Unintended Consequences of Investing According to Environmental, Social and Governance Principles
Institutional investors, asset managers and others in the financial services industry increasingly are adopting environmental, social and governance (“ESG”) investment principles to attract and retain business from socially conscious investors. European institutions have historically been at the forefront of ESG-based investing, but a growing number of U.S. and other global institutions are formally incorporating these principles into their business models.
Also referred to as “socially responsible investing” or “sustainable, responsible and impact investing” (“SRI”) principles, these initiatives often are motivated by a laudable desire to raise the profile of ethical considerations in business. The implementation of ESG criteria should be undertaken with care, however, as their use can have unintended consequences depending on the specific criteria that underlie an institution’s approach to ESG investing. For example, U.S. institutions and even non-U.S. institutions that have U.S. public clients (e.g., state pension funds) that are considering leveraging well-known ESG criteria used by European institutions should be aware of potential issues under U.S. federal and state antiboycott measures that penalize entities that refuse to transact with or invest in Israel and Israeli companies. Issues also can arise under U.S. federal and state laws that authorize or require divestment of investments in companies that have operations in Iran and Sudan.
Overview of ESG Initiatives
Investing entities increasingly employ various ESG criteria to identify activities of potential investment targets – associated, for example, with climate change, environmental conservation, weapons development, human rights, corruption, employee relations and corporate transparency – that might impact financial returns as well as investor reputation. A group of institutional investors, asset managers and state government treasurers recently petitioned the U.S. Securities and Exchange Commission to mandate standardized disclosure of ESG data by publicly traded companies.
A significant challenge in the ESG world, however, is the lack of a single, unified approach to identifying specific criteria to be evaluated. Portfolio managers and individual investors are likely to have differing views on the specific ESG criteria that should be employed even if they agree on the ultimate goal of supporting sustainable investing. Moreover, even with a common set of ESG criteria, the standards by which these criteria will be assessed may vary significantly, even among investing entities with shared goals.
Even after an institution has developed clear criteria for what factors are involved in their ESG investing approach, the implementation of this approach can take many forms. For example, companies that act in violation of these standards might be systematically excluded from a firm’s portfolio. Firms might instead take a proactive approach to identify and invest only in companies that meet ESG criteria. Other ESG approaches might involve neither a negative nor a positive screening and instead focus on leveraging power held through existing investments to influence better behavior by current holdings. Other potential actions might include conducting portfolio reviews to assess ESG risk exposure or discussing in annual reports the specific criteria applied.
In light of the complexity and potential subjectivity associated with implementing ESG investment principles, many investors rely on ESG criteria developed by other organizations. Globally, the United Nations-supported Principles for Responsible Investment set forth a range of possible actions for financial institutions to incorporate ESG issues into investment practice, such as developing a clear ESG policy, requesting the ESG issues be addressed in financial reports of potential investment targets, and communicating expectations to service providers. The PRI do not, however, identify specific criteria that should be part of an ESG strategy (e.g., no investments in tobacco companies) and also do not identify companies that should be excluded for ESG-related reasons.
In contrast, ESG criteria published by certain European asset management organizations, ESG consultants or national pension funds take a more directed approach. These sources set forth specific criteria that should be used in ESG-driven investment decisions, and many identify particular companies that should be excluded from investments as a result of violating such criteria. More than one hundred companies presently appear on these exclusion and observation lists due to their alleged involvement in coal-based energy production, promotion of tobacco, weapons sales and human rights abuses.
Case Study No. 1 – Potential Conflict Between ESG Criteria and U.S. Federal and State Antiboycott Measures
A growing concern for investing entities that employ ESG criteria in their decision-making processes is potential conflict with U.S. federal and state antiboycott laws and regulations. These laws and regulations historically have raised issues for investing entities when they enter into investment management agreements with clients based in the Middle East, and the clients seek commitments that the investing entities will not invest in Israeli companies. Under certain circumstances, regulatory exceptions might permit an investment manager, for example, to agree to a requirement to not invest in Israeli companies (although the receipt of such a request nonetheless might trigger reporting requirements, the regulations are byzantine, and the analysis can be quite complicated).
ESG-based investing raises additional concerns in this regard since certain companies appear on ESG-based exclusion lists because of their alleged support for, or involvement in, human rights abuses and military activities arising from the ongoing conflict between Israel and Palestine. Institutions that employ ESG criteria that call for the exclusion of investments in these companies might encounter issues under U.S. federal and state antiboycott measures that prohibit or penalize participation in international boycotts that are not sanctioned by the United States – including the Arab League boycott of Israel. Both U.S. federal and state measures can raise significant issues for institutional investors, asset managers and other financial services companies, in particular those that implement ESG criteria in their activities or conduct business in the Middle East.
U.S. federal antiboycott laws are implemented by both the Commerce Department’s Bureau of Industry and Security (“BIS”) and the Treasury Department’s Internal Revenue Service (“IRS”). The regulations are nuanced and complex. In general, however, they prohibit and/or impose reporting requirements related to requests or agreements to refrain from doing business with Israeli companies. In addition to federal requirements, about half of U.S. states (including California and New York) have implemented their own independent antiboycott measures. Often referred to as “anti-Boycott, Divestment and Sanctions” (“anti-BDS”) measures, many of these requirements mirror federal antiboycott requirements with respect to the scope of targeted behavior. In other cases, states have imposed requirements that go beyond federal regulations.
State anti-BDS measures take many forms, but most contain some or all of the following elements:
- Maintaining a “blacklist” of companies determined by the state to have engaged in a boycott of Israel;
- Prohibiting state pension funds from investing in or otherwise dealing with entities determined to have engaged in a boycott of Israel (or requiring divestment of funds already invested in or with such entities);
- Requiring entities seeking to contract with state agencies to certify that they have not engaged in a boycott of Israel; and
- Prohibiting entities that have participated in a boycott of Israel from participating in government procurement activities.
State measures are most relevant for entities that have ongoing or potential business with state-owned or -controlled institutions (such as public pension plans). Entities with no commercial ties to state-backed institutions nonetheless may suffer significant reputational consequences from inclusion on a state anti-BDS list, as this could impact relationships with other (public and private) business partners. Currently, at least 11 U.S. states are known to maintain blacklists of companies subject to restrictions due to their alleged involvement in activities associated with the boycott of Israel.
Investment managers and other entities in the financial services sector must consider the potential impact of U.S. antiboycott measures when implementing ESG criteria in their investment decisions and other commercial activities. U.S. federal anti-boycott measures apply as a general matter only to entities with a U.S. nexus, such as those that are headquartered in the United States or have affiliates that are U.S. persons. U.S. state antiboycott measures, by contrast, increasingly pose issues for investment managers and other financial services entities, even if such entities have no U.S. nexus (and therefore are not subject to U.S. federal antiboycott measures) and/or even if the activities in question are not prohibited by federal antiboycott measures. Rather than directly imposing financial penalties, states can deny access to commercial and investment opportunities associated with state funds. For investment managers, this could lead to the loss of significant opportunities to manage funds on behalf of state pension funds and other public entities. Moreover, as many states publicize their blacklists, inclusion on such a list by one state can lead to copycat listings by other states and, more broadly, negative reputational consequences in the global market.
Case Study No. 2 – Potential Conflict Between ESG Criteria and U.S. Federal and State Sanctions Measures
Certain U.S. federal laws – including the Sudan Accountability and Divestment Act and the Comprehensive Iran Sanctions, Accountability and Divestment Act – authorize state and local governments to prohibit new, or divest existing, investments in companies that do business in Iran or Sudan. Pursuant to these authorities, more than 30 states have enacted divestment legislation or policies laws that generally restrict the investment of public funds (including state pension funds) in companies that are identified as doing business in Iran or Sudan. These include states such as California and New York with significant amounts of public funds under management by private entities.
Unlike potential risks under the state antiboycott measures discussed above, there generally is a low risk that the use of ESG criteria could result in investment managers or other financial services companies being added to a state divestment list due to Iran or Sudan business. While it is possible that a firm’s ESG screening could still permit investments in Iran or Sudan that could result in the firm being added to a state blacklist, potential investments in those jurisdictions likely would raise human rights, transparency, social governance, or other ESG-related concerns (leaving aside potential issues under U.S. and other global economic sanctions).
The greater risk is that a firm might employ ESG screening and identify an acceptable investment target that is identified on a state’s Iran or Sudan-related blacklist. Almost all of the companies on these lists are located outside of Iran or Sudan, and connections to those countries might not be evident upon initial review. Investment managers and other entities responsible for handling U.S. state public funds would need to ensure that investments are consistent with any applicable state divestment requirements, even if an investment target otherwise meets the ESG criteria used by the firm and appears to be a “socially responsible” investment.
Investment managers and other financial services entities faced with a prospect of being added to a state blacklist – either due to the use of ESG-based criteria or because of client-specific commitments – should consider a number of steps to avoid becoming listed and/or to mitigate the potential impact of a listing:
- Act Quickly After Receiving Notice.
- Seek the Source of the Information.
- Assess Impact on Overall Operations.
- Consider Proactive Outreach.
Dechert has significant experience assisting institutional investors, asset managers and others in the financial services industry with matters pertaining to ESG, boycotts and sanctions. Please contact the authors of this report to seek assistance in this regard.