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ESG Proponents Weigh Impact of Increased Regulatory Scrutiny

Recent moves by the Department of Labor and SEC are causing ESG advocates to question what impact, if any, the scrutiny will have on its accelerated growth.

As the Department of Labor considers a new regulation that could limit the use of environmental, social and governance (ESG) investing in retirement plans, ESG proponents and advocates are weighing the impact that increased regulatory scrutiny from both the DOL and the SEC could have on ESG growth.

Craig Metrick, a proponent of ESG and chief investment officer for Cornerstone Capital Group, argues that regulators at the DOL are “getting it fundamentally wrong” in their proposed rules. 

“They seem to be making the assumption that environmental, social and governance factors are not material and do not have anything to do with risk-adjusted performance of investments,” he said. “We think it should be the opposite; fiduciary duty should require some level of ESG integration in order to manage the long-term risks of the market.”

The DOL’s proposed regulation would limit fiduciaries from offering ESG investment vehicles that would heighten fees or increase risks in return for nonfinancial goals. According to Bryan McGannon, a policy director with US SIF, the rule would increase the Labor Department’s enforcement capabilities when it comes to ESG advice.

Additionally, McGannon revealed that the DOL has been sending document requests to firms who provide ESG products in ERISA-governed plans to be completed within weeks.

And the DOL isn’t the only regulatory agency considering increased scrutiny; at the SEC, proposed rules on proxy advisor practices and shareholder rights could impact advisors’ and shareholders’ ability to push companies on ESG concerns. The commission also released a request for comment on how certain funds are named, specifically questioning whether some ESG funds mislead consumers. 

Coupled with comments from SEC Chairman Jay Clayton cautioning investors about ESG and concerns on the part of Commissioner Hester Peirce, it would seem regulatory agencies were cracking down on ESG investing. McGannon speculated that it stemmed from ESG critics unsuccessfully lobbying for legislative action in 2017 and 2018, who were now hoping for more success from regulation. 

Like Metrick, McGannon believed the DOL failed to understand the financial services industry’s increased integration of ESG factors into their risk management assessments.

“The regulators have this very 2008 version of the world, where there’s no data and very little understanding of ESG,” he said. “We’ve moved a long way, and there’s a lot of compelling data indicating that ESG is material and contributes to performance.”

ESG investing continues to grow at an accelerated pace despite the impact of COVID-19 on the global economy; U.S. listed sustainable funds had record inflows during the first quarter of this year, according to Morningstar.

Khloe Karova, the founder of Chicago-based firm Modern Capital Concepts, said that the increased regulatory scrutiny was indicative of a larger debate spurred by ESG’s growth that was not going away. She hoped this scrutiny would help separate legitimate ESG proponents from advisors solely looking to capitalize on a marketing trend.

"There's a lot of advisors who really don't know how to adequately describe the benefits of ESG, whether they're using ESG as a means of generating alpha, and if it makes sense in the context of an advisor’s fiduciary duty,” she said. “I think that on balance it's good that the SEC is continuing the debate, because advisors do need to spend more time thinking deeply on whether ESG makes sense for their clients."

Brett Wayman, the vice president of impact investing at Envestnet PMC, questioned the DOL’s role in regulating ESG investing, arguing that due diligence experts are better suited to determine whether an asset manager is properly utilizing ESG data. He also wondered whether the DOL’s rule would increase interest in ESG, as opposed to inhibiting it, especially since the response during the rule’s comment period was immense and one-sided; one report indicated that 95% of the 8,700 public comments and 92% of the 229 comments from investment professionals were opposed to the rule.

“At this point a lot of advisors have heard about ESG but don’t know about it, but the DOL has put that argument center stage,” he said. “As a result, ESG is going to have more credibility in the eyes of asset managers and owners. I think it’s pushed the discussion, and it’s now proving this is a credible, material approach to investing.”

As the market for ESG grows, it’s not surprising that regulations are struggling to keep pace, according to William Burckart, the president and chief operating officer of the Investment Integration Project, which helps investors navigate ESG issues and concerns. But he also found that there was a deeper cultural contrast with some investors about ESG that could be leading to a similar split among regulators.

“We think a lot of conventional investors are skeptical; they dismiss (ESG) as being concerned by political issues and subject to conflicts. They do not consider these factors relevant to material evaluation,” he said. “In the U.S., that’s where you start to see the divergence in how seriously regulators take the issue.”

In an increasingly politicized time, and with a fractious presidential election set for the fall, ESG proponents are aware of the risk that ESG investing would become part of a larger partisan back-and-forth. But Cornerstone Capital’s Metrick still struggles with how to best navigate that pitfall.

“I’ve been in the ESG space for 20 years, and I’ve personally done a lot of work to come up with the evidence to refute the argument that it should be political and that it’s just good investing. Unfortunately, I don’t see that evidence often changes minds that are set,” he said. “If a person is really stuck in the mindset that any restriction in the investment universe is going to lead to an inferior investment...it’s really hard to change their minds, no matter what.”

McGannon felt that one of the biggest indications that ESG investing should not be framed in a partisan way is that many major financial services companies came out in opposition to the DOL’s proposed rule during its public comment period. While he worried that the rule could have a slightly chilling effect on retirement plan fiduciaries’ willingness to consider ESG placements in plans, he believed the moment of ESG investing would be impossible to forestall entirely.

“The market is steaming ahead, and I just don’t think you can put the genie back in the bottle,” McGannon said. “The financial services industry understands that ESG criteria is important to consider alongside traditional financial factors. I don’t think we’re going back from that.”

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