Editor’s Note: Witold Henisz is the vice dean and faculty director of the ESG Initiative at the Wharton School and the Deloitte & Touche Professor of Management. The ESG Initiative has more than two dozen partners supporting its research. Professor Henisz is also an adviser to asset manager Engine No 1, for whom he co-developed the Total Value Framework. He also recently joined the Sustainable & Impact Investing Advisory Council for Glenmede, an asset manager. The views expressed here are his own. Read more opinion on CNN.
President Biden just issued the first veto of his presidency over Republican legislation that aims to limit retirement fund managers from incorporating environmental, social and governance factors into their financial analysis.
While ESG investing is criticized by Republicans as “woke” capitalism that is ideologically motivated and harmful to pensioners, it’s actually something both parties and all investors should support.
Biden’s veto supports free markets in the hard work of analyzing the long-term determinants of financial performance, including both traditional financial information like sales growth, cost margins and productivity, as well as information related to environmental factors like carbon emissions, social factors like labor practices and governance factors like transparency in reporting.
The term ESG was first introduced in 2004 to distinguish a group of investors who considered ESG issues not based on their values, ethics or a desire to be socially responsible, but rather because they believed these factors impacted financial performance, particularly in the long term. Put simply, ESG investing just means considering environmental, social and governance factors alongside more traditional financial data in assessments of long-term financial performance.
The logic here is straightforward and anything but political. The value of some assets depends, for instance, on the degree of global warming or our success in transitioning to clean energy. Consider the value of a deep-water oil field or coal mine in which investment today is only profitable if demand for fossil fuels in 2050 is supported by a large fleet of fossil fuel vehicles and coal-burning power plants.
If zero-emission vehicles dominate global markets in 2050 and solar and wind power continue to decline in costs at current rates, any investments in that oil field or coal mine today will not earn a positive return.
Alternately, consider a lithium processing facility or a new battery plant that will only earn a return if battery-powered vehicles make up the majority of the North American fleet in 2050. If fossil fuel vehicles instead remain dominant, investments in that processing facility or battery plant will not pay.
In each of these cases, environmental factors and their evolution over time alter the expected value of an investment. Whether you voted Republican or Democrat in the last election, you should prefer that the person, organization or algorithm investing your pension takes these factors into account rather than being prohibited from doing so by Republican-sponsored legislation.
Similar arguments can be made for incorporating the likely cost of air or water pollution regulation, human rights lawsuits, minimum wage legislation and anti-money laundering restrictions into forecasts of companies’ earnings and relative performance. In each case, future revenues, costs and productivity are impacted by environmental, social or governance factors.
ESG investing is not about values, nor is it woke or ideological. It’s about being fiduciarily responsible. It is simply good economics and good finance. Pension managers should be able to take all financially material information into account. Climate risk is, in some cases and under some assumptions, investment risk.
Forbidding pension fund managers from incorporating it into their analysis would be akin to forbidding them from considering the impact of artificial intelligence, the Russian invasion of Ukraine or the growing US-China geopolitical rivalry. Each of these factors could be financially material, and asset managers competing in the free market should be able to analyze them, free of government regulation determining what they can and cannot consider to be material.
It’s true that asset managers’ analyses of ESG issues remain imperfect and the returns on ESG funds, so far, have tended to underperform the market. That’s because the data to assess firms’ ESG impacts is only voluntarily disclosed in the US, and the science and financial models linking that data to financial impacts are still evolving. There is a lot of confusion between ESG investing and counterparts such as socially responsible investing or impact investing, which may pursue other objectives than financial performance. There is also a lot of greenwash or virtue claiming by asset managers seeking to convince the public they offer ESG funds when, in reality, these are more marketing efforts than genuine ESG offerings.
As the focus of ESG data improves over time, the hope is that returns on actual ESG strategies should at least match the market on a risk-adjusted basis net of fees. This is the game that fund managers following all strategies seek to play, and while broad-based index funds show the best performance over the long term, enormous efforts are deployed to find means to beat the market.
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Prohibiting investment managers from following ESG strategies when more and more of them are convinced by the underlying logic, following the demand of asset owners and making progress on the data and analytics would be counter-productive. It would preclude investors from having access to some of the biggest and best asset managers. Wharton finance professors have found that ignoring this progress and adhering to Republican legislative proposals to invest only with asset managers not making these efforts would cost taxpayers millions, while separate reports found it would cost investors and pensioners in Indiana and Kansas billions. The process of defining what would be and would not be banned would be a recipe for political chicanery, lobbying and other influence strategies that would further depress returns.
Biden’s veto supports free market efforts to price ESG risks and opportunities. Such efforts benefit pensioners who want their investments to take into account all material factors in their financial analyses — not just those that the Republican party and its billionaire donors support. Pensioners, current and future, both red and blue, should support the hard ongoing work of ESG integration into financial analyses.