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ESG AND SUSTAINABILITY FROM THE INVESTOR'S PERSPECTIVE
HOW INVESTORS APPROACH AND IMPLEMENT ESG AND SUSTAINABILITY GOALS
In this handbook, the term "institutional investor" covers a number of different entities that invest funds, typically in order to support a particular purpose. Institutional investors include pension funds (U.S. public pension funds, ERISA plans, and foreign pension funds) and sovereign wealth funds, as well as nonprofit organizations such as universities, private foundations, and public charities. The term also includes large family offices. Institutional investors can be divided into two major groups: those that have fiduciary duties because they are, in effect, investing funds for the benefit of other persons, and those that do not have fiduciary duties.
Institutional investors that are fiduciaries have various approaches to dealing with ESG and sustainability issues. However, they are consistent in viewing ESG and sustainability analysis through the lens of their fiduciary duties to their beneficiaries or the purposes of their institutions.
Some institutional investors view investing according to ESG or sustainability principles as a version of impact investing or socially responsible investing, which they find difficult to justify from a fiduciary standpoint. To the extent that the purpose of these investing methodologies is to achieve societal benefits, that purpose may be inconsistent with the institution's obligation to provide the benefits for which it was formed. In the extreme case, investment returns may be sacrificed for the societal objective. Even if an impact or socially responsible investment does not detract from returns, an investor that actively seeks such investments may be seen as improperly devoting resources in order to do so. Fundamentally, some investors may believe that ESG and sustainable investing involves a purpose other than the purpose for which the institution exists. Put another way, these investors would see themselves under a duty to invest purely for returns.
Other institutional investors see ESG and sustainability factors as key aspects of their investment decisions because these factors provide insight into the economic viability of their investments, especially over the long term. These institutions use ESG and sustainability factors to identify qualities that will enable the investments to increase in value, as well as qualities that may cause deterioration in value. For example, ESG and sustainability analysis has contributed in many cases to divestment from coal and hydrocarbon production, related infrastructure, and marketing companies, while spurring increased exposure to alternative energy investments. ESG and sustainability factors are also often taken into account in infrastructure investments, given the significant environmental and social impacts of these investments and their long-term nature, the success of which requires good governance. Further, ESG and sustainability considerations are seen as important in efforts to avoid acquiring and holding assets that may become stranded assets, especially those that lose significant value as the result of regulatory or environmental changes. In short, these investors may consider ESG and sustainability analysis not to be merely consistent with their fiduciary duties, but in fact to be required by their fiduciary duties.
Institutions that are not fiduciaries are generally understood to have more leeway to consider ESG and sustainability factors in reaching their investment decisions. Some may implement their ESG and sustainability policies in a similar manner of focusing on the potential effects of ESG and sustainability factors on financial returns. However, family offices may have more of a tendency to engage in impact or socially responsible investing, guided by the family's values. And of course, there are funds created especially to effect such investing—in this case, these funds have a fiduciary duty to invest with the required impacts in mind.
Institutions with ESG and sustainability policies, including fiduciaries and non-fiduciaries, may implement these policies both by eliminating certain sectors from their portfolio (e.g., private prisons, firearms, or alcohol) and by proactively investing in certain sectors (e.g., minority-owned businesses). Some fiduciaries will apply ESG and sustainability considerations in ways that they believe will indirectly advance the interests of their beneficiaries (e.g., construction unions favoring investment in real estate, and public pension funds avoiding investments in businesses that privatize public sector jobs).
Institutions that incorporate ESG and sustainability factors into their investment decision-making process do so in a number of different ways. In some cases, institutions have an ESG or sustainability team that reviews all or a specified portion of the institution's investments through an ESG and sustainability lens. This approach may have the benefit of a consistent treatment of these factors across investments. In other cases, ESG and sustainability analysis is an integral part of each investment officer's evaluation of opportunities. Many institutions choose to focus on certain enumerated ESG or sustainability factors in order to keep the evaluation and monitoring manageable. In particular, this approach may guide the institution's shareholder engagement and proxy voting policies for their public investments.
In sum, many institutional investors are still feeling their way as they develop their strategy for dealing with whether and how to incorporate ESG and sustainability issues into their investing decisions. There is a broad spectrum of approaches in this area—from hesitating to consider ESG and sustainability issues at all, to identifying specific factors to pursue or avoid, to embracing the concepts as fundamental to their investment program, to seeking out investments with positive ESG and sustainability impacts.
UNIQUE CONSIDERATIONS OF ERISA INVESTORS AND PLAN FUNDS
U.S. retirement plan sponsors and other fiduciaries of private sector retirement assets that would like to consider ESG and sustainability factors when making investment decisions must consider ERISA, the U.S. federal pension statute. ERISA imposes strict investment duties on fiduciaries responsible for investing private sector pension plan assets, including fiduciaries with responsibility for selecting and monitoring investment options for 401(k) and other individual account retirement plans. The following are among the fiduciary duties imposed by ERISA (collectively, ERISA principles):
- A requirement that ERISA fiduciaries act solely in the interest of the plan's participants and beneficiaries, and for the exclusive purpose of providing benefits to the participants and beneficiaries and defraying reasonable expenses of administering the plan;
- A duty of loyalty, which requires ERISA fiduciaries to act with a single-minded focus in the interest of plan participants and beneficiaries; and
- A duty of prudence, which has been interpreted to prevent an ERISA fiduciary from choosing an investment that is financially less beneficial than an available alternative.
These fiduciary standards are the same regardless of the investment category, and as a result, present challenges for plan sponsors and investment managers that seek to consider ESG and sustainability factors when investing ERISA assets or offering investment options for 401(k) plan participants. Over the years, the DOL has been asked to consider the application of ERISA's fiduciary rules to ESG and sustainable investing. DOL guidance has not been entirely consistent, and seems to vary based on whether there is a Democratic or Republican administration at the time it is issued. However, a consistent theme runs through the DOL's guidance: when making investment decisions, ERISA fiduciaries must focus solely on the plan's financial risks and returns.
On 30 October 2020, the DOL released its final rule "Financial Factors in Selecting Plan Investments" (the Final Rule). Although the proposed rule aimed to regulate ESG and sustainability investing by employee benefit plans subject to ERISA, in the Final Rule, the DOL rejected the ESG nomenclature as too unclear, removed all ESG terminology, and focused instead on whether a factor is "pecuniary." Broadly speaking, ERISA fiduciaries are not permitted to sacrifice investment return or take on additional investment risk to promote non-pecuniary benefits or any other non-pecuniary goals, and may not subordinate the interests of the participants and beneficiaries in their retirement income or financial benefits under the plan to other objectives. Instead, a fiduciary's evaluation of an investment or investment course of action must be based only on pecuniary factors.
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