Preqin’s ESG roundtable examines the challenges and priorities of ESG investing in the US today
Preqin’s ESG roundtable examines the challenges and priorities of ESG investing in the US today
Environmental, social, and governance (ESG) investing has long occupied financial headlines and boardrooms. The sustainability-conscious form of risk assessment developed from being the preserve of select activists into a prominent facet of due diligence, though not without controversy. Like many other issues in the US, ESG can be divided into two camps: those who see the merit, and those who are opposed.
A significant portion of the alternatives and larger investment community supports ESG and accepts the integration of sustainability considerations. Many investors and fund managers view ESG as an appropriate approach to risk management. BlackRock CEO, Larry Fink, stated in his annual letter to shareholders, ‘[that] climate risk is investment risk’, citing ESG as a key component of the firm's ‘net zero’ plan. In 2022, the US Securities and Exchange Commission (SEC) proposed historical mandates that would require firms of select sizes to disclose scope 1, 2, and 3 emissions. While such mandates will strictly apply to public companies, the proposal has incited a greater push by investors for more transparency around ESG practices.
Beyond risk management, some see ESG as a sequential step to capitalize on the shift to renewable energy and decarbonization in the US. As more companies and nations make pledges to lower their carbon emissions, ESG is increasingly being seen as a means of securing market share. US President Joe Biden’s Inflation Reduction Act, passed in 2022, presented $500bn in new spending and tax breaks to support clean energy. While certainly not the first push toward renewables, the recent rules are the most concerted legislative action toward climate control in US history, signifying the opportunities and financial advantages of pursuing it.
However, ESG in the US is not without its challenges. Specifically, there is the issue of greenwashing, which refers to the use of the term sustainability in name only, without any real action or intentionality. Such practices cast doubt on the validity of ESG efforts. A survey conducted by PwC found that 87% of investors suspect that corporate disclosure contains some level of greenwashing.
What’s more, the ESG movement in the US is currently experiencing some strong backlash. Select right-wing groups have infused the topics of ESG and sustainable investing with political rhetoric dubbing it ‘woke capitalism.’ These groups have utilized multiple political tools to undercut investment firms’ ability to account for ESG-related risks in the belief that ESG purposefully excludes traditional energy sources such as oil and imposes certain social justice assumptions on those involved in the investment process.
A federal level backlash was expected, though most has come from state legislature. Public pension funds are the most recent battle ground. Within their respective jurisdictions, some US state representatives are advocating that public pension plan capital should not be allocated to fund managers with certain ESG standards. Specifically, those that divest from traditional energy assets.
Indiana and Kansas were two of the first states to pass legislation restricting public pension funds from investing in ESG commitments. On April 25 of this year, Kansas Governor Laura Kelly approved a bill preventing state pension funds from considering ESG. A similar law passed in Indiana just a day earlier. Both pieces of legislation were significantly diluted from the original bills, and according to Greg Ellis, VP of Energy and Environmental Policy for the Indiana Chamber of Commerce, ‘ended much better than they started.’ However, similar future legislation could be met with legal action as fund managers and investors may face limitations in terms of potential returns from investments in large tech companies and private capital managers such as Apple, BlackRock, and Google.
Representatives from Texas, Kentucky, North Carolina, and Florida have also all threatened to divest from fund managers which commit capital under ESG risk-management standards. Despite this recent pushback, public pension plans in these states are continuing to invest with fund managers that give some degree of consideration to ESG in their investment policies as of June 2023.
To better understand ESG’s place in the alternatives space, Preqin hosted a roundtable. Here are some of the questions we asked.
What are the biggest challenges in implementing ESG at your firm?
Most respondents cited misconceptions. The discussion highlighted misunderstandings and a lack of education on what ESG means, as well as how it would look at respective firms. Experts noted that it was occasionally more effective to discuss such topics outside of industry terms like ‘sustainable.’ They said they found it more valuable to first ask companies about their activities to gain a sense of which practices align with ESG. Doing so removes the barriers associated with these terms. One example they gave was policies around general materiality. Clients and companies often do not get to see how ESG works in tandem with analyzing general risk. Governance and social assessments extend to the risks posed by employee working conditions, including sweatshops in the clothing industry and machine safety within manufacturing assets.
Which issues take the highest priority in your ESG considerations?
The challenges facing ESG were not limited to miseducation, according to respondents. They highlighted two top priorities to address in ESG going forward: governance and net-zero targets. The former struck an important point, that poor governance can prevent an investment from occurring. According to a study by the International Financial Corporation, infrastructure development and private investment in emerging markets like Africa will hinge on, and are currently being improved by, the implementation of solid governance.
Net-zero targets were also a key concern. Experts made the case that such goals are set too far in the future (for example, 2050), claiming that there can be a lack of motivation if targets seem extremely far away, particularly among managers that don’t hold assets for as long. Such longevity also brings concerns about the cost of capital. The differing costs of insurance may scare managers away from sectors with higher insurance costs, such as oil and natural gas projects. Participants acknowledged that net-zero goals play an important role in sustainability efforts, but that longevity for its own sake is ineffective without clear infrastructure to maintain or guide it.
Have ESG concerns been the main reason for turning down an investment opportunity? Is ESG inclusion therefore a fiduciary duty?
Participants explained that ESG obscurity can be cause to turn down an investment. They noted that some market players won’t move forward with an investment if it doesn’t disclose enough information about ESG. Asset managers see it as a crucial step in the due diligence process, and in some cases, investors also insist on going that extra mile.
ESG investing has hit the political third rail in the US. It’s the latest example of age-old questions around investment autonomy and fiduciary responsibility coming back to the fore. Respondents concluded, ‘there is consensus that ESG inclusion is part of fiduciary duty’, though to what degree is still up for debate. Some noted the incorporation of carefully composed ‘if/then’ statements could categorize the level of fiduciary duty as material, important, or significant. For example, whether during the due diligence process a fund manager’s level of ESG transparency could inform investment decisions. The exploration of such classification and tiering will likely play a key role in managers’ and investors’ successful navigation of the politically-charged discussions surrounding the role of ESG in risk management.
Regardless of its political future, ESG investing has become integral to the dialogue around due diligence, risk management, and investment responsibility. Fund managers, investors, and political officials alike will long be tasked with determining the extent to which sustainability impacts the future of investing.