Greater ESG scrutiny prompts caution

ESG continues to be top of mind for asset owners, but investment consultants say recent high-profile political skirmishes have many asset owners seeking more data to evaluate risks vs. potential rewards.

A growing number of states are putting environmental, social and governance investment practices under the microscope, with some states putting limits on how state pension plans can invest in ESG funds.

For example, the $8.2 billion Missouri State Employees' Retirement System in October pulled $500 million from funds managed by BlackRock Inc. over its approach to ESG investing. The concern, the retirement system said, was over BlackRock's public statements and record of prioritizing ESG initiatives over shareholder return.

But other state pension funds continue to move toward greater ESG information gathering and integration.

According to meeting minutes from Nov. 14, the $124.7 billion Minnesota State Board of Investment in fiscal year 2022 had its consultants and data providers conduct "portfolio-wide surveys to gather ESG information from managers with a particular focus on climate change risk management and diversity." The goal of these surveys, the board said, was to "establish a baseline so that the SBI can better monitor changes to its long-term risk exposures."

If it seems like the response to ESG is all over the board, it's because it is. Viewpoints about the utility of ESG strategies in investment portfolios fall across a wide continuum for both regulators and allocators, investment consultants said. BlackRock has emerged as something of an example of this continuum. Even as conservative states divest, New York City Comptroller Brad Lander, fiduciary for the $242.4 billion New York City Retirement Systems, recently wrote to BlackRock CEO Larry Fink pushing him to do more on ESG issues and said pension dollars could be at stake.

As a result, consultants that are tasked with tracking ESG investment strategies, frameworks and investment rules are facing heightened demands from investors for ESG education and information. They are also conducting their own surveys to track allocator sentiment and interest in ESG.

"ESG has become much more political," said Greg DeForrest, San Francisco-based senior vice president and manager of Callan's West Coast consulting team. "The politics are masking investment metrics and merits behind considering ESG factors when you look at investing in any category of investments or securities specifically."

Over the summer, Callan, which advised on $4.18 trillion in total U.S. institutional, tax-exempt assets as of June 30, according to Pensions & Investments data, conducted an ESG survey of 109 institutional investors including public and corporate retirement plans as well as foundations and endowments.

The survey pool was a mix of Callan clients and non-clients and their responses highlight the broad variance in how investors are thinking about ESG.

In a November webinar on the survey results, Thomas H. Shingler, a senior vice president and Callan's ESG practice leader, pointed to a decline in the number of institutional investors considering ESG.

Some 35% of respondents said they were considering ESG factors in their investment decisions, down from 49% in 2021. That decline likely reflects the additional scrutiny ESG strategies are under from regulators as well as pushback against the use of such strategies in pension fund portfolios, industry sources said.

The reasons given by respondents underline a growing divide among investors. For pension funds and other investors that do use ESG in investment decisions already, half of the respondents said they thought it aligned with fiduciary responsibility. For those that do not incorporate ESG, 47% said they thought that the benefits of ESG were unproven and unclear.

Matt Scott, Bristol, England-based senior strategic research consultant at Mercer Investments LLC, which advised on $4.94 trillion in total U.S. institutional, tax-exempt assets as of June 30, said that even if the rhetoric is making investors more cautious, they should be wary of focusing on it to the exclusion of effectively analyzing potential investments.

"People try to bring an element of the culture war to this discussion and many of them want to get caught up on terminology," he said. "But ESG factors have long been considered in some form because there is an investment opportunity and a business improvement opportunity. Solving the world's problems can be pretty profitable, but you have to strike the right balance."

Mercer recently published an investment outlook looking at how ESG might influence investment opportunities. Mr. Scott has been speaking with investors about issues like the global energy transition and highlighting where investment is still needed. He noted that there are areas of underinvestment like metals and mining companies that supply the components needed to run renewable energies such as solar and wind. "What we're talking about here is investing in technology improvements," he explained. "Metals and mining companies can help us capture and store these types of energy. That's important in an energy transition which is already happening. That's just a fact. It doesn't have to be some type of moral crusade."

Looking beyond the headline rhetoric, some of the decline in investment interest may be a result of allocators taking a wait-and-educate approach, consultants said.

Over recent administrations, views of ESG have varied widely with the Department of Labor under President Joe Biden pushing back on the Trump administration's approach to ESG before governors got in the mix.

Just this month, the DOL finalized a rule to explicitly permit retirement plan fiduciaries to consider climate change and other ESG factors when selecting investments and exercising shareholder rights. The rule was first proposed in October 2021 and is a reversal of two rules promulgated under the Trump administration.

Prior to the final rule's release Nov. 22, Mr. DeForrest said ERISA fiduciaries were eagerly awaiting the DOL's guidance on ESG and had been in a bit of a holding pattern until that guidance was available.

In the meantime, institutional investors have been continuing to educate themselves on the range of ESG strategies, ratings and frameworks that were available.

Steve Voss, Chicago-based senior partner and director of investments, North America at Aon PLC, said they are having more conversations with allocators about defining and refining ESG investment beliefs and approaches. The consultant advises on $3.25 trillion in U.S. institutional assets, according to the P&I survey.

"ESG is a complex issue regardless of whether you're running a defined benefit plan, defined contribution plan or are a not-for-profit foundation or endowment," Mr. Voss said. "ESG means a lot of different things. We spend time helping our clients understand the landscape as it relates to their particular interests."

In October, Aon brought on Daniel Ingram as a partner and head of responsible investing to continue to advance Aon's ESG offerings. Mr. Voss said that Mr. Ingram will be helping with improvements to the firm's dual-pronged ESG approach. Aon already considers ESG as part of its investment manager research efforts, looking at how ESG impacts investment strategy for a given manager. The other prong involves looking at how ESG is incorporated or can be incorporated into investor portfolios.

Ahead of the final rule's release, Mr. Voss said the firm would be discussing the new guidance with its clients and would be "using those updates to inform how ESG might be incorporated in ERISA portfolios."

He also predicted that the DOL's guidance was unlikely to mean a significant shift in allocation strategies right out of the gate.

"We think it's going to be a months and years, not a weeks and months approach to ESG investing across all investor types," Mr. Voss said. "The specific guidance while important isn't the only consideration, fiduciaries have to consider what is best for plan participants overall and as a result those plans tend to take a very measured approach to making changes."

Mr. Voss added that the months-and-years approach is likely also true for large state plans. "Public funds, just like ERISA funds, have to take into consideration the best interest of their participants absent what legislative action does or doesn't ultimately do. So we are seeing a lot of states take a wait-and-see approach," he said.

Brian Croce contributed to this story.