The facts behind the latest culture war and ‘social justice investing’

If the level of rancor in Congress could be a measure of importance, one might assume that recent efforts to overturn the Department of Labor’s rules on Environmental, Social and Governance (ESG) investing by retirement plans will have generational reverberations.

As Senate Majority Leader Chuck Schumer (D-N.Y.) recently claimed, these attacks on ESG come from “hard-right MAGA Republicans” bent on preventing business “from adapting to the future” in the name of “ideological obsessions.” Rep. Andy Barr (R-Ky.), on the other hand, says that the same ESG rules undercut “the core purpose of financial institutions” and jeopardize “the economic security of investors.” Barr’s fellow Republicans in Congress, joined by a handful of Democrats, have now passed a resolution striking down the new retirement plan rules and President Joe Biden, for his part, has promised to veto it.

What seems to be another simmering culture war, however, will have far less impact than one might think. Implemented properly, ESG standards can be a tool for managers and investors that governments respectful of free enterprise should allow but not require.

Let’s start with the facts: both the Biden administration’s “pro-ESG” rules and the Trump administrations’ “anti-ESG” rules allow the use of ESG metrics. Under both rules, retirement plan managers can look at things like workforce diversity and environmental performance if they improve risk-adjusted returns but not solely to achieve broad social goals. Under both rules, a fund manager could invest in an insurer because it seeks to improve returns by modeling the impacts of climate change on its book of business. The same manager, however, could not legally prefer one retailer over another solely because it had done more to reduce its own carbon footprint. In short, both sets of regulations allow value-based ESG intended to improve returns by paying attention to a broader universe of factors in searching for returns but forbid values-based investing that makes these factors the sole reasons to invest.

So, then what is the controversy over? In part, the ESG movement scares people on the right because it tends to use language and ideas taken from the progressive left. Conservatives may not feel comfortable when they read about the major financial firm RBC’s white paper on “social justice investing” when it talks about “systemic racism, inequality in access to healthcare and justice and education, and extreme wealth imbalances.” Likewise, participants in a Harvard law forum speaking about their desire to overturn the “doctrine of shareholder primacy” and thereby transition to a system of “stakeholder capitalism,” probably do not warm the hearts of die-hard laissez-faire capitalists.

That said, so long as they obey the law and follow basic standards of decency, even the most doctrinaire free-market adherents will agree that executives and investors should have broad latitude in making business decisions. And markets are encouraging firms to integrate ESG practices and provide products that speak to the issues the ESG movement raises. Many investors are showing their preference for “sustainable” funds: ESG-focused funds total holdings now measure in the trillions.

Furthermore, broad social and environmental factors obviously can have enormous impacts on company performance. For example, a company that works hard to discover talent in previously underrepresented demographic groups might reap huge benefits from its superior workforce, while one that pays careful attention to its overall environmental impact may improve its capital access while avoiding negative publicity from an environmental disaster.

The problems that should concern everyone really arise when governments attempt to force compliance with centrally-planned ESG standards. The Biden administration’s own efforts to impose massive new “climate risk disclosures” could cost an enormous amount to implement and asks most firms to measure a variety of factors that may have little relation to their bottom lines. The state of Maine’s mandate to divest from fossil fuels seems likely to hurt its investment returns, while a Texas law intended to forbid fossil fuel divestment efforts may end up costing more than $500 million according to professors at the University of Pennsylvania. Laws like these—which figures on the left and right have proposed in roughly equal numbers—are best understood as restrictions on free choice for investors, corporate managers and markets.

While there may be legitimate reasons for concern about the Biden administration’s new pension rules—they may give too much leeway to retirement fund managers with ideological agendas—they are hardly a drastic change in policy. And they are part of a movement that, when its tools are used voluntarily and with shareholder value in mind, can improve investment returns while helping the private market confront major challenges.