What is ESG?
ESG stands for Environmental, Social, and Governance. ESG investing is a type of investing that focuses on companies and corporations making efforts to address environmental, social, and governance issues and causes. This can include policies and standards, initiatives and projects, disclosures and research, and more.
ESG factors can be anything within these areas. Here are some examples.
Environmental factors include energy consumption, waste, and greenhouse gas emissions.
Social factors include employee compensation, community involvement, and safety and quality standards.
Governance factors include corporate leadership, C-suite pay structures, and business ethics.
Choosing ESG investments involves the use of quantifiable metrics and often strict criteria. These metrics evaluate a company's performance from the perspective of sustainability. You can research companies yourself to learn about their behavior, use ESG scoring platforms to compare investments, or both.
But just because a company has a high ESG rating doesn’t necessarily mean it’s more sustainable than another. Different platforms score businesses differently, and it's easy for companies to make claims about their standards that don't show the full picture. ESG investing comes with due diligence.
Retirement fund managers are legally obligated to consider the economical risks and rewards of each opportunity. The whole debate we’re about to get into is about whether or not ESG considerations are relevant.
If you’re curious about ethical investing, click the link below.
More: Demystifying ethical investing (ESG vs. SRI vs. impact investing)
What led to the veto
There’s quite a bit of history leading up to this veto, and it’s important to understand where it all started and how we ended up here.
It all started with the Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights Rule. Let’s call it the Prudence and Loyalty rule.
Basically, this rule, created by the Department of Defense in 2022, puts language in place to permit fiduciaries to use ESG factors to help choose investments.
In years past, fiduciaries were already using ESG-related information to make decisions about which investments would promise the best returns and lowest risk to their plan holders. But under the Trump administration, this became much more difficult.
In 2020, the U.S. Department of Labor placed barriers on ESG investing by issuing a rule requiring pension and 401(k) fund managers to put pecuniary factors (those strictly related to money) ahead of non-pecuniary factors. ESG considerations were not to be included unless they were materially economic in nature.
And if fiduciaries were to make a choice between otherwise economically-equivalent investments that ultimately came down to a difference of non-pecuniary considerations (such as ESG), they would have to jump through extra hoops by extensively documenting these decisions.
The Biden administration issued the Prudence and Loyalty rule to reverse this plan. The final version of the new rule was released in November 2022, and it restored the ability of fiduciaries to make ESG considerations as needed to choose the best investments for their plan holders.
On February 7, 2023, the Republican-led House Education and the Workforce committee proposed a bill (H. J. Res. 30) that would overturn the Prudence and Loyalty rule. This anti-ESG bill passed the House and then the Senate by a narrow margin.
But then it reached the president’s desk.
President Biden stopped the bill in its tracks. Without his approval, the rule could not be reversed. The House attempted to override his veto but only achieved a 219-200 majority when they needed a two-thirds majority to trump it.
“There is extensive evidence showing that environmental, social, and governance factors can have a material impact on markets, industries, and businesses. […] Retirement plan fiduciaries should be able to consider any factor that maximizes financial returns for retirees across the country. That is not controversial — that is common sense.”
This controversy is not new
What’s this controversy Biden’s talking about?
Republicans and Democrats have been debating the merits of ESG investing for years now. It’s a deeply partisan hot topic with at least two clear sides.
On one side, you have those who believe that allowing fiduciaries to use ESG factors is a political landmine. They feel that ESG investing pushes a liberal agenda and could allow fiduciaries to put political causes and social values over returns and performance. This side is in favor of overturning the Prudence and Loyalty rule.
On the other side, you have people who believe that allowing fiduciaries to use ESG factors is safer than not. They feel that, long-term, ESG investing is more likely to yield better returns for investors because it can account for outside risk factors, e.g. climate change and global warming, that could affect the market. This side is in favor of the Prudence and Loyalty rule.
You can see why it’s been so difficult for the government to put policies in place on the subject.
With his veto, Biden is siding with the pro-ESG camp.
Reading between the lines
In the letter accompanying his veto, President Biden stated the following:
“[The rule] allows retirement plan fiduciaries to make fully informed investment decisions by considering all relevant factors that might impact a prospective investment, while ensuring that investment decisions made by retirement plan fiduciaries maximize financial returns for retirees.
[…] This resolution would prevent retirement plan fiduciaries from taking into account factors, such as the physical risks of climate change and poor corporate governance, that could affect investment returns.”
The president is showing support for ESG investing, but his reasoning isn’t about values. He believes that not considering ESG factors would be risky to investors because these factors are likely to impact businesses.
Basically, ESG is about “outside factors” that matter to the economy. Climate change, environmental threats, social events and movements, and governance developments have a broader effect on the world. This, then, should be reflected in investment portfolios. If it weren’t, these portfolios would be influenced by changes but not protected against or prepared for them.
Imagine a person knows it might rain and they decide to go on a walk. They can either pack an umbrella or take their chances, but they risk getting soaked. Pro-ESG investors take an umbrella.
This veto is good news for supporters of ESG, but right now it’s impossible to say what it could mean for investing as a whole.
We’re not sure what to expect from the Biden administration moving forward. But for now, this veto is important to be aware of. The debate will continue as lawmakers from both sides continue to address the topic.