid political backlash and investor scrutiny.

State Street Corp., Columbia Threadneedle Investments, Janus Henderson Group Plc and Hartford Funds Management Group Inc., among others, unwound more than two dozen ESG funds this year, according to data from Morningstar Inc.

On Sept. 15, BlackRock told regulators it, too, intends to close a pair of sustainable emerging-market bond funds with total assets of about $55 million.

While the US had 656 sustainable funds as of June 30, according to Morningstar data, the number of liquidations is increasing from prior years. More US sustainable funds have closed in 2023 than the prior three years combined, the data show. Investors pulled more money from the funds in the first half of the year than they put into them.

“We have definitely seen demand drop off in 2022 and 2023,” Alyssa Stankiewicz, associate director for sustainability research at Morningstar, said in a phone interview.

The closings underscore shifting fortunes for sustainable investing as returns disappoint investors and anti-ESG rhetoric persists. …

BlackRock Chief Executive Officer Larry Fink stopped using the term ESG earlier this year, saying it has become too politicized. Instead he discussed investments tied to the transition to a lower-carbon economy.

ESG selloff accelerates in UK

For months, ESG funds have experienced consistent outflows in the United States while generally experiencing modest quarterly inflows in Europe since the start of 2022. The U.K. was a mixed bag, but recent data from Calastone showed that the country’s investors were net sellers of ESG funds in August 2023 for the fourth straight month:

Investors in Britain dumped both stocks and bonds in August as they continued to opt for the safety of cash and money-market funds, according to data from fund network Calastone published on Tuesday.

Funds focused on environmental, social and governance issues (ESG) also saw a fourth consecutive month of net selling, down 953 million pounds – taking the total pulled from such funds to nearly 2 billion pounds since May. …

Asset managers, which had previously cashed in on a surge in demand for ESG funds, should take note of the developing sell-off, said Calastone’s Glyn.

“The move out of ESG funds has gathered pace in a remarkable reversal after the boom in recent years. Four months of outflows signals a new trend emerging that fund houses will have to work hard to counteract.”

In the spotlight

ESG returns compared to broader markets continue to shrink

Scientific Beta, described as “a ‘smart beta’ index provider linked to the Edhec Research Institute” by the Financial Times, published a report in the spring of 2021 titled “Honey, I Shrunk the ESG Alpha,” which was among the first studies comparing ESG funds’ performance against the broader markets. The study argued that non-ESG factors were primarily responsible for the outperformance of funds that promoted ESG investing standards.

Recently, Scientific Beta released a new report, which it says shows that ESG funds have underperformed the markets over the last decade:

Exchange traded funds investing on the basis of environmental, social and governance criteria have not beaten the market over the past decade, analysis has shown.

The findings come despite widespread claims since 2020 that ESG is able to deliver outperformance by steering investors away from poorly run and heavily polluting companies and towards the “winners” of the future.

Analysis by Scientific Beta, an index provider and consultancy linked to the Edhec-Risk Climate Impact Institute, suggests that 2020 was a “statistical outlier” and, if anything, ESG ETFs have marginally underperformed their traditional peers.

“‘Real-world’ ESG performance is unremarkable, with no evidence of sustainable ETFs outperforming,” Felix Goltz, research director at Scientific Beta said.

“Quite often it’s suggested there should be some outperformance. [People say] ‘they are better businesses, they are going to generate higher returns’. That’s clearly not something we see in the data.”

Alex Edmans, professor of finance at London Business School, who is unconnected to Edhec’s yet to be published, Sustainability Alpha in the Real World: Evidence from Exchange Traded Funds, said it “does a good job of highlighting the folly in simple claims like ‘ESG investing outperforms, period’ but these claims should have never been made in the first place as they were based on short-time series with inadequate controls. Unfortunately, they are lapped up uncritically due to confirmation bias.”

Scientific Beta crunched data on every US equity ETF domiciled in either North America or Europe and categorised by Bloomberg as either “socially responsible” or ESG, from 2012 to the end of 2022. These ETFs had assets of $97.6bn at the end of the period, having peaked at $114bn in December 2021.

The paper is relatively unusual in being based on real-world data, weighted by the popularity of individual ETFs, rather than being based on more theoretical strategies.

It found that average annual returns for ESG ETFs were 0.2 percentage points lower than for comparable non-ESG ETFs.

This undershoot fell to 0.1 points when returns were adjusted for the market risk exposure of portfolios. However, the annual underperformance increased to 0.7 percentage points when industry factors’ contributions were removed, balancing the sector weights between the two universes.

“Over the past decade, the sustainable investing portfolio did not outperform its benchmarks. If anything, realised returns were marginally lower than its benchmarks,” the paper said.