As interest in the integration of environmental, social and governance (ESG) factors into investment processes has grown, fiduciaries have been caught between competing viewpoints. One side posits that, strictly defined, fiduciary duty entails “a legal duty to act solely in another party's interests,”1 which has traditionally meant a sole focus on maximizing financial returns for that party. Hence, a focus on any factors besides the bottom line—such as ESG—could be seen as a violation of that responsibility unless that focus was deemed to potentially increase returns. Advocates of ESG-based investing make precisely that point—ESG risk factors could potentially be material to the bottom line, and positive ESG scores may contribute to long-term sustainable value. Accordingly, ESG risk factors could be considered an appropriate input by a prudent plan fiduciary.
In a recent development, the US Labor Department issued guidance on October 22, 2015 for retirement plans covered by the Employee Retirement Income Security Act of1974 (ERISA). The guidance states that, although collateral goals of ESG investing may be considered only as “tie-breakers,” when choosing between otherwise equal investment alternatives, “environmental, social, and governance issues may have a direct relationship to the economic value of the plan’s investment. In these instances, such issues are not merely collateral considerations or tie-breakers, but rather are proper components of the fiduciary’s primary analysis of the economic merits of competing investment choices,” thus providing fiduciaries with comfort in incorporating ESG considerations in their investment decisions.2
We believe a central concern that impedes action around ESG is a focus solely on it as an outcome, rather than as part of a good investment process.
As the United Nations noted in a recent study of fiduciary duty, “when evaluating whether or not an institution has delivered on its fiduciary duties, courts will distinguish between the decision-making process and the resulting decision3.” In other words, the most important fiduciary element to consider is the investment process, not the outcome. For fiduciaries to meet their obligations, it is essential that the consideration of ESG does not diminish the rigor applied under “traditional” investment diligence, but instead supplements it. To that end, when integrating ESG into the investment process, fiduciaries must measure and manage for risks that are introduced to the portfolio to ensure that ESG is accretive or, at the very least, costless. To be sure, some investment strategies that focus on ESG factors will not pass this stringent muster, but others could.
While some investors may be skeptical that ESG factors will not detract from performance, many people would agree that neglecting to address certain aspects of ESG could introduce substantial investment risks. Some organizations, such as the United Nations Environment Programme, have even gone as far as to assert, “it may be a breach of fiduciary duties to fail to take account of ESG considerations that are relevant and to give them appropriate weight.” Events like oil spills, water contamination and improper waste disposal, which can be mitigated through environmental controls, not only carry substantial headline risk, but also can be a major detriment to the bottom-line.
In this light, it may not be most productive to ask whether all ESG criteria lead to outperformance, but rather to focus on what ESG factors in the hands of specific investment managers have the potential to have a material positive impact on investment returns.
As with most aspects of investing, these situations do not lend themselves to all-or-nothing answers.