Since 2021, Ropes & Gray has been actively tracking the various approaches states have taken on how or whether environmental, social and governance (ESG) factors should be applied to the investment decisions for public retirement systems. States have used legislative, administrative and enforcement mechanisms to address this area, which has been complemented by Congressional Republicans' various attempts to shine a spotlight on ESG in recent months. Judging by the significant uptick in activity this year at both the state and federal levels, the fight over ESG in public investments is far from over and may even be just beginning.
This white paper seeks to provide context for understanding what has happened in the states in 2023 along with considerations that asset managers should be mindful of when engaging with public retirement plans. In the first part of this paper, we provide an overview of current trends in state ESG legislation and regulation along with background for how we got to this point. In the second part, we provide a recap of what has transpired in each state along with an assessment of the state's policymaking regarding ESG and public pension investments.
Part I: Overview of How We Got Here and Current State ESG Trends
Early State ESG Actions
As a result of the ongoing debate over what role ESG considerations should play in investment decision-making, there has been a growing substantive divergence between how public pensions and private sector retirement plans subject to ERISA are regulated. While those who manage the assets of governmental plans are subject to the fiduciary and other legal requirements of applicable state law, most states' standards have historically mirrored the fiduciary responsibilities and requirements under ERISA, often using the same terminology and principles, such as the duties of prudence and loyalty. Moreover, for many years, in the absence of guidance at the state level, investment professionals have construed the rules that govern public plans by applying the same interpretations that the U.S. Department of Labor (DOL) had issued under ERISA.
We now find ourselves in a new world where many state governments have started articulating their own standards of what it means to be a fiduciary overseeing public pension money, especially when it comes to ESG matters. Initially, this effort to flesh out state pension fiduciary duties in terms of ESG considerations came from a few blue states in the late 2010s.
- Connecticut – In January 2015, a bill was introduced in the Connecticut General Assembly (HB 5733) that directed the Treasurer to encourage fossil fuel companies in which state funds were invested to take actions to reduce environmental harm and preserve the sustainability of such companies and to divest (or to decide not to further invest state funds or enter into any future investment in any fossil fuel company) if the Treasurer had determined that such action was necessary and warranted. Additionally, in December 2019, after numerous attempts to engage with civilian firearms manufacturers around reforms that could be made in the wake of the Sandy Hook school massacre, the Connecticut Treasurer at that time announced his decision to divest from these companies as part of a first-of-its-kind comprehensive policy framework known as the "Responsible Gun Policy", which was designed to mitigate the risks associated with gun violence.
- Illinois – Also in 2019, spearheaded by the Illinois Treasurer, the legislature passed the landmark law, "The Sustainable Investing Act" (PA 101-473), which provides that all state and local government entities that hold and manage public funds should integrate materially relevant sustainability factors into their policies, processes and investment decision-making. According to the Treasurer, sustainability factors can have a material impact on business performance and long-term shareholder value, and investors have an interest in integrating these factors into investment decision-making processes.
- Maine – In June 2021, Maine became the first state in the U.S. to enact legislation that requires the board overseeing the state public retirement system to divest the plan's holdings of the 200 largest publicly traded fossil fuel companies in the world, which must be complete by January 1, 2026.
In the last two years, we have seen a shift—the number of actions from the red states addressing ESG in the public pension context has significantly increased. The recent surge can be attributed in part to both blue state activity and the backlash the Biden administration generated from its May 2021 directive to the DOL to identify steps the agency could take to protect the life savings and pensions of U.S. workers and their families from the threats of climate-related financial risk. President Biden's executive order culminated in the 2022 socalled "ESG rule", which revisited fiduciary standards under ERISA regarding investment selection as well as exercises of shareholder rights, and the role that ESG factors can play in those processes. The DOL's 2022 ESG rule clarifies that climate change and other ESG factors may be relevant to the risk and return analysis of a potential investment, and when they are relevant, they may be weighted and factored into investment decisions alongside other relevant factors as deemed appropriate by fiduciaries. The DOL's 2022 ESG rule does not require or suggest that plan fiduciaries must or should consider ESG factors when investing plan assets.
The Red States' Backlash
The core of the DOL's 2022 ESG rule—the neutrality of approach to ESG factors and the need to focus on relevant riskreturn factors and not subordinate the interests of participants and beneficiaries to objectives unrelated to the provision of benefits under the plan—are in line with established DOL principles. However, elected officials in many red states have described this rule as a mandate that ESG factors must be part of a plan fiduciary's investment process. Consequently, politicians in these red states have aggressively pursued through legislation and administrative fiat (i) prohibitions on the ability to consider ESG factors to the extent they are found to be "non-pecuniary" (as described below) as well as (ii) restrictions on the ability to invest with financial institutions that allegedly boycott certain industries such as fossil fuel and firearms.
Anti-ESG Laws Imposing Limits on Investment Considerations and Fiduciary Discretion
With anti-ESG initiatives, lawmakers seek to impose new requirements and conditions on the ability to act as a fiduciary to state pension plans by requiring them to commit to making investment decisions based solely on material financial factors, which are commonly referred to as "pecuniary factors" (as derived from the now-superseded Trump administration's investment duties regulation that was adopted in 2020). The phrase, "pecuniary factors" is a loaded one since it has been broadly understood (dating back to when the terminology first appeared in the Trump administration's notice of proposed rulemaking) to engender extreme skepticism that ESG characteristics can ever qualify as pecuniary or material financial factors. Moreover, in many of the bills that have been introduced over the last year, there is often an express presumption that "pecuniary factors" do not include the consideration of the furtherance of social, political, or ideological interests.
Florida's HB-3, which took effect on July 1, is a leading example of this kind of anti-ESG legislation, but many other states have taken this approach as well, as shown in the table that follows in the next sub-section. To a manager seeking to do business with a state that has either enacted or is considering such restrictions, there is concern that if the manager uses ESG factors in any way in its investment process, it will be prohibited from managing the state's retirement assets, regardless of whether the manager is seeking to promote an ESG goal or other related impact goal or focus. This concern stems from the interpretive uncertainties these laws raise such as (i) what does it mean for something to be a pecuniary factor, (ii) when can a financial factor or characteristic be considered material, and (iii) when does one cross the line from using ESG factors as part of an integration strategy to using them for other purposes (such as a fund that has an impact strategy or social mandate)?
These challenges reflect the fact that anti-ESG laws are highly subjective, and their interpretations can vary among different state officials, which may shift over time in light of the changing political climate in states. For example, despite forceful messaging from state political leaders that managers who consider ESG are practicing "woke capitalism" that goes against the best interests of plan participants and beneficiaries, state pension plan fiduciaries may construe these new requirements narrowly in order to avoid having to remove their investment managers on the basis of ESG. Furthermore, the concern that a manager has crossed the line from using ESG factors as part of an integration strategy to using them for other purposes is exacerbated by the fact that neither the states nor the DOL has defined the different types of ESG investment strategies that exist (in contrast to the three-part framework that was included in the SEC's 2022 proposed rule on enhanced disclosures by certain investment advisers about ESG investment practices as well as the analogous spectrum of funds with ESG features that appears in the EU's Sustainable Finance Disclosure Regulation (SFDR)). Given the lack of precise categories and definitions, it can be difficult for managers to know what exactly these laws were intended to prohibit.
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