European Normative Power Will Likely Externalize Sustainable Investing Regulations to the United States

Published January 15, 2021 by Jacob Eigner, Class of 2021 at Georgetown Law, IIEL Fellow.

Background: 

While not uniformly agreed upon, Environmental, Social, & Governance Factors (ESG) are generally defined as a set of standards for a firm that socially conscious investors use to evaluate potential investments. ESG is often used interchangeably with Socially Responsible Investing (SRI), which implies that a financial product has screened out certain investments according to ethical guidelines. Neither SRI nor ESG are always mutually exclusive with pecuniary factors; for example, the “governance” prong of ESG examines a firm’s decision-making structure, which comports with the investment approach advocated by Warren Buffett.¹ Sustainable Investing is a catch-all term that refers to ESG or SRI, and generally signals that a fund or product considers some ethical rather than solely pecuniary factors.

Analysis:  

The United States has broken with the world on sustainable investing. Since 2016, the Trump administration has signaled outright hostility, including essentially banning consideration of ESG factors in employer-sponsored plans subject to the Employee Retirement Income Security Act of 1974 (ERISA). Perhaps most significantly, in October 2020, the Department of Labor (DOL) released the final rule “Financial Factors in Selecting Plan Investments,” which proscribes employee benefits plans subject to ERISA from considering non-pecuniary factors except as a tie-breaker between two otherwise identical investment options.² This regulation makes any investment vehicle that integrates ethical considerations for non-pecuniary reasons effectively off-limits for many of the institutional investors that collectively shepherd upwards of 80% of the equity market capitalization of large US companies.³ Banning sustainable investing in the context of pension funds stands in stark contrast to the rest of the world.

As one example of this contrast, consideration of ESG factors has become nearly ubiquitous in the EU. Consultants estimate that 89% of European Pension Funds take ESG risks into account in their investment approach as of 2019.⁴ Additionally, the European Commission has finalized regulations requiring additional disclosures encouraging the integration of ESG concepts into financial decision-making by pensions⁵ and proposed regulations mandating investment firms consider ESG preferences of retail clients when providing investment advice.⁶ These regulations are likely to further accelerate the proliferation of sustainable investing in Europe, which has an outsized regulatory influence abroad.

The European Union has a history of diffusing human & environmental rights-related norms through “normative power”. This is particularly true in the area of discouraging man-made climate change through regulation.⁷ The EU tends to diffuse these norms by setting a more stringent regulatory example than its peers rather than coercively through military power. In the context of sustainable investing, for example, European regulatory embrace of these principles appears to belie a global acceptance of the investing discipline. While investing based on ethical considerations was once seen as an indulgent pet project of Nordic Pension Funds, it is now a vital and growing part of the investment universe globally.⁸

This trend towards sustainable investing is accelerating quickly. The signatories to the United Nations Principles for Responsible Investing now represent over $100 trillion in Assets Under Management. In total, ESG assets under management have reached $2.2 trillion globally. In the first half of 2020 alone, a record $20 billion surged into ESG-themed ETFs, to say nothing of ESG-themed active mutual funds and alternative investments. The outperformance of sustainable investing strategies has also played a role; according to Blackrock, 94% of sustainable indices outperformed their parent benchmarks in the first quarter of 2020.⁹ The massive inflow of assets to sustainable investment strategies has incentivized global financial firms to release ESG-themed iterations of mutual funds, ETFs and alternative strategies and to rapidly turn their attention to socially responsible factors as a basis for investments in the European Union and abroad. However, the United States has bucked this trend by disincentivizing the pensions that make up some of the largest institutional investors in the world from investing in ESG funds.

America is an extreme outlier in this respect; as the EU has set the tone for the world to move towards sustainable investing, the Trump Administration has resisted. Despite this divergence, the election of Joe Biden is widely expected to accelerate preexisting global trends towards sustainable investing and render recent executive branch regulatory activity unimportant. Leading financial firms have confidently predicted that the Biden administration will lend support to ESG investments through regulatory guidance and executive orders.¹⁰ Major donors and stakeholders also appear to have fallen into line; in November, forty of the largest American Multi-National Corporations signed a letter to the Biden transition team which implored the President-Elect to take aggressive action on this front.¹¹ Several of the signatories, including Amazon, represent some of the most valuable publicly traded companies in the world and reflect an eagerness and wide expectation that President-elect Biden will quickly reverse American regulatory disapproval of sustainable investing. 

The lack of a necessity for legislative action makes rapid change on this front feasible. Both the Trump and Obama administrations shared tendencies to use executive orders rather than legislation to achieve climate-related objectives. For example, the Obama Administration issued guidance in 2015 that clarified material ESG factors as being pecuniary and therefore able to be considered by plan fiduciaries, and the Biden administration is widely expected to re-release that guidance. This action will negate 26 CFR 2550-404a-1 and allow plan sponsors to add funds with sustainable components.¹² Furthermore, financial professionals and former Obama officials widely expect the Securities & Exchange Commission under a Biden administration to follow Europe’s lead in mandating disclosure of ESG factors in financial decision-making.¹³ This commitment to sustainable investing is consistent with Biden’s intention to make the United States a global leader on climate change issues.¹⁴

Conclusion: 

As European regulators turn their attention towards encouraging sustainable investing and consumers flock into ESG-themed funds, the world seems to be following suit. These grand trends toward ESG investing underscore the outsized regulatory influence and normative power of the EU. Although America under the Trump administration has thus far been an outlier, the incoming administration is likely to take aggressive action to keep pace with Europe and the world in the first days of the administration by releasing regulatory guidance encouraging investment in ESG-themed and socially responsible funds. 

With special thanks to Dr. David Kleimann, Visiting Senior Research Fellow, Institute of International Economic Law, Georgetown Law, for his review and critical feedback.

Sources:

¹ Tae Kim, Warren Buffett on judging management: ‘See how they treat themselves versus how they treat the shareholders’, CNBC, May 9, 2018, https://www.cnbc.com/2018/05/08/warren-buffett-heres-how-to-judge-management.html.

² 29 CFR 2550.404a-1; Note that the Department has stated the tiebreaker situation is a “unicorn” which will likely come about rarely.

³ Robert Frank, Fact-Checking Gary Cohn’s Claims on Pensions, CNBC, September 1 2017, https://www.cnbc.com/2017/09/01/fact-checking-gary-cohns-claims-on-pensions.html; Charles McGrath, 80% of equity market cap held by institutions, Pensions & Investments, April 25, 2017, https://www.pionline.com/article/20170425/INTERACTIVE/170429926/80-of-equity-market-cap-held-by-institutions/. 

⁴Michael Katz, ESG Becoming the New Normal for European Pensions, Chief Investment Officer Magazine, August 31, 2020, https://www.ai-cio.com/news/esg-becoming-new-normal-european-pensions/. 

⁵ Regulation (EU) 2019/2088 of the European Parliament and of the Council of 27 November 2019 on sustainability‐related disclosures in the financial services sector, https://eur-lex.europa.eu/eli/reg/2019/2088/oj/. 

⁶ Hazel Bradford, U.S. regulators split with EU/U.K. over ESG investing – Fitch, Pensions & Investments, September 11, 2020,  https://www.pionline.com/esg/us-regulators-split-euuk-over-esg-investing-fitch/. 

⁷ Yan Shaohua, Europe as a Normative Power on Climate Change? The EU’s Engagement with China, E-International Relations, May 27,2015, https://www.e-ir.info/2015/05/27/europe-as-a-normative-power-on-climate-change-the-eus-engagement-with-china/

⁸ Reeta Ilona Paakkinen, Asset managers try to catch up with leading Nordic Pension Funds on ESG, Watch Medier Denmark, January 1, 2019, https://amwatch.dk/AMNews/Ethics/article11645311.ece/ 

⁹ Hugh Leask, New BlackRock Research Points to ESG Resilience During Coronavirus Downturn, HedgeWeek, May 19, 2020, https://www.hedgeweek.com/2020/05/19/285741/new-blackrock-research-points-esg-resilience-during-coronavirus-downturn/ 

¹⁰ Leola Ross, What Changes could a Biden Administration Bring to ESG Investing?, Russell Investments, November 30, 2020, https://russellinvestments.com/us/blog/biden-esg-investing/. 

¹¹ https://s.wsj.net/public/resources/documents/Post-Election%20Climate%20Statement.pdf/. 

¹² Jon Hale, Biden Administration will Improve Regulatory Climate for Sustainable Investing, Morningstar, November 13, 2020. https://www.morningstar.com/articles/1011098/biden-administration-will-improve-regulatory-climate-for-sustainable-investing/. 

¹³ Susanna Rust, Biden Signal is Green for ESG, Investments & Pensions Europe, December 2020, https://www.ipe.com/home/biden-signal-is-green-for-esg/10049235.article/; Aaron Nicodemus, Biden’s SEC set to require disclosure of ESG, climate change risk, December 3, 2020,  https://www.complianceweek.com/regulatory-policy/bidens-sec-set-to-require-disclosure-of-esg-climate-change-risk/29788.article/. 

¹⁴ Alice C. Hill, Biden’s Climate Change Policy, Council on Foreign Relations, December 10, 2020, https://www.cfr.org/in-brief/biden-climate-change-policy-why-climate-envoy-matters/.