Oct 19, 2022

A spate of recent political commentary and legislative resolutions in pension fund investments in states such as Arizona, Florida, and Indiana appear to seek to prohibit or limit ESG investment considerations.

A closer look at some of the proposed language suggests that the stipulations do not explicitly prohibit ESG considerations in investments. The Florida resolution only stipulates that firms must base their investment decisions on pecuniary factors and may not be subordinated to objectives that sacrifice investment return or take on additional investment risk to promote non-pecuniary factors.

However, the assumption behind the political commentary and noise that surrounds these stipulations is that ESG addresses only a sociopolitical agenda and does not contribute to economic/pecuniary benefits for the investor. Consequently, such resolutions are being interpreted as explicitly prohibiting ESG considerations in investments.

But do ESG considerations lack any financial or economic benefits whatsoever?

Let us look at investment managers’ views on this topic. In late 2021, Cutter surveyed over 30 investment managers, a mix of asset managers and asset owners in the United States, Europe, Australia, and Japan. One question addressed by firms examined their reasons for considering ESG in their investment analysis and decision-making.

As we can see from the results, the leading reason that firms listed for ESG considerations is “Managing Investment Risk,” with “Identify investment opportunities” not far behind. While this result may be revealing for those who view ESG as only fulfilling a political or social agenda, the response would not surprise investment professionals.

The belief that climate risk impacts investments existed well before the term ESG was coined. Take the simplistic example of property valuations, which will be negatively affected if a property is declared to be in a flood zone or contaminated waste area.

The case for consideration of the S (social) and G (governance) factors in investments is less obvious. Consider the example of KLP, Norway’s largest pension company, which divested from CoreCivic and GEO Group, two U.S. operators of private prisons and immigration detention facilities, for allegedly violating labor and human rights laws. At first glance, the decision seems motivated only by social and political concerns. However, CoreCivic and GEO Group could potentially lose existing contracts or face legal action, which would hurt their profitability and investment returns. Viewed through this lens, the decision by KLP appears motivated by the investment risk-return paradigm.

These simplistic examples illustrate how ESG considerations impact investment decisions. The reality is certainly more complex. Investment managers must account for an array of voluminous and diverse ESG data from a host of vendors ─ from raw ESG data to ESG scores and analytics ─ and find a way to collect and normalize this data in a manner that can enable sound investment decisions. To do it right takes a lot of effort.

For more information, join us at the Cutter Connect 2022 member meetings on November 2-4 in Fort Lauderdale, Florida, and November 16 in Sydney, Australia, and look for Cutter’s research publication on this topic later this year.