On April 23, 2018, the U.S. Department of Labor (DOL) published a Field Assistance Bulletin providing guidance to fiduciaries of private-sector employee benefit plans as they consider implementing environmental, social and governance (ESG) investing for assets covered by the Employee Retirement Income Security Act (ERISA).
According to the DOL, the “sub-regulatory action” was not meant to substantially change the status quo with respect to ESG investing under ERISA, but instead merely to clarify how the new administration views existing regulations in this area. In particular, the Field Assistance Bulletin addressed Obama-era DOL 2015 guidance on economically targeted investments and related 2016 DOL guidance on shareholder engagement.
Even though the DOL was careful to note that it had not changed the underlying regulations with its bulletin, retirement industry stakeholders were left to reassess their own stances on the risks and rewards of utilizing ESG investments for plan assets. According to attorneys with Stradley Ronon, this period of introspection has largely concluded, and ESG “continues to proliferate at breakneck speed across asset classes.”
In written commentary shared with PLANSPONSOR, Stradley Ronon attorneys said they are helping both registered and private-fund clients incorporate various ESG strategies. They are also advising fiduciaries on the implications of using ESG under ERISA, “such as how integration, shareholder engagement and divestment can be conducted in a manner consistent with ERISA.”
“We simply don’t see ESG going away anytime soon,” they explained. “Environmental, social and/or governance issues are a fact of life. Cybersecurity and climate change are two examples.”
According to the attorneys, one factor slowing growth in this domain is widespread confusion over what ESG actually means. In particular, clients want to know how “ESG investing” differs from “impact investing,” “socially responsible investing,” “economically targeted investing,” and “sustainable investing.” They also spend a lot of time explaining that the days are gone when ESG investing consisted primarily of either screening out or divesting from certain issuers/sectors because they do not meet some moral or other noneconomic test.
“Today’s ESG is much more driven by data linking one or more ESG factors and investment performance—an ESG factor can now be a material risk,” the attorneys wrote. “On an even more fundamental level, there is not unanimity on what constitutes an E, S or G factor. ESG is an umbrella term capturing as many as 40 different topics.”
George Michael Gerstein, co-chair of the fiduciary governance practice at Stradley Ronon, suggested the DOL “might prefer integration as an ESG approach over strategies that make investment decisions for moral reasons or to otherwise promote a public policy.”
Gerstein defined “ESG integration” as more sophisticated efforts by managers to incorporate ESG-related data or information into the wider process they use when making an investment decision within a given fund or portfolio. The main purpose of such integration is to enhance portfolio return or reduce portfolio risk, rather than to advance an environmental or social cause.
“The DOL stresses the importance of documenting why the fiduciary believes the respective ESG factor will have a material effect on performance, without having to make a series of wishful assumptions to reach that conclusion,” Gerstein said. “We suggest that fiduciaries will want to build a record in support of the view that a particular factor bears a relationship with investment performance, and carefully consider how much weight to put on that specific factor.”
The Stradley Ronon attorneys pointed out that the DOL’s most recent guidance on the ESG topic also “zeroed-in on shareholder engagement in respect of ESG issues that have a connection to the value of the plan’s investment in the company, where the plan may be paying significant expenses for the engagement or development of proxy resolutions.”
If anything, the attorneys concluded, this shareholder engagement aspect of the most recent DOL bulletin has the most significant ramifications—though it has received less attention from sponsors and advisers.
“If plans are viewed as paying indirectly for engagement through the management fee, which view we think the DOL takes, then proxy voting and other forms of shareholder engagement need to be monitored for both costs and benefits, particularly as the time spent on the engagement increases,” the attorneys recommended. “In our view, ESG will continue to evolve and proliferate, while also garnering the attention of both the DOL and SEC on a number of levels. ESG is, in essence, entirely fluid and will continue to present business opportunities and compliance challenges. We will likely have more to say on this in the coming weeks.”
Hands-Off Approach Likely from SEC?
Despite calls for additional guidance to ease fiduciary concerns, regulatory experts do not broadly anticipate further action under the current administration.
The Trump DOL, indeed, has already “clarified” its stance on ESG investing under ERISA. And when it comes to the prospect of the Securities and Exchange Commission (SEC) building some sort of unified ESG reporting framework for stock issuers, that’s also seen as unlikely.
In fact, in one of his final public speeches of 2018, SEC Chair Jay Clayton directly addressed this topic. From his perspective, Clayton said, the main hurdle to a wider embrace of ESG or SRI investing by fiduciaries has to do with the availability, quality and comparability of data being provided by publicly traded companies. Yet he does not necessarily see this as a challenge for SEC to address.
“Disclosure is at the heart of our country’s and the SEC’s approach to both capital formation and secondary liquidity,” he said. “As stewards of this powerful, far-reaching, dynamic and ever-evolving system, a key responsibility of the SEC is to ensure that the mix of information companies provide to investors facilitates well-informed decision making. The concepts of materiality, comparability, flexibility, efficiency and responsibility (i.e., liability) are the linchpins of our approach.”
Turning to ESG, which he called “a broad term,” Clayton said the investment industry is increasingly seeing disclosure of ESG information by issuers—and requests for ESG information by investors.
“I am also aware of efforts by third parties to develop disclosure frameworks relating to ESG topics as well as calls by some market participants for issuers to follow third-party disclosure frameworks relating to ESG topics,” he said.
Clayton said his belief is that while third-party standards relating to ESG topics may allow for comparability across companies, this should not mean that issuers should be required to follow these frameworks in order to comply with SEC rules.
“Each company, and each sector, has its own circumstances, which may or may not fit within a standard framework,” Clayton said. “That does not mean the standards do not have value. They do, in some cases, in much the same way that appropriately presented non-GAAP financial measures and key performance indicators add value to the mix of information.”
Clayton went on to say that as third-party standards have evolved and been discussed by market participants, he has seen investor-company dialogue around “certain issues and in certain sectors improve.”
“That said, I think it is important to remember two principles: first, in complying with our disclosure rules, companies should focus on providing material disclosure that a reasonable investor needs to make informed investment and voting decisions based on each company’s particular facts and circumstances; and second, investors—and here I’m thinking about asset managers who are required to vote in the best interest of their clients—should also focus on each company’s particular facts and circumstances,” Clayton said.
“It is important to note that although we do regulate disclosure and oversee registered investment advisers, we do not regulate the merits of any particular investment strategy,” he concluded. “The success of a particular investment strategy depends upon a multitude of factors, which may or may not include the extent to which the asset manager incorporates ESG factors. From my perspective, what is important is that investors have full and fair disclosure of the material facts about the investment strategy their fiduciary is following so that they are in a position to make informed investment choices.”
Sponsors Look for Better ESG Data
Survey data shared in 2018 by Natixis Investment Managers, based on a broad survey of 500 institutional investors including managers of corporate and public retirement funds, offers some additional context for measuring the progress of ESG investments.
The survey results show that institutional investors are embracing greater use of ESG investing programs even as they continue to have some concerns. Relatively few are implementing simple negative screens in the ERISA context. Instead, retirement plans are moving toward more sophisticated investments that directly weigh factors such as upstream or downstream environmental waste, resource scarcity, the present and future impact of global warming, the embrace of corporate best practices, and many other potential elements as part of overall risk and return analyses.
ESG advocates say this type of approach represents the future of ESG and SRI, especially when it comes to ERISA plans. They say ESG implementation in this fashion directly, materially and positively impacts the long-term performance of portfolios.
The Natixis research shows that 45% of institutional investors feel it is difficult to measure and understand financial versus nonfinancial performance considerations when establishing ESG programs—a factor that is holding back an even more rapid embrace of ESG. Some of their concern may be based on the criticism received by CalPERS and the New York City pension funds following fairly enthusiastic ESG implementation and fossil fuel divestment efforts.
Shared by fewer investors (37% in the survey pool) but perhaps even more concerning is the fear that publicly owned companies may be “greenwashing” reported data to enhance their image from the ESG investing perspective. The same number cited concern about a general lack of transparency and standardization by companies when it comes to reporting ESG-related information for the purposes of securities disclosures.
The research further shows that slightly more than a quarter feel concerned about a lack of third-party-reported data—almost exactly the same as the number who are concerned about how ESG trends “may not play out in the long-term.” Important to note: in a 2016 edition of a similar survey, 42% of institutions cited difficulty measuring performance as the biggest challenge of ESG investing. So it seems that those who favor greater use of ESG are making some slow progress in winning over the world’s largest public and private investors.
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