Over the past year, the debate over environmental, social and governance (ESG) standards in the United States has revealed stark political contrasts between red and blue states. Red state officials have proposed and enacted “anti-boycott” bills that prohibit state business with companies that divest from favored industries. Blue states, on the other hand, have largely considered efforts to force divestments in the same industries. Neither of these approaches makes economic sense. Recognizing this creates a real opportunity for a truce, based on fiduciary duty and the separation of political issues from investment decisions.
And we need a truce because the pace of ESG legislation is only accelerating. Data collected by the law firm Simpson Thacher & Bartlett shows that at least 28 policies and laws have come into force since 2021 alone and, as of spring 2023, there were at least 13 pending ESG-related bills. This does not count the huge number of existing policies – ranging from preferences for small businesses to laws against the investment of public funds in companies operating in certain countries – that would fall under ESG if proposed today. While the stated goals of financial and future protection that underlie these proposals are worth considering, they are bad policies that can fail on their own while causing significant fiscal damage.
Let’s start with the red state boycott ban bills that typically target investment firms that limit investments in guns or fossil fuels. These bans represent a reckless ceding of legislative power that will cost states billions. Law in force in TexasThe language of – typical of similar bills introduced across the country – defines a boycott as any effort to “penalize, inflict economic harm, or limit business dealings with a company ‘involved in the fossil fuel industry without’ ordinary business purpose”. The law, furthermore, allows the mere “judgment” of the state comptroller to be sufficient to determine that a company has initiated a “boycott”. If such a decision is made, the state could end business with a company even if it has the best price, quality or performance record. Studies from the University of Pennsylvania estimate that this political decision could cost the state more than $400 million a year and $6 billion over the next decade.
But that may be an understatement, in part because the law cedes so much power to the comptroller. Since a simple portfolio rebalancing, which a large financial firm will do somewhere every day, can “limit” trading relationships, a controller willing to do so could probably disqualify almost any entity. Standards elsewhere ranging from a Anti-ESG Order Issued by Florida CFO to almost identical Kentucky And Oklahoma laws that similarly restrict ESG investing are likely to have similar deleterious tax effects. And an even more expansive Florida bill— which adopted that state’s Senate — seems likely to grant even more arbitrary power to state officials. In other words, efforts to “protect” public funds from ESG are likely to have very high costs for states and represent a huge concession of power by legislatures.
Although the anti-boycott bills are too recent for anyone to have long-term evidence of their effects, there is little doubt that their mirror image – the mandatory divestment policies – have negative tax consequences and fail to produce the desired results. As such, a Maine Law That Forces State Pension Funds to End Fossil Fuel Investments– typical of the proposals circulating in several blue states – seems almost certain to have about the same impact as past divestment policies targeting narrower categories of companies. Analysis conducted by the Californian giant CalPERS And CalSTRS the pension funds are both posting billions of dollars in losses as a result of that state’s existing divestment policies. Worse still for proponents of divestment efforts, the best evidence seems to indicate that they are in fact counterproductive. A disorganized written by Vaska Atta-Darkua and three others indicates that divestment efforts do nothing to encourage green innovation but simply reallocate capital to companies that already have significant “green” revenues. Writing in Harvard Business Reviewlikewise, Tom Johansmeyer points out that divesting from any publicly traded asset can actually attract new capital to that asset and improve its prospects.
The example of cigarette manufacturers shows how it works: widespread divestment did temporarily lower their stock price beyond what their fundamentals would warrant. But it made them more attractive and as such they outperformed other investments; Philip Morris International now has a higher market capitalization than well-known companies ranging from Morgan Stanley to Bristol Myers Squibb. Even if stock prices remain depressed, a highly profitable company can still become an attractive investment simply by increasing dividends. And the same dynamic that made divestment a failure seems likely to apply to long-term boycott bans, even if they become widespread enough to impact stock prices.
But even though most pro- And Anti-state ESG policies do not work as advertised, it is unwise to dismiss the rationale behind them out of hand. State employees – who ideally will represent the full spectrum of a state’s views – should not see their pension funds invested in ways that put what may be political views above investment returns . State governments, especially those whose economies are based on disadvantaged industries, have a legitimate interest in ensuring that their money is not invested in companies that harbor an irrational bias toward those same industries.
On the other hand, a number of ESG considerations can have strong links to investment performance. The footprint of the coal industry has shrunk for decades and dozens of coal companies have gone bankrupt in recent years as coal has been replaced by natural gas, wind and solar. Companies in any industry can reap huge benefits if they can recruit talented workers from groups that others might discriminate against or ignore. Recruiting Millennials and Gen Z workers is particularly difficult, and diversity is a priority for many of them. Even overtly political considerations that might be distasteful to some may have strong financial justifications. For example, a pro-gun investment manager who believed that federal legal changes could make gun makers liable for intentional shootings were both inevitable and very likely to depress stock prices would have an obligation to dump the stock.
This brings us to a proposed solution that the left and the right should be able to agree on: clear fiduciary duty laws that define who is responsible for the state’s investment, allow them to consider the factors ESG only when they contribute to the creation of economic value and ensure that government employees in defined contribution schemes can select non-ESG options.
The clear description of fiduciary responsibility must come first. Although systems differ from state to state, and even between various retirement systems within the same state, laws must clearly define a specific individual or group as a trustee and, if existing state laws do not not already echo or exceed them, use the Taft-Hartley law. provisions on union-sponsored health and pension plans as a model to describe their functions. Even where standards exist somewhere in the law, legislatures would do no harm in clarifying the exact responsibilities: most plans have developed over time and, given the difficulty of pension reform in general, many State laws remain unclear.
More importantly, states should adopt clear limits on ESG investments in the first place. Laws voted in red decidedly North Dakota And Idaho provide good models in this regard. North Dakota law defines “social investing” as “the consideration of socially responsible criteria…for the purpose of achieving an effect other than maximum return” and requires the North Dakota Investment Board State “demonstrates that a social investment would provide an equivalent or greater rate of return compared to a similar investment that is not a social investment and has a similar time horizon and risk” before doing so. Idaho law contains language with a similar effect and permits state defined contribution plans to offer employees social purpose investment funds only to the extent that they also offer alternatives. Both policies are worthy of emulation.
While nothing short of a hard-to-pass constitutional amendment can bind future legislatures, states seeking broad-based ESG policy should do their best to isolate pension funds, other investments, public contracts and investments from political concerns. This will differ from state to state, but, at a minimum, it’s a good reason for states to avoid “cause du jour” divestment/investment legislation on issues such as invasion of Ukraine by Russia, attacks on the State of Israel and global human protection. trafficking efforts. If states feel they need to take token action on issues like these — most of which are federal matters anyway — they have a wide range of other tools at their disposal. Legislatures can create grant programs, sponsor research, designate or change place names, etc. All of these things can have much more symbolic impact than investment policies.
Standards and norms like these would ensure that state officials could not use a procurement or investment process to make political arguments. Instead, they would exercise their business judgment regarding ESG factors, as a fiduciary. Under such rules, for example, state investment managers could not favor one consumer products company over another just because it bought more alternative energy. On the other hand, the standard would allow investment managers to reduce their fossil fuel holdings because their analysis predicted a decline in demand for fossil fuels. This truce on state-level ESG laws involves give and take on both sides. It points the way to a financially sound future that empowers investment managers while allowing them to make the best judgments possible.