Investors committed to ESG fighting against the backlash

Institutional investors committed to ESG principles admit they were slow to take the anti-ESG movement seriously. Now, as more than a dozen states consider legislation to prohibit public pension funds or other public funds from investing with money managers considering ESG factors, and a handful of states have already enacted some limits, asset owners and managers are fighting back.

On March 23, the newly formed Freedom to Invest coalition produced a statement with now more than 300 signatories that argued investors need to consider all material financial risks and opportunities associated with climate change and other challenges, and cautioned that policies limiting that approach would hurt everyone. The statement, which continues to collect signatories, is coordinated by coalition members Ceres and the We Mean Business Coalition.

Both sides of the ESG debate frame their positions as focused purely on fiduciary considerations, yet the conversation often morphs into more of a culture war between investors and some Republican politicians like Florida Gov. Ron DeSantis, who is considering a 2024 presidential run.

Some Republican-backed bills would blacklist banks that refuse to invest in key state industries, like coal in West Virginia. In the last two years, at least 14 states have passed bills or taken executive measures to restrict ESG investing, according to the law firm Ropes & Gray LLP.

Many of the bills are based on model legislation promoted by conservative-backed groups including Heritage Action for America and the American Legislative Exchange Council, an association of state legislators. According to Heritage Action's state legislative campaign, "ESG hurts specific industries for politically motivated reasons."

A Heritage one-pager titled "recommendations for states to fight ESG," calls ESG policies "a thinly veiled attempt to radically transform corporations into social justice warriors and exclude from the system of global financial capital any company or even individual who doesn't agree with the prevailing environmental or social ideology."

Some ALEC-inspired laws have passed in red states including Arizona, Ohio, Arkansas and Oklahoma. Some states, like Texas, have extended their reach to banks and insurance companies that they see as "boycotting" fossil fuels by not financing or underwriting them.

Some of the anti-ESG campaigns have had mixed results, with business groups such as the American Bankers Association opposing what they see as politicians interfering in the free market. "Where it has failed, it is because the legislators understand the actual cost of limiting the free market," said Steven Rothstein, founding managing director of the Ceres Accelerator for Sustainable Capital Markets in Boston.

A group of state financial officials warned in a recent statement that imposing an ideological screen against investment managers and bankers could increase costs and potential risks. "States that focus solely on the short term will fail to compete over the longer time horizon that is necessary for them and their pension funds to succeed," they cautioned.

Joe Keefe, president of Impax Asset Management in Portsmouth, N.H., with $48.6 billion under management, calls embracing ESG considerations in investment portfolios "smart investing vs. not-so-smart investing," he said. "Basically the financial community sees these as tools to build better investment portfolios that are more in tune to risk and more attuned to opportunity," Mr. Keefe said. "We think an open marketplace is the right answer. Closing it off for political reasons is the wrong answer."

There is also the question of cost to taxpayers if competition for investment services or underwriting contracts shrinks. A study based on a University of Pennsylvania analysis found that taxpayers in six states would have to pay more than $700 million in excess interest payments on municipal bonds if competition to underwrite government bonds is restricted through bans on sustainable investing.

One anti-ESG bill in Indiana lost steam after state pension officials offered a fiscal analysis showing investment returns dropping $6.4 billion in defined benefit portfolios and $300 million in defined contribution ones over a decade. Similar input from pension experts in Kansas estimated a $3.6 billion drop in returns that could hurt pension participants and taxpayers.

For public pension fund fiduciaries, the legislative campaigns against ESG-related investing presents what legal experts writing on the Harvard Law School Forum for Corporate Governance call "a legal quagmire." Adoption of the bills supported by ALEC "would impose irreconcilable legal requirements on such fiduciaries, and subject them to compliance with arbitrary and unworkable legal demands," the legal experts wrote.

At the end of the debate, fiduciary duty should prevail, backers of the Freedom to Invest initiative argue. "You just have tune out the noises because you had a fiduciary duty to the people whose money you are investing," said Brad Lander, New York City comptroller and fiduciary of the $243.6 billion New York City Retirement Systems.

Between ESG principles so broadly woven into investment and financial decisions and free market principles at stake, many people "understand how absurd and dangerous what the GOP politicians are doing here is," Mr. Lander said in an interview. "They are waging a culture war on behalf of their fossil fuel donors, at the expense of beneficiaries."

Anne Simpson, global head of sustainability for Franklin Templeton Investments in San Mateo, Calif, with $1.4 trillion under management, advises asset owners and managers to "keep calm and carry on," paying attention to investment risks and opportunities like climate change and the energy transition. "We don't want the 'woke' noise to distract us from the day job of making money," Ms. Simpson said.

Illinois Treasurer Michael Frerichs, a Democrat who oversees the Illinois State Board of Investment as CIO for a $50 billion investment portfolio, believes that "people who believe in the free market will prevail." He sees increasing dissension within the Republican party on whether it is worth risking the appearance of not supporting free markets or being led by fossil fuel interests instead of financial calculations. "Bankers were not divesting because the government made them. They did it because they saw risk with certain investments," said Mr. Frerichs, who signed the Freedom to Invest statement.

Delaware Treasurer Collen C. Davis said she signed on when she saw what she called "fear mongering" behind some of the ideas and the quick traction in some states. "If we are contracting the competitive market, the costs of all those investments go up, and retirees will be footing the bill. It flies in the face of our fiduciary duty," Ms. Davis said.

Eli Lehrer, president of R Street Institute, a center-right think tank in Washington, sees the anti-ESG movement as a bigger long-term problem for conservatives, who are "increasingly turning against free market principles. This is the first time we are seeing anti-business sentiment with its roots in the Republican party. It is a fact that politicians across the political spectrum will have to confront," he said.

Leonard Gilroy, vice president of government reform at the libertarian-minded Reason Foundation in Los Angeles, is seeing a "spectrum of reactions" to anti-ESG positions in conservative states, from Arizona, where legislators originally tried to ban outsourced proxy voting but found it unrealistic, and "on the other end of the spectrum, there is Florida and Texas," he said.

Terminating high-profile asset managers like BlackRock "is taking the easy step," Mr. Gilroy said. Limiting or banning all ESG-related investments brings "legal transformation (and) is almost a cronyist protection of certain industries like oil and gas and firearms. Those are fairly heavy-handed interventions in the market. Let's not lose the script here: fiduciaries need to make judgments," said Mr. Gilroy, who acknowledged that ESG "is a potent issue around a donor base" that will be mobilized for the 2024 elections.

Mr. Gilroy worries that "Republicans seem more concerned with the politics of what to invest in" instead of the bigger issue of underfunded public pensions. "That problem needs fixing, not distractions," he said. "They are dialing up the politics instead of dialing it down, where it ought to be." He worries that some ambiguously worded legislative proposals could bring states legal headaches. "When you create laws that open doors like that, don't be surprised when unintended consequences come through," Mr. Gilroy said.

"What we are hoping over time is that both sides tone it down," he added.