Policy Corner | July 14, 2020

Trump administration seeks to turn back the ESG tide

Amy Cortese and David Bank
ImpactAlpha Editor

Amy Cortese

ImpactAlpha Editor

David Bank

ImpactAlpha, July 14Investors are flocking to funds keyed to environmental, social and governance factors, or ESG. The Trump administration is trying to reverse the trend. 

A year that has exposed one systemic risk after another – from pandemics to climate change to structural racism – would seem an odd time to discourage an investment approach designed to mitigate such risks. 

And on first blush, the changes proposed by the U.S. Department of Labor – which reverse Obama-era guidance that itself reversed Bush-era guidance that had rolled back Clinton-era reforms – would not seem to make much of a difference.

The proposed rule would amend the Employee Retirement Income Security Act, or ERISA, to bar fund managers from investing in ESG vehicles that “subordinate return or increase risk for the purpose of non-financial objectives,” according to a DOL press release. 

How far will the pendulum of ESG guidance swing back in a Biden administration?

“Private employer-sponsored retirement plans are not vehicles for furthering social goals or policy objectives that are not in the financial interest of the plan,” said Secretary of Labor Eugene Scalia. 

That’s a low bar, since most sustainable funds outperformed their conventional peers in the first quarter downturn and held their own in the April bounce back, largely driven by social factors – the ‘S’ in ESG.

Focus on workers, customers and governance drive ESG outperformance amid COVID uncertainty

But Scalia appears to be after something bigger: the very definition of ‘fiduciary duty.’ Rather than simply issuing guidance, as this and previous administrations have done, the Department of Labor is seeking to change the rule itself.

“It is going in and trying to essentially rewrite the definition of the duty of prudence and the definition of loyalty,” the Pension Resource Institute’s Jason Roberts told ImpactAlpha.

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

That change could reverberate through investment decisions far beyond the plans covered by ERISA. Fund managers have increasingly used consideration of non-financial factors such as ESG to identify well-managed companies and reduce exposure to long-term and systemic risks. A reversion to short-term performance criteria could paradoxically increase risks to pensioners, as racial inequality, the COVID pandemic and global warming destabilize markets and communities. Americans held $28 trillion in retirement plans at the end of the first quarter.  

“Everyone who’s skeptical about this, it gives them the extra ammunition to hide behind,” says The Investment Integration Project’s William Burkhart.

The short window for public comments on the proposed changes closes on July 30. Comments (identified by RIN 1210-AB95) can be submitted to www.regulations.gov.

Fund flows

With the proposed changes, the ostensibly market-savvy administration is bucking the market. More than $15 billion flowed into ESG investment products in the first six months of the year, topping earlier records, according to ETF Flows. 

Asset managers such as $7 trillion BlackRock have embraced ESG as a risk-mitigation strategy. The COVID pandemic has only “further reinforced our conviction that ESG characteristics indicate resilience during market downturns,” BlackRock wrote in a recent report. 

“Over the long run, COVID-19 could prove to be a major turning point for ESG investing, or strategies that consider a company’s environmental, social and governance performance alongside traditional financial metrics,” agreed J.P. Morgan’s Jean-Xavier Hecker and Hugo Dubourg. 

The DOL’s suggestion that fund managers are pursuing ESG for non-financial, politically-driven reasons is “out of step with professional investment managers, who increasingly analyze ESG factors precisely because of risk, return and fiduciary considerations,” says US SIF’s Lisa Woll. 

US SIF recently surveyed 141 money managers with more than $4 trillion in assets under management about their motivations for incorporating ESG criteria into their investment process. Three-quarters cited the desire to improve returns and to minimize risk over time, and 58% noted their fiduciary duty obligations. 

“We think the DOL is really out of step with the market,” the U.S. Impact Investing Alliance’s Fran Seegull told ImpactAlpha. 

Preparing an impact investing policy agenda for the next administration

Back and forth

The ruling is the latest in a string of rollbacks by the Trump administration of Obama-era environmental and social rules. In late May, a banking regulator rushed out changes to the Community Reinvestment Act that could lead to less funding for Community Development Financial Institutions.  The Securities & Exchange Commission has weakened shareholder rights and the ability to hold corporations accountable. The Environmental Protection Agency under Trump has dismantled at least 70 environmental rules, from emissions limits to wetlands protections. 

Agents of Impact call recap: 10x’ing community capital

The DOL’s guidance on ESG investing has been a political football for two decades, with Democratic and Republican administrations trading interpretations of the fiduciary duty of retirement plan sponsors. The Trump administration flagged its intentions in guidance issued in 2018. Still, the latest DOL reversal could have far-reaching consequences. 

“This is a tennis match that is almost expected,” as administrations implement their own interpretations of how ERISA fiduciary duties square, or don’t, with ESG, said the Pension Resource Institute’s Roberts. He said Scalia, the labor secretary, has gone further than previous administrations, however. 

U.S. Department of Labor: Green Light for ‘Economically Targeted’ Impact Investments

By changing the rules themselves, rather than merely the guidance for interpreting them, Scalia appears to be trying to future-proof the administration’s position. Under the Congressional Review Act, an incoming president and Congress have 60 ​legislative ​days to ​revoke rules. Beyond that, it can be difficult to unravel rules.

Affected parties, such as retirement plans and fund managers, could take to the courts. One challenge to finalized rules proved effective. A 2016 rule pushed by Obama’s Department of Labor required brokers to act in the best interests of their clients in retirement accounts. The rule was challenged by the U.S. Chamber of Commerce and negated by a U.S. appeals court before it was fully implemented. 

Heading the legal opposition to the Obama-era rules: then private lawyer Eugene Scalia.

“If anyone thinks that Scalia is going to get a rule finalized that could be subject to a court of appeals,” says Roberts, “we’re back to a Hail Mary, and then some.”