The Impact Alpha: Prudence, materiality and impact in the Trump era



ImpactAlpha, April 26 – It would be easy to see the guidance provided to pension fund investment managers this week by the U.S. Department of Labor as just the latest swing of the political pendulum.

As per consideration of environmental, social and governance, or ESG, factors in investment decisions, the Clinton administration was pro-, Bush was anti-, Obama was pro- and now Trump is…

But wait. The “field assistance bulletin” from the Employee Benefits Security Administration may have queued up exactly the right question: Is the environmental, social and governance performance of a company or a fund in fact “material”?

The answer is important. If such factors are material to long-term financial performance, it  follows that prudent pension-fund fiduciaries are not just allowed to, but duty-bound to consider them in investment decisions.

That would go beyond even the Obama Labor Department’s 2015 guidance that, all else being equal, pension funds may consider such factors. (That guidance superseded the 2008 Bush administration guidance, which in turn reversed the 1994 Clinton administration memo). Indeed, the new memo from President Trump’s Labor Department recognizes, “The factors are more than mere tie-breakers.”

You can parse the five-page document for yourself (“If you read it, you’ll need to drink several cups of coffee, take a nap, and try again,” warned US SIF’s Meg Voorhes at today’s Total Impact conference in Philadelphia). For example:

To the extent ESG factors, in fact, involve business risks or opportunities that are properly treated as economic considerations themselves in evaluating alternative investments, the weight given to those factors should also be appropriate to the relative level of risk and return involved compared to other relevant economic factors.

The memo goes on to say that fiduciaries “must not too readily treat ESG factors as economically relevant” and that “it does not ineluctably follow” that investments that promote ESG factors, or even positive market and industry trends are a prudent choice. The fiduciary’s evaluation “should be focused on financial factors that have a material effect on the return and risk of an investment” over the plan’s time horizons.

Default options

And the memo warns that for default investment options, it “would not be prudent” to provide an ESG-themed option that provided a lower expected rate of return or higher risk than non-ESG alternatives.

But what if it is instead non-ESG funds that deliver lower returns and higher risk? Is it then not prudent not to make ESG the default?

A host of studies suggest at least no difference and arguably out-performance and lower risk for companies and funds with strong environmental, social and governance guidelines and practices. Just Capital’s Martin Whittaker, also at the Total Impact conference, said the nonprofit’s large-cap index of highly-ranked “just” companies outperformed relevant benchmarks, such as the Russell 1000.

“This guidance pointedly ignores the materiality of ESG risks in business management, and investment underwriting and diligence,” Caprock Group’s Matthew Weatherley-White told me in an email exchange. He pointed to the work of groups like the Sustainability Accounting Standards Board, which is defining “materiality,” industry-by industry, precisely in order to drive environmental and social factors into the decision-making of all investors.

Instead of calling it “ESG,” investors should call out inarguable strategic and market threats, suggests Equilibrium Capital’s Dave Chen. For example: “the threat of water constraints on farms and agricultural assets and corporations, the impact on profits of carbon taxes outside the U.S., or the threat of not getting a license to operate in a Asian or African country because of a bad reputation.”

“These factors operate in a long-tail timeframe which represents the fiduciary timeframe of almost all pension plans,” Chen says.

Fran Seegull, executive director of the U.S. Impact Investing Alliance, said the new memo shouldn’t discourage pension plans from considering ESG  issues, “because the fundamental importance of evaluating the material impacts of ESG factors on both returns and risk remains as clear as ever.” In an email, she called on the Department of Labor to help make plan administrators aware of “all the tools at their disposal, including the increasingly robust and sophisticated array of ESG investment options.”

Shareholder engagement

The “materiality” question also is central to the other part of the Labor Department bulletin, which warns plan managers not to spend too much time or money on “shareholder engagement” activities unless they directly affect economic performance. Shareholder resolutions, once a mostly quixotic exercise, have become a potent tool, now that major asset managers like Blackrock and Vanguard at least sometimes vote in favor of measures seeking disclosure, for example, of carbon-risk by major oil companies.

Pension and other funds are increasingly embracing reporting requirements such as those recommended by bodies like the Task Force on Climate-related Financial Disclosures. “We’ve done modeling with outside assistance of the two-degree scenario and it does have potential impact,” Jack Ehnes, CEO of the $252 billion California State Teachers Retirement System, or CalSTRS, told me earlier this year.

Some corporations have been fighting back against shareholder resolutions, and several have received clearance from the Securities and Exchange Commission to bar them from even coming to a vote. Recently, JPMorgan Chase requested such clearance to put off shareholders questioning its financing of oil-sands producers and pipeline companies, as did Amazon for a resolution regarding food waste in its growing grocery business.

If pension-plan fiduciaries are going to spend time or money “to actively engage with management on environmental or social factors,” the new memo says, they should be prepared with “a documented analysis of the cost of the shareholder activity compared to the expected economic benefit (gain) over an appropriate investment horizon.”

In other words, game on.

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