In recent years, a number of financial firms have taken what some consider a sharp turn to the left, marrying so-called environmental, social and governance (ESG) criteria to traditional investment strategies.
Many saw supporting an energy transition towards renewables as a slam dunk both for short-term and long-term returns. That honeymoon, however, ended abruptly last year when global disruptions battered many of the resulting funds. This left investors and retirees feeling deceived. Republican-led state legislatures pounced. More than a dozen red states passed or are considering bills that will blacklist investment managers that offer ESG-related funds. This is based on the mistaken belief that these companies — such as BlackRock, State Street and Vanguard — exclude traditional energy and firearms sectors from their investments.
Lawmakers are right to want to stop Wall Street from playing politics with taxpayer money, but they will also want to avoid inadvertently creating costlier problems than those they set out to fix. Fortunately, it’s possible to satisfy both goals — and Florida offers a powerful example of how to go about it.
There is mounting evidence that laws intended to protect investors from financial mismanagement can result in higher borrowing costs for cities and towns, expenses that are ultimately passed on to taxpayers. That’s because these laws can force out major underwriters and investment managers over entirely unrelated offerings, suppressing competition in the municipal bond market and retirement fund asset space.
Recent research conducted by economists at the Wharton School of Business and the Federal Reserve Bank of Chicago found that Texas’ anti-ESG laws will cost issuers between $300 and $500 million in additional interest on money borrowed within just the first year of legislation taking effect. A subsequent study found that identical legislation in Florida would imply $97 to $361 million in additional costs, while issuers in Kentucky, Louisiana, Oklahoma, West Virginia and Missouri could collectively be on the hook for hundreds of millions of dollars more in interest.
If these estimates are anywhere close to accurate, then the costs of enacting the wrong kind of legislation could be astronomical.
Does that mean lawmakers should sit idly while investors are duped into putting their savings into suboptimal funds? Of course not. Elected officials have a duty to protect the interests of their constituents, and the use of unproven investment criteria is a threat to the financial security of millions of Americans. Yet, the problem with “socially conscious” investing is not that it incorporates environmental, social and governance considerations, but rather that it subordinates investment outcomes to those considerations. If financial firms can verifiably show that ESG criteria generate increased returns, then there is no reason why it should not be permitted. If they cannot, then a justification for excluding them already exists and states can hold investment managers accountable without incurring the political and economic consequences of a blanket boycott.
In this regard, Florida provides a model for other states to follow.
Gov. Ron DeSantis (R-Fla.) recently approved measures that require state-run fund managers to “focus solely on maximizing the highest rate of return.” This approach avoids an unnecessary fight over new boycott-focused legislation and allows the state to continue to benefit from investment products that provide strong rates of return while creating a mechanism for excluding those that do not, regardless of their origin. The Florida approach also preserves competition in the municipal bond markets and in the investment management spaces by restricting only those funds that entail a breach of fiduciary duty, thereby maximizing outcomes for both investors and taxpayers.
I have worked as an attorney at the intersection of energy and financial services policy for much of my professional life. I believe investors deserve better than to be misled by reckless fund managers, and the urgency of the issue demands bold solutions. Investors also should have the right to choose financial services products that reflect their values, if they so choose. The heavy-handed, one-size-fits-all approach, however, represented by legislative ideas being pursued in some states will do more harm than good.
Rather than create new laws likely to encounter legal challenges and induce undesirable side effects, states should instead pursue more precise solutions that seek to enhance the efficacy of existing rules. As Florida showed us recently, a free market-informed approach that compels financial firms to make good on their fiduciary duty without undermining competition is the best way to go. And, if those firms fail, then they should be held accountable by provisions that make enforceable their obligation to maximize returns.
Sarah E. Hunt is president of the Joseph Rainey Center for Public Policy and director, policy & strategy at the Arizona State University Rob and Melani Walton Sustainability Solutions Service. Previously, she was director, Center for Innovation and Technology, at the American Legislative Exchange Council.