ESG: Growing Government Action Requires a Thoughtful Approach

Environmental, social and governance — or ESG — has become increasingly popular as more investors and customers seek to align their investments with their values, and agnostic investors seek to capitalize on the trend. But, ESG is facing increasing scrutiny from legislators and state attorneys general (AGs), as ESG’s opponents attempt to stem its growth. This growing backlash has the potential to significantly impact investors, investment advisers, investment companies, and companies touting their ESG bona fides in hopes of securing ESG-oriented investment and consumers. Going forward, companies need to be thoughtful and strategic as they explore new opportunities involving ESG. This update provides a high-level summary of significant recent developments in the space and offers a few guiderails to utilize when addressing ESG. 

The Conflicting Views of ESG

Proponents of ESG offer a variety of arguments in its support. One of the most common is that companies with strong ESG practices are better equipped to mitigate or adapt to Environmental, Social, or Governance risk factors. This is because ESG factors, such as good governance and responsible environmental policies, help to protect against regulatory penalties, reputational damage and other risks that could negatively impact a company’s financial performance. As a corollary, proponents argue that companies with strong ESG practices are better positioned for long-term success. This, they contend, is because companies that prioritize ESG factors are more likely to be responsive to societal and environmental transitional or present changes, and are therefore better equipped to adapt and thrive in a rapidly changing business environment. 

Additionally, proponents maintain that investing in companies with strong ESG practices can help to drive positive change in society and the environment. They note that by investing in companies that prioritize ESG factors, investors can encourage these companies to continue their responsible practices and help to create a more sustainable and equitable world.

Opponents of ESG criticize it as an improper insertion of politics into investing and business more broadly. This movement is driven by concerns over the role of government in dictating corporate social responsibility. These opponents fear that ESG regulations could be used to advance political agendas through private companies and that companies may drive social policy that is more properly the government’s responsibility. They argue that ESG investment criteria can lead to increased costs and decreased returns for pension funds, as well as decreased competitiveness for companies in ESG-regulated industries. Further, they contend that ESG policies by private companies may adversely affect industries that are financially or culturally significant to certain states — such as the fossil fuel or firearms industries. Additionally, opponents argue that fiduciaries utilizing ESG criteria are at risk of violating their duty to maximize returns. Other ESG critics note the risk of so-called “greenwashing” and the lack of accountability with respect to ESG reporting. For those in this camp, some believe more regulation and enforcement is needed. Whatever the rationale, at all levels of government, critics of ESG have begun pushing back. 

Federal Action 

At the federal level, the most notable recent activity is Congress’s vote to overturn a Department of Labor (DOL) rule finalized in November 2022. That rule allows, but does not require, ERISA fiduciaries to consider ESG factors in their risk-return analysis. (It reversed a rule created by the prior administration specifically prohibiting consideration of nonpecuniary factors in making investment decisions.) President Biden, as promised, vetoed the legislation. 

Additionally, the Securities and Exchange Commission (SEC) recently proposed several new rules and amendments to existing rules, which are intended to create a common disclosure framework relating to ESG for both public companies and investment management companies. These rules have not yet been finalized. Our prior updates have summarized and analyzed the proposed rules that concern public companies, that concern investment management companies and that relate to climate change disclosures.

On the enforcement side, the SEC is looking for “greenwashing” or other misstatements in the ESG space. It launched an ESG task force in March 2021 targeted at “material gaps or misstatements in issuers’ disclosure of climate risks under existing rules, and disclosure and compliance issues relating to investment advisers’ and funds’ ESG strategies.” Since its formation, the ESG task force has brought several enforcement actions involving misleading ESG claims against companies including Bank of New York Mellon Corp., Goldman Sachs Asset Management, L.P., robo-adviser Wahed Invest, LLC, and publicly traded Brazilian mining company Vale. S.A.  

State Legislative Action

Twelve states passed or considered anti-ESG legislation in 2022, and at least 16 are expected to, or have done so, this year. (The governors of Utah, Kentucky, Arkansas and West Virginia all signed anti-ESG legislation in the past two months.) Such legislation is varied and nuanced, but typically involves prohibiting state agencies and managers, including pension fund managers, from considering ESG in making investment decisions. Some legislation goes further and prohibits state agencies from contracting with companies viewed as penalizing certain industries, such as the fossil fuel or firearm industries, via their adoption of ESG policies. 

These laws have significant financial impact for both the companies and the states. For example, it is estimated that, collectively, Florida, Louisiana and South Carolina pulled $4 billion in pension and investment funds from Blackrock. On the other side, a recent Wharton Business School analysis estimated that Texas municipalities incurred an additional $300-500 million in interest costs in the eight months following that state’s implementation of a statute barring municipalities from contracting with banks that allegedly restricted funding to oil, gas or firearm companies, which resulted in five of Texas’s largest municipal bond underwriters exiting the market. 

As these laws are considered and go into effect, states will face challenges of conflicting priorities and obligations. For example, in February 2023, a Kentucky pension system informed the state’s treasurer that it could not comply with her directive, pursuant to a recently passed law, to threaten to divest its assets from certain asset managers that the state treasurer identified as boycotting the fossil fuel industry. The pension system explained that doing so would be a breach of its fiduciary obligations. As these types of laws are passed and implemented, litigation to resolve such issues is likely to result. 

State Attorneys General Action

AGs from around the country have been active on both sides of ESG, but the AGs opposing ESG have been most active to date. The most notable AG actions over the past year include:

• In June 2022, 20 AGs submitted a letter in support of the SEC’s proposed climate-change disclosure rules and 12 AGs submitted a letter in opposition. 
• In July 2022, the Missouri AG sent civil investigative demands to Morningstar, Inc., and its Sustainalytics ESG ratings subsidiary, questioning the company’s ESG practices. In August 2022, 17 other AGs joined the Missouri AG’s investigation of Morningstar for potential violations of states’ respective consumer protection and deceptive trade practices laws.
• In August 2022, the Texas AG led a coalition of 19 state AGs in writing Blackrock’s CEO regarding the company’s public statements and commitments relating to ESG and questioning whether those commitments were consistent with the company’s fiduciary duties in managing state pension funds. Notably, the letter questioned the propriety of Blackrock using its proxy voting power to further ESG objectives and offered the example of Blackrock allegedly penalizing board members who voted to invest in coal projects. Additionally, it attacked Blackrock’s membership in coalitions that have committed to taking steps to decarbonize, such as the Glasgow Financial Alliance for Net Zero and Climate Action 100+, on the basis that the commitments required by such organizations are at odds with fiduciary obligations to maximize returns and may violate antitrust laws. 
• In August 2022, seven AGs sent a letter to the SEC in support of its proposed rules for ESG disclosures by investment advisers and funds.
• In August 2022, the Louisiana AG issued “legal guidance” to various state officials asserting that major investment firms had likely violated their fiduciary duties to customers by joining the Climate Action 100+ coalition and allegedly utilizing ESG criteria without providing full disclosure relating to that use. 
• In September 2022, the Indiana AG issued an opinion stating that the Board of Indiana Public Retirement System could not use ESG criteria in making investment decisions or hire an investment manager or adviser that previously joined a climate coalition.
• In September 2022, the Texas AG issued civil investigative demands under the state’s deceptive trade practices and consumer protection law to S&P Global, Inc. regarding its use of ESG standards in credit ratings analyses.
• In October 2022, the Kentucky AG and state treasurer sent a letter to the state’s pension fund directors asking the directors to advise them about the directors’ efforts to ensure ESG considerations were not being used in making investment decisions.
  
• In November 2022, 13 AGs filed a motion to intervene with the Federal Energy Regulatory Commission (FERC) in order to oppose an application by The Vanguard Group, Inc., to acquire voting security in public utilities under the Federal Power Act. The AGs argued that Vanguard’s climate commitments were inconsistent with its representations to FERC that it would not control utilities’ day-to-day activities or take actions that would impact electricity prices.
• In January 2023, 21 state AGs sent a letter to two proxy advisory services suggesting the advisers violated their duties of care and loyalty by making recommendations in support of ESG policies rather than solely on financial bases. The AGs asked that the companies respond to several questions regarding their practices and more broadly on a number of policy questions. 
• In January 2023, the Texas AG led a coalition of 25 states in suing to block the DOL’s final rule allowing ERISA fiduciaries to consider ESG factors in making plan investments and engaging in proxy voting.

Thus far, state AGs generally have not filed litigation against companies regarding their ESG practices. But, ESG opponents are clearly looking for an opportunity to do so. Such suits will likely be based on allegedly false or misleading statements or practices under states’ deceptive trade practices and consumer protection laws, or antitrust statutes. 

On the other side, AGs who support ESG will look for enforcement opportunities to penalize companies that make false or misleading statements regarding their ESG practices — whether to investors or consumers — to secure additional investment dollars or customers. 

Precautionary Measures

Given the increasing focus of AGs around the country on ESG practices, companies must be careful and strategic when discussing ESG. Litigation regarding ESG will almost certainly involve allegations that companies made false or misleading statements. For professional investors that consider ESG in their investment decision-making associated with their client assets, establishing a robust internal control environment that governs the implementation and monitoring of such investments is imperative. Companies seeking to be active in the ESG space should consider preparing a formal ESG policy. That policy should be part of, and align with, a broader overall corporate strategy. Given that there is not a set definition for ESG, the policy should clearly define what companies mean when they say “ESG.” Once a policy and plan are created, that strategy should drive any public statements or marketing materials relating to ESG, so that any ESG-related statements align with companies’ internal definitions and goals. Further, when planning public statements, including marketing materials, companies must consider how the statements they make can be substantiated or measured. Statements should be fact-based and objectively verifiable. 

In sum, ESG represents a significant opportunity for companies. But, given the charged politics associated with it, companies must be cautious and strategic when working in the space, as there is a corresponding potential risk.