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US Department of Labor allows fiduciaries to consider ESG risk

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The US Department of Labor (DoL) has issued a final ruling to allow investment managers to factor ESG risks in their decision-making around pension plans.

  • The DoL has removed obstacles in the provisions of the Employee Retirement Income Security Act (ERISA). 
  • The ruling allows investment managers to consider risks from climate change and other ESG factors when making investment decisions.
  • The decision underlines the importance of considering ESG risk factors to maximise returns, rather than viewing sustainability as a political issue.

ERISA’s role in private sector pension plan management

US private-sector retirement plans are subject to the provisions of ERISA, which is regulated by the DoL. It sets investment standards for investment managers and fiduciaries responsible for defined benefit and defined contribution plans.  

Under ERISA, plan sponsors and other fiduciaries must act solely in the interest of the plan participants and beneficiaries. This includes a requirement to invest with the care, skill and diligence of a prudent person, and diversify plan investments to minimise the risk of large losses. 

Not considering the material financial impacts that may result from ESG risk factors appears to be a violation of this requirement.

DoL’s final ruling reverses prior policy that politicised ESG investing 

Prior to 2020, ERISA did not preclude fiduciaries from making investment decisions that reflected ESG considerations. It also allowed them to choose economically targeted investments (ETIs), which could provide benefits beyond the investment return to the employee benefit plan. Alternative terms that have been used to describe ETIs include socially responsible investing, sustainable investing, and even ESG investing.

In November 2020, during the Trump administration’s tenure, the DoL introduced proposals which amended the allowance of ESG factors and ETI considerations. Among these was a prohibition on considering any investment fund, product, or model portfolio which included even one non-financial objective in its investment objectives. By December 2020, amendments were also made to restrict the ability of fiduciaries in exerting shareholder rights via proxy voting.

These actions were reversed by the Biden administration by executive order in January 2021. By doing it in this way, it avoided a political debate on the consideration of ESG and non-financial factors on total shareholder return by managers of private pension plans.

Backlash against ESG deepens climate action divide along party lines

While the DoL rules apply to private pension plans, state pension plans in Republican-led states are a different matter. Leaders and lawmakers from 19 such states have vilified the term ‘ESG’, claiming ESG-oriented investments are damaging local industries such as oil and gas, thereby affecting the US economy. For example, the state treasurer of West Virginia, Riley Moore, banned banks on the Restricted Financial Institutions from banking contracts with the state of West Virginia in an attempt to “beat ESG”.

The attorney generals from virtually the same list of states also opposed climate-related disclosure rules by the US regulator. A letter to the chairman of the US Securities and Exchange Commission (SEC), published in April 2022, alleged that the proposed rule is “not within the SEC’s mission to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation”.

ESG has been labelled a fascist strategy by Republicans, claiming it is being used by the “woke left” against free markets and the fossil fuel industry. Multiple studies, however, have shown an increasingly positive correlation between financial performance and sustainability, refuting the anti-free market claim. 

North American business leaders lag global counterparts on ESG

Business leaders around the world agree that ESG will be important their operations over the next decade. In a survey carried out by global consulting firm Protiviti and the University of Oxford, over three-fourths of respondents said they believe ESG reporting will become mandatory by 2032.

A consistent finding of the survey was how the view of North American business leaders lagged that of their global counterparts. Around 80% of Asian and European respondents believe their spending managing environmental risks would increase, while 61% of North American business leaders believed their spending would remain the same or go down.

Protivit concluded that many business leaders in North America appear to be in a “wait and see” mode. Yet, recent analysis from Credit Suisse suggests that the impact of the Inflation Reduction Act in the US has the potential to generate $1.7 trillion in climate spending over the next decade, suggesting the opportunity presented by sustainability-oriented investments.

DoL ruling can help emphasise ESG role in improving risk-adjusted returns 

Putting the ongoing political debate in the US aside, it is important to remember that an ESG lens helps identify risks that go beyond financial metrics, as it includes the impact of factors such as policy and weather events on the economic well-being of countries and companies alike.

Removing obstacles to ESG investing in US private sector pensions is a good first step to ensure all risks are considered when making financial decisions. Now the Biden administration needs to raise awareness of climate and social risks to US savers, which will provide added incentive to investment managers to act on sustainability.

Even though there are signs of progress, a lot more needs to be done to get fund flows in the world’s largest economy to become sustainably aligned.

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