17 Democratic AGs pushback on the pushback
ESG drives value and doesn't push values
Over the summer, 19 Republican State Attorney Generals sent a letter to the CEO of BlackRock, Larry Fink, with concerns about ESG. This letter caused a flurry of news around a counter-movement to ESG, the anti-ESG or anti-woke movement. Regardless, the world has kept moving around regulation and disclosures. For example, the EU adopted the Corporate Sustainability Reporting Directive (CSRD), the UK Financial Conduct Authority (FCA) announced its progress towards ESG standards, and the US Department of Labor (DOL) rolled back a Trump-era regulation that will allow ESG into retirement portfolios.
The Republican letter has codified the anti-ESG sentiment and captured much media attention, even now morphing into a conservative push for legislation against it. Yet, with all of this attention and ESG inflows slowing in Q3, the simple fact remains that there is a fundamental misunderstanding of ESG as values-based or impact-investing when it is focused on value from risk mitigation and new opportunities.
And so, on November 21, 17 Democratic State Attorney Generals sent a letter in support of ESG. But, instead of being sent to some financial services boogeyman, they sent the letter to members of the Committee on Banking, Housing, and Urban Affairs in Congress and the Committee on Financial Services in the Senate.
This letter is only eight pages, and I’d wager that there is little actual text because of the many citations. Let’s pull out some highlights because this letter hasn't gotten nearly enough for all the attention the Republican AG letter received over the summer (including from me).
Section I ESG: Value, not Values
The Democratic AG letter is broken into two sections, the first containing this short primer on ESG.
…it (ESG) simply acknowledges that environmental, social, and governance issues are material factors that can affect returns.
In the Republican AG letter, there isn’t a definition of what ESG is and isn’t, but the conflation and confusion between ESG and impact investing is apparent, and this seems to be the issue. For example, that letter opens its Neutrality section regarding BlackRock joining the Net Zero Managers Alliance (NZAM). The commitments for NZAM are published online. Most of the commitments focus on decarbonization, but there is one reference that gets close to ESG.
Provide asset owner clients with information and analytics on net zero investing and climate risk and opportunity
Still, ESG isn’t mentioned.
The Democratic AG letter goes further to point out that the Republican AG letter is partisan politics around allegiance to the fossil fuel industry and refers to an interesting study by Morningstar that found:
…the average level of support from public pensions based in Democratic-leaning states, split states, and Republican-leaning states all outpaced support from general shareholders by double-digit percentage points.
Here’s what the support for ESG across investors looks like:
This point illustrates that either the Republican AGs do not understand ESG or are unaware that their State Pensions support it most of the time. What’s even more fascinating is this nugget in the Republican AG letter.
BlackRock’s engagement strategy, in which a net zero climate agenda is a significant or main consideration, would covertly convert states’ core index portfolios to ESG-Focused funds should the SEC’s recently proposed definition of an ESG fund be adopted.
The Morningstar study linked above also found that State Pensions tend to focus more on ESG than ESG-Focused funds.
The Democratic AGs sum up the reason why this is.
Put simply, public pension funds are considering ESG factors because doing so yields positive results.
In other words, there’s nothing to see in the Republican AG letter. So let’s move to the next point. The letter discusses one significant environmental risk, namely extreme weather.
Companies that fail to take climate-change risks into account, for example, can suffer serious financial consequences, both in terms of physical damage and litigation and regulatory costs.
It doesn’t take long to find recent supporting evidence for this claim, so let’s add on. This past week, The Financial Times reported that catastrophe reinsurance is set to soar by around 30%. Reinsurers help share risk and premiums with primary insurers. However, after this past year’s extreme weather, many reinsurers have left the market, causing a strain on supply.
TLDR: Extreme weather is more costly to insure. That’s a risk for every company, which is an ESG risk.
The point builds by discussing diversity, citing the many studies showing the benefits. Side note: I recommend this read on inclusion from The Conversation.
Finally, this section acknowledges the confusion in the market around ESG and supports the SEC's recent draft proposal on ESG-labeled funds. I made this handy graphic to explain the SEC’s recommendations.
As I’ve written before, I hope “ESG Impact” becomes “Impact” in the final ruling because I feel it is still mislabeled and will perpetuate confusion.
Section II Fiduciary and Antitrust Laws
In the opening of this section, we quickly see the fiduciary case for ESG laid out. The evidence starts with this whitepaper: Best Interests in the Long Term: Fiduciary Duties and ESG Integration, where funnily enough, we see the difference between ESG and impact investing.
For the purposes of this Article, the term “impact investing” is used for a strategy that is different from ESG integration because impact investing may contemplate below-market returns in exchange for nonfinancial benefits.
The paper cites several studies and meta-studies pointing to the success of ESG strategies and their impact over the long term (as opposed to short-term results). It also covers how materiality, which is always useful in this case for investor decision-making, has evolved to include “financial as well as extrafinancial reasons” (page 771).
The paper concludes:
By comparing the net returns to benchmarks, a fiduciary investor can be confident that consideration of ESG factors does not reduce the financial position of the portfolio.
This also doesn’t necessarily preclude investment from any industry, which is a sticking point of the Republican AG letter in the form of divestment. The interpretation there is around boycotts and punishment. They state:
The definition of an energy boycott includes actions to penalize companies for failing to meet emissions standards beyond what is required by relevant law. In a document entitled, “Our Approach to Sustainability,” you detail numerous votes against companies for failing to meet disclosure standards that are not required by law.
Let’s be clear, voting against a company’s stance in a proxy vote is the right of an investor by ownership and not a punishment or boycott. Still, the Democratic AG letter calls it out a little differently. A company that addresses its ESG issues well could still be included in an ESG fund.
Consideration of those factors does not categorically block investment in any given industry or sector.
Even the NZAM commitments mentioned above don’t encourage divestment. Instead, it promotes stewardship and engagement, which can be done through voting. Remember, asset managers can’t vote or influence management if they don't invest in a company. ESG risk mitigation and creating new opportunities happen through action-driven ownership.
Summary: Value, not Values
I find it fascinating that the Democratic AG letter isn’t garnering nearly as much attention as the anti-ESG one did over the summer. While companies are pulling back spending in various ways, I haven’t seen them slow down their ESG or sustainability efforts yet. The reason is apparent as companies and investors see the value in ESG efforts. For great examples of how companies might drive this value from E, S, and G considerations, we can look to DC Attorney General Karl A. Racine’s website.
In reality, the Republican AG letter is noise at this point, and if pursued legally or through legislation, it will just be a waste of taxpayer dollars and time. It might go down interesting but unproductive rabbit holes like ESG rating agencies or complicated risk analysis models. The Republicans will have a massive challenge proving that understanding ESG risks is not intersectional with financials. I believe the SEC is on a more productive path to rein in some of the ESG mess to provide investors with better ways to understand ESG financial products.
That doesn’t appear to be the worry, though. The concern is some liberal boogeyman driving change and possibly naive political posturing. If we were to sum up the main counterpoint in the Democratic AG letter, it might come early on in Section II as this statement:
Public pension funds and their investment managers that consider ESG factors as part of their return-maximizing investment strategy are not doing so as a matter of morals or ethics (Values), but rather because using ESG criteria is in the best interest of investors (Value).
In talks with companies, I’ve seen ESG (Value) and sustainability, CSR, and DEI (Values) flow in and out of each other as companies transform, but this is why the SEC’s labeling and investor understanding of these issues are so critical. Of course, there will be financial products for both, with even the same holdings in some cases, but the difference between value and values is clear.