An American in Paris? ESG’s Regional Regulatory Conundrum for Managers

Despite the climate change concerns of many Americans, our political and regulatory stance on environmental issues has diverged from much of the rest of the world. America’s withdrawal from the Paris Agreement, the administration’s easing of environmental regulations and enforcement, and the increased support for coal production are examples of this pivot.

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For institutional investors, the incorporation of environmental, social, and governance (ESG) principles in the investment decision-making process has led to questions about fiduciary risk. This was made especially relevant with a recent Department of Labor (DOL) directive clarifying fiduciary duty as purely financial, dialing back an earlier bulletin that appeared to open the door to including ESG as a factor in making sound fiduciary decisions.

Specifically, the DOL directive, issued April 23, 2018, reinforces that Employee Retirement Income Security Act (ERISA) fiduciaries “must always put first the economic interests of the plan in providing retirement benefits.” It also reminds ERISA investors that “fiduciaries must not too readily treat ESG factors as economically relevant to the particular investment choices” and that “it does not ineluctably follow from the fact that an investment promotes ESG factors, or that it arguably promotes positive general market trends or industry growth, that the investment is a prudent choice for retirement or other investors.” In other words, it’s all about financial risk/return. If incorporation of ESG into an investment process does not provide equal or improved risk/return, it is not on sound fiduciary ground.

The challenge for U.S. investors is that the impact of ESG on financial risk and return is unclear. The limited research on the subject has produced mixed results, some good and some bad, but it is based on questionable data. And it tracked results over short time horizons, while ESG is focused on a much longer time horizon.

Contrast the U.S. approach with a recent European Commission proposal to regulate the required integration of climate risk into financial decision-making. The commission does not require these considerations to be risk/return enhancers. Its goal is to achieve a sustainable economy—not necessarily to maximize risk/return. The proposal is introduced as “part of a broader Commission initiative on sustainable development. It lays the foundation for an EU framework which puts Environmental, Social and Governance (ESG) considerations at the heart of the financial system to support the transformation of Europe’s economy into a greener, more resilient and circular system. To make investments more sustainable ESG factors should be considered in the investment decision making process, when taking into account factors such as greenhouse gas emissions, resource depletion, or working conditions.”

What’s a global investment manager to do? If the EU proposal is enacted, European clients may be required to integrate climate risk into investment decision-making. But here in the U.S., those same considerations might not be allowed unless optimal risk/return is achieved. As a global manager research specialist, I’ve noticed several non-U.S. based managers pitch strategies that benefit society and the environment. We all need to be aware that if marketing to U.S. investors, those benefits can only be considered if they result in optimal risk/return. Craft your messages carefully to the U.S. marketplace, and realize the messages would be more powerful if they were backed up by superior risk-adjusted performance.