“Over the last year, 18 states have proposed or adopted state legislation or regulation limiting the ability of the state government, including public retirement plans, to do business with entities that are identified as ‘boycotting’ certain industries based on environmental, social and governance (ESG) criteria”, according to a round-up from law firm Morgan Lewis. The law firm Ropes and Gray has produced a similar table here. As of December 6, 2022, Ropes and Gray show 13 enacted laws that limit taking ESG factors into account. Eleven states’ laws prohibit investment in businesses that “boycott” fossil fuel, forestry and agricultural companies. For the most part, these laws apply to financial institutions that might have contracts with the state, mostly with state retirement funds.
In contrast, two states, Illinois and Maryland, now have laws on the books that promote integration of ESG factors in investment decisions. Maryland’s law governs the state retirement system while Illinois governs state and local entities that manage public funds.
Not surprisingly, anti-ESG lobbying is taking place at many levels. Much of this advocacy relates to preserving the use of fossil fuels and firearms, but anti-ESG advocacy also apply to social issues. Former House Speaker Paul Ryan is making the rounds with corporate CEOs to warn them against considering ESG issues. At the Robinhood Investors conference in October, ImpactAlpha (paywall likely) commented: Paul Ryan is advising corporate CEO’s “not to focus on ESG too much” and to “keep their heads down”. Ryan explains that his recommendation to corporate leaders is not to get tangled up in disputes like the one between The Disney Corporation and Governor DeSantis around laws such as “Parental Rights”, also known as “Don’t Say Gay”. ImpactAlpha quoted Ryan: “The next shoe to drop is to go after woke corporations.”
Of Dropping Shoes and FlipFlops
The consideration of ESG factors in investing has gone through numerous flip-flops in policy at the federal level. Should parties change again in the 2024 presidential election, we are likely to see further flip-flops. In November, 2022, President Biden’s Department of Labor issued a final rule for pension plan fiduciaries, that they may consider climate change (“and other environmental, social and governance factors”, aka ESG) when selecting retirement investments. This rule specifically applies to ERISA-governed pension plans that are regulated by the federal government. (ERISA stands for the Employment Retirement Income Security Act of 1974, was passed by Congress during the Nixon administration in 1974 but signed by Gerald Ford about a month after President Nixon resigned from office. More info on ERISA here.)
The rule reverses the prior administration’s action on the same topic, “Financial Factors in Selecting Plan Investments”, which President Trump issued just before the presidential election in 2020. That rule was intended to limit consideration of ESG criteria when selecting investments for ERISA-governed plans. The Trump administration was also keen on reversing policies related to the environment and climate from the Obama administration, such as the Clean Power Plan, vehicle emission standards (remember “cash for clunkers”?) and clean water protections. The rule for ERISA-governed retirement plans reinforces that approach.
While the Department of Labor oversees corporate retirement plans through ERISA, the states control large public employee pensions as well as a variety of other investment activities within their borders – hence the legal and regulatory actions against ESG considerations at the state level, as mentioned above.
Finding Relief in the Judicial System
Alongside legislative and regulatory changes, anti-ESG activists are pursuing their goals through the court system. (This is nothing new, of course, and is a pathway for resolving grievances on both sides of the aisle.) In West Virginia et al vs. EPA (20-1530), the Supreme Court trimmed the EPA’s authority to set carbon emission caps on power plants that were part of the Clean Power Plan, CPP (note that this link pre-dates the Supreme Court decision). The court favored states, finding that petitioner states have been harmed.
The CPP, implemented through federal EPA, was a signature program of the Obama administration to combat climate change. It included steps and criteria for electric generators to change their fuel source from coal to cleaner, more efficient forms of fuel and then to eventually replace fossil fuels with renewables. In the decision summary, the court notes that the EPA, “rather than setting the standard ‘based on the application of equipment and practices at the level of an individual facility,’ had instead based it on ‘a shift in the energy generation mix at the grid level’. The Supreme Court found that “…at least one group of petitioners – the state petitioners – are injured by the Court of Appeals’ judgment….And there can be ‘little question’ that the rule does injure the States, since they are ‘the object of’ in its requirement that they more stringently regulate power plant emissions within their borders.”
Another lawsuit who’s outcome could weaken environmental protections was raised by Jaynee LaVecchia, former senior associate justice of the New Jersey Supreme Court at the recent Global Interdependence Center ESG panel at Rowan College in New Jersey. The case relates to California Proposition 12 which is designed to “prevent animal cruelty by phasing out extreme methods of farm animal confinement”. Prop 12 was a voter initiative that passed in 2018 by 63%. The case involves the “Dormant Commerce Clause” of the US Constitution, was brought by the National Pork Producers Council and joined by the American Farm Bureau Federation. Plaintiffs argue that Prop 12 would force out-of-state farmers to make expensive upgrades to their animal housing. (More information about the case can be found here.)
The National Conference of State Legislatures, NCSL, wrote the following about this case: “The outcome of this case may impact how states may address intrastate issues with interstate effects such as climate change and environmental protection (italics ours).” (Docket number: 21-468 argued October 11, 2022). More detail can be found here.
Cost vs. Benefits of ESG Action
The court’s decision in West Virginia et al vs. EPA highlights an asymmetry in the climate change debate unique to our federal system, that makes it difficult to advance solutions, compared with governments elsewhere. That is, the cost of actions to reduce carbon emissions at the local level do not necessarily match the benefits derived at that local level. A report from Resources for the Future (“Policy Evolution under the Clean Air Act”) stated, “Because GHGs (greenhouse gasses) are well-mixed globally, change is particularly well suited to the use of market-based instruments. But this also means that global damages are unaffected by the location of emissions. Thus, any jurisdiction taking action will incur the direct costs of its actions, but the direct climate benefits will be distributed globally…”. The report also states: “The state-by-state approach in the CPP did not guarantee cost effectiveness, because under the formula employed, marginal abatement costs would vary greatly across the states.” The bottom line is that it is hard to accept the rationale for incurring costs when the benefits are somewhere else in the world.
The current Supreme Court may well decide in favor of the Pork Producers for similar reasons of “harm” outside California in the Dormant Commerce case mentioned above. Issues of “damage and loss” came up as well in the recent COP27 (Conference of the Parties) in Egypt – that major carbon producing countries should compensate those countries most harmed by pollution. We expect to hear more about this concept on both sides of the debate in 2023 (pro- vs. anti-ESG).
This asymmetry also underscores the difficulty of proving monetary benefit from investing in particular securities labeled “green”, “social” or “ESG”. This question comes up frequently with green bonds: is there financial benefit or differentiation between these bonds and non-green? At best, the case is being made by “alignment” and “integration” with Principles for Responsible Investment, or PRI (as applied to municipal bonds, see here). The asymmetry is driving a wedge between those investors that want ESG products and those that find ESG implementation as counter to their business interests.
Double Materiality
Investors consider ESG factors in the context of avoiding portfolio risk while others seek to achieve impact with their invested dollars. Bloomberg.com has commented on the anti-ESG movement as it affects “Impact Investing in the US” here. Anti-ESG efforts appear to be having effect: Vanguard recently withdrew from the “Net Zero Asset Managers Initiative” (NZAM), not without criticism (see Responsible Investor, here). Interestingly, Vanguard responded to criticism that the withdrawal “would not affect its commitment to helping investors navigate climate risk.” (Quoting the Responsible Investor article).
Vanguard’s response touches on the issue of “double materiality” in ESG. That is, climate change (as in extreme weather events) may pose financial risks to a company or government’s financial condition (internal) but may also contribute to exacerbating global climate change that may cost others (carbon emissions — external).
Aspirational investment is quite different from risk avoidance, but both goals pull from the same growing body of scientific, social, governance and market data. The recently published Milken Institute “Financial Innovations Lab” does a good job distinguishing “risk” analysis from “impact” in the municipal market with an emphasis on using data. Further discussion of “double materiality” can be found here. Unfortunately, anti-ESG prohibitions are also likely to slow data collection and ESG measurement efforts, including securities pricing.
Central Bankers and Regulators Take Note
Central bankers and governments are increasingly integrating dangers and damages from climate change into their overall assessments of financial risk. In its 2021 report, the Task Force on Climate-related Financial Disclosures, TCFD, reviewed 1,600 companies and found significant growth in disclosure aligned with the TCFD recommendations. We note that the Task Force report is addressed to the Chair of the Financial Stability Board of the Bank for International Settlements in Basel, Switzerland. Lael Brainard, now Vice Chair of the Federal Reserve discussed “Financial Stability Implications of Climate Change” in 2021, here. The SEC Chair, Gary Gensler discusses the SEC’s role in promoting disclosure of climate risks (here, with links). The SEC has also established a Climate and ESG Task Force in the Division of Enforcement – in this case to protect investors against “greenwashing” (see cases here). The US Treasury, in 2021 established a “Climate Hub” and appointed a “Climate Counselor” to coordinate efforts to address climate change.
Complainants against “greenwashing” or, as Paul Clements-Hunt, originator of the term ESG dubs, “ESG fairy dust” are making valid points and growth of these “green” attributions are further evidence of investor demand (whether or not the attributions were made in good faith).
While much of the effort on ESG disclosure of financial risk centers on corporate securities, the municipal market is wrestling with these issues as well. In 2021 the Municipal Securities Rulemaking Board, MSRB, (the industry’s self-regulatory body) issued a “request for information” from market participants about ESG. A summary of their findings can be found here. A summary of responses can be found here. Numerous mutual fund families have developed their own, proprietary approaches to assessing municipal securities. We share one whitepaper from Nuveen, which describes their proprietary approach in depth.
Channeling Milton Friedman
One of the major critiques of ESG considerations is that this approach introduces non-financial or non-pecuniary factors into analysis. In 1970, Milton Friedman summarized the case against consideration of “non-pecuniary” factors in investment decision-making in an opinion piece for the New York Times (titled: “The Social Responsibility of Business is to Increase its Profits”; paywall likely). In it he explains that the corporate executive has a direct responsibility to increase the company’s profits for “his employers”, that is, the shareholders/investors in the company. However, he also stated, “That responsibility is to conduct the business in accordance with their desires, which generally will be to make as much money as possible while conforming to their basic rules of the society, both those embodied in law and those embodied in ethical custom” (our emphasis). We would add that ESG integration is being driven by shareholder/investor desires. This statement also implies that law-making is responsible for setting the guard rails against violating “basic rules of the society”.
Lawmakers have historically enacted sweeping legislation that imposed costs on businesses guilty of “externalities” such as severe degradation of land and resident’s health. For example, around the same time as Milton Friedman’s op-ed, a company was hired to remove dioxin from tanks that dated from the time of production of “Agent Orange” for the Army during the Vietnam War. According to the EPA, waste oil hauler Russell Bliss mixed dioxin with oil and used the compound to suppress dust along dirt roads and horse tracks throughout the state of Missouri. Bliss sprayed “more than 25 locations with the dioxin-contaminated mixture, including the town of Times Beach.” Still a ghost town, Times Beach became uninhabitable and was completely evacuated at the time.
In the late 1970’s, toxic chemicals that were leaching into residents’ backyards and basements near Love Canal, New York led to another evacuation. Valley of the Drums in Bullitt County, Kentucky was another example of toxic dumping. In 1980, Congress passed the “Comprehensive Environmental Response, Compensation and Liability Act (aka CERCLA, or Superfund) to address the dangers of toxic waste dumps. This law was unique in creating a fund for remediation as well as identifying liability for “Potentially Responsible Parties” or PRP. Prior to CERCLA, it was easier (and more profitable) to dump waste products into the Love Canal or Valley of the Drums, when there were few laws addressing safe storage and containment of toxic waste. For those interested in Superfund history, see timeline here and history here.
US reaction to the OPEC oil embargo in the 1970’s is another example that involved increased costs to business and individuals, at least initially, although not motivated by environmental damage. In this case, motivation to protect the national interest was invoked. Following the 1973 Arab Israeli war, members of the Organization of Petroleum Exporting Countries voted to embargo oil shipments to the United States to punish its participation in helping Israel. An effort to reduce dependence on Middle Eastern oil to re-gain control of pricing was mounted. US automakers retooled their factories to produce more fuel-efficient cars. See Federal Reserve commentary on this here and here. Geopolitics of energy have again come into play since Russia’s invasion of Ukraine in February 2022. However, sentiment has shifted against transition to cleaner energy in the face of higher costs.
These are concrete examples with relatively clear links between exposure to toxic chemicals, health effects and pollution of water and land. It is more difficult however to draw a direct line from site-based carbon emissions to the changing climate – particularly when the locus of damage may be in another state or country. In an era of deepening nationalism, it is difficult to think globally about these issues.
A Further Divide: Adaptation vs. Mitigation
Given asymmetries between carbon emissions and damage, a further wedge can be driven between climate adaptation and mitigation by anti-ESG advocates. For example, it is hard to argue climate change in Florida where the state’s population has experienced a growing frequency of severe storms. Most recently Hurricane Ian destroyed wide swaths of Fort Myers, an affluent city on Florida’s west coast. However, in this context, “adaptation” passes the “anti-ESG” test for Florida’s Governor DeSantis, while “mitigation” does not.
Time Magazine commented: “DeSantis has piloted a new Republican approach to climate change by spending money on climate adaptation but not on mitigation. In other words, he has sought to pay for his state to adapt to a changing climate but not to address its greenhouse gas emissions, the root causes of climate change.” So, it is ok to build sea walls, raise buildings, and develop “better preparedness in the future”. But it is not ok to consider carbon emission reduction, which the governor dismisses as “left-wing stuff”. In our opinion, this is like a doctor telling you, “It’s ok to keep smoking. Don’t worry, we’ll fit you with an iron lung when you get cancer.”
Conclusion
Keep in mind that the ESG trend is being driven by investor demand. Many investors want to put their money into companies and municipalities that embrace ESG, or bonds that have been certified as ESG compliant in some fashion. Others of course, want to limit exposure to companies and governments that are at financial risk of extreme weather events, social unrest, and corrupt governance/management behavior.
We need to re-think the levels of engagement given the asymmetry between the costs and benefits of adaptation vs. mitigation. That is, the level of government dealing with an issue should be aligned with the problem at hand. For example, global entities such as the United Nations, Intergovernmental Panel on Climate Change (IPCC) are dealing with the global impact of planetary warming; national and sub-sovereign entities are dealing with adaptation infrastructure and investment. COP 27, (the “Conference of Parties) that recently concluded in Egypt, took the first steps in establishing a “Loss and Damage” Fund for countries most vulnerable to impact from climate change.
Recognition that actions in the high carbon emitting countries affect life in smaller, poorer countries was key to the COP 27 agreement. (We recommend Simon Mundy’s book “Race for Tomorrow” wherein he describes in detail the human effect of climate change in 26 countries.) Implementation of the agreement, of course, could be sketchy and slow; meanwhile consequences such as migration from uninhabitable and non-productive land will continue apace. Pope Francis was quite clear in his 2015 Encyclical detailing the connections between religion and caring for our global “common home”. The encyclical also highlighted the plight of the world’s poor who bear the greatest burdens from the degradation of nature and “our obligation to use the earth’s goods responsibly.”
Finally, the most critical point for anti-ESG politicians and executives, is that being wrong is a high stakes position to take. Degradation of living conditions has already affected numerous countries, leading to migration and political unrest. Financial costs to business and individuals from extreme weather events are accelerating. In the worst case, ignoring or rejecting these factors could pose what hundreds of scientists argue is an existential threat to stability of life on the planet. To use the medical metaphor again, doctors, when faced with a complex procedural decision of uncertain outcome, are directed by the medical ethics dictum, “do no harm”.
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*If you are still reading, thank you; our title references the widely different political views between Nick Hanauer and Mike Lindell, aka “My Pillow Guy”, (although Lindell’s approach affirms Hanauer’s “pitchfork” thesis.) The former is popularly known for his Ted talk “Beware, fellow plutocrats, the pitchforks are coming” and his “Pitchforks” podcast. He takes the view that there is good business sense for corporate leaders to reduce inequality. If not, the pitchforks are coming. The first talk was in 2014, well before the widespread demonstrations in 2020 following the murder of George Floyd and before the storming of Congress. Mike Lindell is described as a “far-right political activist and conspiracy theorist” (Wikipedia). He is an ardent supporter of former president Trump and supports Trump’s attempts to overturn the 2020 election results. Both men derive some of their wealth from companies that manufacture pillows and other bedding products.
