Public pension plans need to consider the risks and drawbacks of environmental, social and governance investing

The goals of ethical investing are easier to annunciate than accomplish. While it is attractive to think that public investors can deploy their assets to optimize environmental, social and governance conditions, the tradeoffs and measurement problems can get in the way. Further, when public pension funds allow environmental, social and governance (ESG) concerns to eclipse their primary objectives of maximizing risk-adjusted investment returns, they let down public employees and taxpayers.

ESG portfolios can be constructed in a variety of ways. One method involves excluding securities issued by corporations that engage in objectionable activities from an asset manager’s choice of possible equity and fixed-income investments. For example, Pacific Investment Management Company’s (PIMCO) Enhanced Short Maturity Active ESG Exchange-Traded Fund (Ticker EMNT) excludes companies in the following industries:

• Alcoholic beverages
• Tobacco
• Commercial animal husbandry for food production or animal testing
• Military equipment
• Civilian firearms
• Gambling
• Private prisons
• Adult entertainment
• Oil extraction, production, and refining
• Coal distribution and coal fired generation

In most cases, this type of restriction applies only to companies that realize 10% or more of their revenue from the proscribed categories, although some of the exclusions apply if the company has any involvement in the category whatsoever. Given the limits of corporate disclosure, such as management’s discretion to exclude activities it deems “non-material,” it may not be possible for outsiders to confidently conclude that a company’s activities are completely free of these practices.

Further, the longer the list of excluded categories, the fewer number of companies an investment manager committed to ESG can choose from. With fewer investment choices, the likely outcome is lower investment returns for the public pension fund and the retirees expecting retirement benefits. Although some proponents of ESG investment strategies cite relatively strong performance by ESG funds, this may be because they are often heavily weighted in technology firms, that generally do not appear on exclusion lists. Technology stocks performed relatively well in 2021, but have underperformed in early 2022, which could have negative implications for environmental, social and governance funds going forward.

Furthermore, there is also a question of divestment achieving optimal social and environmental outcomes. To some criminal justice advocates, for example, it may seem straightforward to not invest in private prison companies. Divestment from private prisons could result in a shift toward government-operated prisons, but that may not be in the best interests of inmates.

Prisoner mistreatment and employee misconduct occur in a wide range of prisons, both publicly- and privately-run. Indeed, Rikers Island jail in New York City, still under a 2015 consent decree for the use of excessive force against inmates, could be the most unsafe corrections facility in the country for inmates and staff and has always been publicly operated.

Similarly, a February report by the Associated Press found pervasive sexual abuse of female prisoners at Federal Correctional Institution, Dublin, a Northern California facility owned and operated by the federal government. Alabama’s Department of Corrections (ADOC) currently faces a consent decree for the “cruel and unusual” conditions of its prisons. While the ADOC, Alabama’s legislature, and the state’s governor are now eager to replace some of its older prisons as part of their response to the consent decree, ESG activists persuaded the underwriter of two projects to pull out of the deal “following criticism that it was breaking a promise not to get involved in for-profit prisons.”

An alternative to exclusion lists is the use of ESG ratings to determine which funds a public pension plan should invest in. Incumbent credit rating agencies, startups, and other competitors provide assessments of how well companies perform in accordance with various environmental, social and governance factors. Unfortunately, such assessments are generally not based on standardized data and transparent criteria. And, as a result, environmental, social and governance ratings are often subjective and opaque.

Rating agencies have failed to assign reliable credit ratings at various times in the past, most spectacularly in the case of Residential Mortgage-Backed Securities and Collateralized Debt Obligations in the early 2000s. Those rating errors are widely blamed for triggering the 2008 financial crisis. Given this past performance, it is fair to question whether such organizations should act as arbiters of corporate social responsibility.

Further, assessing credit risk is fundamentally different from measuring environmental, social and governance factors. Credit ratings have a readily observable benchmark: the occurrence or non-occurrence of default. If a high proportion of highly rated securities in a given asset class default, we can confidently conclude that the ratings were faulty. With ESG ratings, by contrast, the benchmarks are less easily measurable. It is often difficult to determine what volume of greenhouse gas emissions a company’s activities generated, for example, let alone how that compares to competitors’ results or to the amount a socially responsible firm would or should have generated.

The lack of standard measurements, for both rating factors and final results, often makes the ESG rating industry vulnerable to greenwashing—the act of misrepresenting a company’s activities as being more environmentally sustainable than they really are. For ESG rating firms, the challenge is one of determining whether the rated company’s environmental, social, and governance policies are thoroughly implemented, or whether they are merely public relations spin. And, if ESG rating fees are paid by rated companies it raises questions about ESG rating firms having the objectiveness to make this determination.

Whether an ESG investor relies on ratings or exclusion lists, the amount of social benefit their investment activities achieve is debatable. But even if they could be certain that their investments were achieving set societal benefits, ESG investing may well constitute a fiduciary failure for pension funds and other institutions making investment choices on behalf of third parties. Federal law (which governs private-sector pension plans) states:

The primary responsibility of fiduciaries is to run the plan solely in the interest of participants and beneficiaries and for the exclusive purpose of providing benefits and paying plan expenses. Fiduciaries must act prudently and must diversify the plan’s investments in order to minimize the risk of large losses.

Unless ESG funds can match or consistently outperform more traditional investment options, like index funds on an after-expenses basis, they are often a poor choice for public pension systems that are charged with safeguarding public employees’ retirement benefits at the lowest possible cost to taxpayers.