As investors increasingly focus on environmental, social and governance issues in the corporate sector, one important question remains: What is the true purpose of ESG? Is it to drive returns, or to simultaneously do right by society?
That question is accompanied by concern over fiduciary responsibility. Do investors hold up their legal and ethical relationship of trust by creating the greatest level of profit, or do nonfinancial outcomes matter, too?
The U.S. Labor Department has tried to address those questions in a recent rule.
On Oct. 30, 2020, the Labor Department released a rule that modifies certain provisions of the investment duties regulation, which is applicable to plans included in the Employee Retirement Income Security Act (ERISA).
In the rule, the department affirms that managers hold a fiduciary duty to evaluate investments based on appropriate perspectives consistent with the plan’s objectives. The rule insists that funds in retirement plans select risk and returns on investments over ESG or other nonfinancial outcomes. This is not to say that ESG strategies must be excluded from investing in retirement plans, but it does imply that a strong correlation be substantiated when selecting ESG strategies to drive profits.
The rule includes new documentation requirements in instances when a fiduciary uses nonfinancial factors in choosing investments. The requirements are intended to prevent fiduciaries from making investment decisions based on nonfinancial results without considering how they could affect returns.
Despite this rule, many middle market firms argue that the proposal is overly prescriptive and prioritizes financial outcomes over the behavior itself. After all, many investments with the right ESG objectives drive the returns that would be expected of a fiduciary. Does it have to be one and not the other?
Further, there is overwhelming empirical evidence showing that organizations that implement ESG practices enhance long-term corporate financial performance. A company’s ESG information is transmitted through its systemic risk profile (lower cost of capital and higher valuations) and its idiosyncratic risk profile (higher profitability and lower tail risk).
An analysis of more than 2,000 empirical studies found that 90% of these studies found a nonnegative relationship between ESG practices and corporate financial performance, and a large majority found a positive relationship.
This has become particularly true in RSM’s proprietary middle market research, which shows that companies are committed—often with formalized plans—to serve a variety of stakeholder interests. Among those companies familiar with ESG, 79% of middle market organizations said they use ESG criteria to evaluate their own performance, and 74% use ESG to evaluate the performance of other organizations.
The rule is subject to a period of public comment and can potentially be reversed. But it is set to become effective at the end of the year.