Pushback has managers holding ESG credentials close to the vest

U.S. asset management executives eager to talk about their firms' ESG credentials have become rare as hen's teeth this year, with a number attributing their reticence to a desire to steer clear of "politics."

Good luck with that.

Over the past year or so, efforts to take environmental, social and governance-related risks into account when investing U.S. retirement assets have somehow managed to move from the financial mainstream to the vortex of America's political divide, joining hot-button cultural issues such as critical race theory.

Larry Fink, chairman and CEO of BlackRock Inc., the world's biggest money manager with $8.59 trillion in assets under management, in his latest annual letter to shareholders referred elliptically to that newly complex environment, noting the challenges "a truly global asset manager like BlackRock faces" now amid the divergence of opinion emerging across regions as well as "within regions — especially in the U.S."

Admittedly, politics has never been a total stranger to the world of public pension funds, as any executive answering to boards representing teachers' unions as well as fire and police departments can testify.

But for big money managers balancing efforts to maintain businesses in a U.S. market newly divided on ESG-related risks while moving ahead in markets wholeheartedly embracing them such as Europe, the operating environment has become considerably more complex in a short space of time.

After four or five years of the wind being in the sails of money managers focusing on sustainable investments, "suddenly over the last six months it feels like there's a real organized, concerted effort to attack ESG as so-called woke capitalism," noted Joseph Keefe, Portsmouth, N.H.-based president of Impax Asset Management LLC.

London stock exchange-listed Impax was managing $48.6 billion as of Feb. 28, with a focus on investing in a global economy in transition to greater sustainability, Mr. Keefe said.

While there have been skeptics over the years, "last year is when we saw a much more fully formed anti-ESG reaction in the United States," prompting internal discussions at asset management firms asking "how do we navigate these divergent directions that are emerging," said Jag Alexeyev, head of ESG insights with New York-based Broadridge Financial Solutions Inc., a New York-based provider of investor communications and technology solutions for financial services companies.

Republican governors Ron DeSantis of Florida and Greg Abbott of Texas — potential contenders for America's 2024 presidential contest — have led the charge in pushing back against ESG, fashioning policy initiatives aimed at constraining the use of ESG considerations in the management of state pension money.

But they aren't alone. Conservative policy heavyweights, including the Washington-based Heritage Foundation and the Arlington, Va.-based American Legislative Exchange Council, have likewise joined the fray, offering up model legislation for states to reference in hammering out their own anti-ESG bills.

According to a tally by New York-based law firm Ropes & Gray LLP, more than 20 states were working on such bills at last count.

In late March, pro-ESG forces announced their own counterweight under a "freedom to invest" banner, looking to oppose state government efforts to narrow asset manager choice in managing public retirement assets.

Both sides of the debate claim the fiduciary high ground, with the anti-ESG camp saying potential investment gains are being sacrificed in pursuit of squishy liberal policy goals and proponents insisting that not taking material climate and governance risks into account will leave money managers at a disadvantage in competing against firms that don't ignore them.

Dueling news releases on March 16 by Gov. DeSantis, announcing a 19-state alliance to combat "the pernicious effects of the ESG regime" and Gov. Abbott, focused on the threat the "radical ESG agenda" poses for Texas' oil and gas industries, suggest the issue could have staying power as America's political season barrels toward its November 2024 climax.

A number of factors helped set the stage for ESG's moment in the political limelight.

At the most basic level, ESG simply became too big a business to ignore, said Michael Wible, a Columbus, Ohio-based partner with Thompson Hine LLP's corporate transactions and securities law practice.

Laura Kane, New York-based head of ESG research with Voya Investment Management Co., which manages $315.6 billion in client assets, cited the surge in fossil fuel demand in the wake of Russia's February 2022 invasion of Ukraine — ending a spate of outperformance for fossil fuel-light ESG strategies — as helping breathe life into the anti-ESG movement.

Both sides of the debate agree the politicization of the issue has been unsettling for asset managers.

The financial world was "kind of blindsided" by the Republican party's decision to make ESG a cultural issue "like critical race theory or trans-drag-queen story hours," said T.J. Helmstetter, a political activist working on campaigns to push BlackRock and, more recently, Vanguard Group Inc. in a more ESG-friendly direction.

A regulatory affairs executive with one global asset manager, who declined to be named, admitted to frustration, noting that "the pitched rhetoric about the dangers of ESG to American society and our way of life…just doesn't reflect the reality of the types of ESG considerations that are an everyday part of fiduciary management."

If financial markets hate uncertainty, there's a lot to dislike about the current moment in time, said EJ Antoni, a Philadelphia-based economist and research fellow at the Heritage Foundation, noting the frustrations of asset management executives grappling now with the lack of clarity regarding "which way this is going to go."

And with states accounting for combined public pension and state-owned investment fund assets of more than $1.1 trillion moving now to restrict their retirement funds from taking ESG risk factors into account, the operating environment for asset managers could remain murky for some time to come.

At the state level, "we're seeing for the first time in history meaningful divergence from what the prudence and loyalty standards mean" under the federal Employee Retirement Income Security Act, with an initial spate of rule-making over the past year likely to be followed this year by refinements on implementation, said Joshua A. Lichtenstein, a New York-based partner heading up Ropes & Gray's ERISA fiduciary practice.

If asset managers initially had to provide extra due diligence questionnaires in response to those new rules, the next iteration could involve "formal undertakings and side letters about not considering non-pecuniary factors," Mr. Lichtenstein noted.

"It's a little bit of a sleeping giant," he said, adding "a lot of people are just sort of waking up to the fact that this is going to be a really significant issue for fundraising and deployment of assets for funds."

Despite such uncertainties, a number of ESG proponents remain confident the current "political football" phase for integrating climate change and diversity risks into the management of public pensions will prove to be more speed bump than brick wall.

The whole world is talking about the anti-ESG movement in the U.S. but "it's not infecting the rest of the world," said David Atkin, London-based CEO of the United Nations-backed Principles for Responsible Investment. "Those who understand the risk will not stop doing what they believe is right," he said, adding "you can't unknow what you believe is a material risk."

"The rest of the world is moving forward pretty quickly" and despite the tough rhetoric associated with the anti-ESG push by a handful of U.S. states, on balance, the U.S. as well "is still moving forward on responsible investment," agreed Gregory Hershman, PRI's Washington-based head of U.S. policy.

Others are more cautious.

Impax hasn't seen any political headwinds in terms of attracting and serving clients so far, but it's too early to rule out that possibility, said Mr. Keefe. "My guess is it's going to be with us through the 2024 election," he predicted. Even so, for Impax, the politically motivated attacks will have no effect on the firm's fiduciary duty to take ESG risks into account, he said.

Where the new environment is having an effect on money managers is in the way they choose to talk about environmental, social and governance risks — with terms such as ESG being downplayed in favor of phrases such as "value-driven risks."

"Today we really have a spectrum that goes all the way from ESG integration just for returns all the way to the other side…targeting a specific impact," said Voya's Ms. Kane. For money managers trying to figure out how to appeal to a broad range of client viewpoints, there's a need for sharper distinctions to be made on that score, she said.

Rich Nuzum, executive director, investments and global chief investment strategist with New York-based Mercer LLC, predicted that a principal outcome of this politically fraught stage in the evolution of ESG will be money managers speaking with greater precision in discussing sustainability, energy transitions and climate change-related investments.

Increasingly, managers will need to be "crystal clear (about) what's inside" their ESG packages — whether their approach rests strictly on risk-return foundations or includes a focus on values or the goal of achieving a certain impact or outcome, Mr. Nuzum said. In that new environment, "we don't have to use the term ESG at all," he said.

Still, market veterans say asset management executives looking to finesse their choice of words to appeal to the broadest set of clients will have their work cut out for them.

Ropes & Gray's Mr. Lichtenstein said he tells asset management clients that in the current divisive political environment "you want to be really careful and measured about the way you're talking about things, and you want to keep in mind that any message you provide for one audience may be seen by other audiences."

For firms with business in Europe — with its "double bottom line" framework that investment decisions should be made with financial outcomes and social outcomes in mind — dropping ESG entirely from the lexicon "is not an option," said Donna Anderson, vice president and head of corporate governance with T. Rowe Price Group Inc., a Baltimore-based firm with AUM of $1.2 trillion.

"You can't go quiet on ESG issues and have a global business," she added.

At the end of the day, the path forward will be determined by whether the politicians and regulators forming the tip of the spear on the anti-ESG front opt for a hard line or something less decisive.

A hard line would leave asset managers in a tight spot.

The Heritage Foundation's Mr. Antoni, while supporting vigorous pushback against what he called aggressive federal overreach in prioritizing ESG at the expense of the best interests of public-sector employees, said the response now by some states could ultimately become just another example of "the heavy hand of government."

If federal regulators are breathing down the necks of asset managers saying they must do X, Y and Z and state governments turn around and say if asset managers do X, Y and Z they'll be banned from managing state pension money, that leaves those firms "between a rock and a hard place," focusing on which governments to appease rather than on their proper focus, the best interests of clients, he said.

Mr. Lichtenstein said there's reason to hope "that we wind up in (a) place of moderation" and de-escalation, with the recent crop of anti-ESG laws still in place, perhaps, but an understanding that as long as asset managers "are somewhat quieter about trumpeting ESG…that they kind of get left alone, kind of like an inverse of greenwashing."

For asset managers really focused on using ESG for risk management, who don't market on how stakeholder capitalism is a core belief, there's room for "a sort of a truce," but one that could rely heavily on asset managers' ability to "read the room," to find state fiduciaries looking for cover in order to flexibly interpret anti-ESG strictures, Mr. Lichtenstein said.

An alternative way forward, where instead of moderation, state executives push for meaningful change — more divestments from managers with high-profile commitments to ESG and stricter demand for hiring only managers not taking ESG risks into account — would raise the odds that the retirement savings of public employees in those states will be put at risk, he said.

With the 10 largest U.S. asset management companies all Principles for Responsible Investment signatories, states looking to clean house will have to ask "who are you going to replace your current investment managers with," noted PRI's Mr. Hershman.

For the most part, market participants expect the run-up to the next big U.S. election cycle in November 2024 to work against moderation.

Still, analysts said they're not losing sleep about the possibility of a candidate who campaigned on an anti-ESG platform — whether its Mr. DeSantis, Mr. Abbott or Vivek Ramaswamy, the entrepreneur and "Woke Inc." author who has thrown his hat in the ring — becoming America's next president.

"Often there's a big difference between the rhetoric of a politician's campaign and the public policy that politician engages in once they're in office," said Impax's Mr. Keefe.

It's about politics right now and it's easy to understand "why it might be in (a) certain politician's interest to inflame the base" on certain issues, but it's doubtful if that would translate into a coherent program for governance, he said.