Pension funds often consider non-financial metrics when they pick stocks. These metrics include ESG, or environmental, social, and governance factors. For example, a wealth management firm may decide not to purchase stock from a coal company, or an oil company, if the company’s actions damage the environment.
ESG funds may place these factors above absolute returns on investment. For example, a coal company might pay a 5 percent dividend. A competing wind turbine maker or solar panel producer may not pay a dividend at all. And the coal company may trade at a lower price-to-book multiple than the clean power company. But an ESG investor will avoid the apparent bargain and consider factors besides value. It may even argue that the coal company is a value trap. Many countries are phasing out coal power, so paying a low price for the coal company’s stock may not be a bargain in the long run.
Now the Department of Labor (DOL) is proposing a rule change that would make it harder for pension fund managers to consider ESG metrics when they select stocks. The federal agency makes several arguments against ESG use. One argument is that ESG ratings are not standardized, unlike traditional financial metrics like the price-to-book ratio and the dividend yield. The ratings firm may use arbitrary or unclear guidelines to decide that one company is environmentally friendly and another one isn’t. And companies that cause environmental damage may receive high ESG scores anyway.
The agency also argues that monitoring ESG metrics increases costs for the pension fund manager. So the pension fund may charge higher fees to shareholders for providing this service. And fund managers may make unsupported claims about environmentally friendly investing to justify charging higher fees. So the DOL is investigating whether pension funds are misleading investors with ESG claims as well. Just because a fund says it’s an ESG fund doesn’t mean that it is one.
If the regulatory changes are adopted, pension funds regulated by the DOL will have to consider financial returns first. They will still be able to consider ESG factors when they buy stock, but the environmentally friendly stocks they purchase will need to have similar levels of projected returns and risk as their other investments. Federally regulated pension managers will not be allowed to accept higher risk levels or sacrifice pension performance to invest in clean power companies, for example. Their analysts will have to argue that the clean power companies will outperform petroleum stocks in the long run.
Analysts at Harvard Law School drew several conclusions from the regulatory proposal. They say that companies with high ESG ratings have recently outperformed companies with low ESG ratings, so using ESG ratings to pick stocks is a valid approach. Additionally, this rule change could make it costlier for wealth managers to offer ESG funds to investors. And if this rule passes, fund managers will not be allowed to invest employees’ money in an ESG fund by default. Employees will have to tell the fund manager to pick investments that meet these criteria. So employees will have to opt into an ESG fund rather than opting out of one. This extra step makes it less likely that employees will pick ESG stocks.
The Groom Law Group has provided some background for the rule change. In 2019, the president announced an executive order to encourage investment in oil and gas. This order directed the DOL to come up with new regulations, which is why the DOL is considering this rule change in July 2020. Environmental activism in the energy industry is becoming more common, and the government may believe that this is interfering with national energy policy.
The rule change has not been finalized yet. The proposal will remain open for comments until July 30, 2020. So if you want to tell the Employee Benefits Security Administration your opinion on this policy change, you have about three weeks to do so. The EBSA is a subsidiary of the Department of Labor and is the actual agency proposing the rule change.