Lately, I’m fond of saying “ESG is everywhere”. Not a day passes without a client meeting or policy document to review which has environmental, social and governance (ESG) at its center. The same is true for most global asset managers who are inundated with updates, conferences, literature and policy news as ESG washes across the industry. Europe remains the epicenter of ESG regulatory activity with the triangulation of the EU Taxonomy, Sustainable Finance Disclosure Regulation (SFDR) and Corporate Sustainable Reporting Directive (CSRD) continuing to challenge the industry across the spectrum of size and influence. And while the intensity of ESG scrutiny might be most fervent in the EU, the debate in the U.S. continues to accelerate. We have flagged before that under the Joe Biden administration, it is clear that U.S. policymakers will jump on board the ESG train, perhaps not to the extent that Europe has, but the shift towards ESG integration is no doubt a global phenomenon.
The Winds of Change Blow Strong
An overarching financial policy goal of the Joe Biden administration is to adopt policies that consider ESG and sustainability of investments. An Executive Order issued by President Biden in May 2021 directed federal agencies to assess and mitigate financial risks related to climate change. One offshoot of that Executive Order was that the U.S. Department of Labor (DOL) conducted a market consultation with multiple stakeholders to review some of the prior administration policy revisions made in relation to ESG adoption. What’s more, in March, the administration stated that they would not enforce the previous DOL regulation, which was a major signal that the rule was bound to be reversed.
This long-standing ESG policy debate in the U.S. has tended to swing back and forth depending on which political party affiliation the DOL Secretary held. The ebb and flow of the DOL rule highlights one of the long-standing deterrents to ESG policy adoption in the U.S. which holds that ESG as a concept swings in and out of favor depending on who holds the presidency. This latest DOL rule change is just another indicator that often partisanship colors U.S. policymaking as much as the objective reasoning of any issue.
In 2020, under the Trump administration, the DOL introduced two rules whose effect was to curb the concept of ESG integration to a degree. The first dictated that plan sponsors could buy investments for any “non-pecuniary” (or non-financial) reason. The second, related to proxy voting and put certain strictures and additional processes in place for plan fiduciaries. This rule recommends that proxy vote decision making should be related to investment returns almost exclusively and the role of a plan fiduciary was not to act as an activist on non-financial matter pertaining to an investment. Both rule changes drew vocal and impassioned criticism from various stakeholders within the consultation period. In fact, the DOL reported that it had received 8,737 public comments, far in excess than the norm and a strong indicator of the strength of feeling across U.S. plan sponsors, asset managers, asset owners, and ESG and investor advocacy groups on the prior rule implementation. The call for change was too strong for the DOL to ignore.
As a result of widespread dissent, on Wednesday, 13 October, the DOL proposed a new rule to explicitly allow Employee Retirement Income Security Act (ERISA) plan fiduciaries to consider ESG factors when selecting investments and when exercising their voting rights. The not so elegantly entitled “Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights” is set to replace the Trump-era rule. This is highly significant because it swings the pendulum back in favor of ESG integration and undoes much of the previous administrations’ attempts to discount considerations or “collateral benefits” as the new rules call them other than financial return. The prior DOL changes commonly referred to as the “pecuniary standard” meant that plan fiduciaries were asked not to consider any other factors other than investment returns, therefore discounting possibly material effects of certain non-financial impacts on an investment, such as climate change.
Investment Prudence Duties
The primary change is a shift in emphasis from seeing non-financial characteristics of investments as being material to their valuation whereas the prior rule looked solely at financial measures. The old rule suggested that anything that was deemed to be “nonpecuniary” should be considered wholly irrelevant by plan sponsors. The new rule removes certain restrictions that were previously imposed under the Trump administration.
The old rule dictated that 401k plan fiduciaries should avoid screening investments or considering ESG factors for investment purposes, if such activity would lead to diminished investment returns or increased risk “for the purpose of non-financial objectives.” The November 2020 rule generally required plan fiduciaries to select investments based solely on consideration of “pecuniary factors.” The revised rule now is quite explicit in stating that plan sponsors can select investments for their retirement plans which do consider ESG within the investment process. In the consultation, many stakeholders indicated that the previous rules put a thumb on the scale against the consideration of ESG factors, even when those factors are financially material.
Investment Loyalty Duties
The second rule change which is almost as consequential as the first relates to proxy voting. The DOL’s guidance has historically always recognized that the fiduciary act of managing employee benefit plan assets should include exercising voting and other shareholder rights, and shareholder engagement activities to the benefit of the underlying employee investors. This active ownership principle is enshrined broadly in ERISA’s prudence and loyalty requirements (plan sponsors should always act in the best interest of the employees and not themselves nor investee companies). The previous rulemaking was seen to diminish the value of proxy voting to an extent.
In the consultation, many respondents deemed the failure to engage or vote on matters which could have a material impact on the value of a particular investment such as climate change, board composition or other factors was in fact a dereliction of their fiduciary duty and that financial condition was just one of many factors which impact an investment’s value now and into the future. The new rule is clear that these revisions do not mean that fiduciaries must always vote on proxies. Fiduciaries may choose to vote, or not vote, nor should plan fiduciaries proactively engage in shareholder activism against a particular company.
So, the DOL revisions now undergo a 60-day period of review before becoming applicable and what is certain is that this is just another large and significant step in the U.S. markets towards the integration of ESG rulemaking. Believe me when I say, as I did in my latest LinkedIn video: ESG IS EVERYWHERE!
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