Pension funds could be a formidable force in getting companies to embrace environmental, social, and governance (ESG) values such as combating climate change or advancing employment equity. Yet they must align those goals with their fiduciary duty of protecting the retirement funds of their members. In the U.S., they must also overcome challenges including gaps in ESG adoption metrics and ambiguity about government rules on such investing. Those were the key takeaways from a two-day conference organized by Wharton’s Pension Research Council titled “Sustainable Investments in Retirement Plans: Challenges and Opportunities.”

Sufficient momentum exists: Sustainable investing in the U.S. has grown dramatically over the past 25 years, and the $17 trillion of sustainable assets under management now make up a third of the $51 trillion that is professionally managed, according to the 2020 report of U.S. SIF Foundation on trends in sustainable and impact investing.

Total assets incorporating ESG principles managed by U.S. institutional investors have also grown appreciably over the past 15 years, to $6.2 trillion as of 2020, and public pension funds account for more than half of that (54%), according to the report. Investment policies related to climate change and conflict risks in terrorist or repressive regimes have recently been among the top concerns of investors, followed by tobacco use, corporate governance, and sustainable practices in natural resources and agriculture.

Nevertheless, investor appetites for ESG principles swing between extremes. Investors in ESG funds are shifting interest from growth stocks to value stocks, while other institutional investors are “lining up trillions of dollars to finance a shift away from fossil fuels,” according to the Wall Street Journal.

“There are many different viewpoints in this debate, and battles rage over how we should define and think about ESG criteria when shaping pension decisions,” said Wharton professor Olivia S. Mitchell, director of the Pension Research Council, in her opening remarks at the conference. Mitchell is also the International Foundation of Employee Benefit Plans Professor, as well as professor of business economics and public policy, and insurance and risk management.

A total of 25 experts discussed those issues at the conference. ESG investors can be grouped in three buckets, according to Billy Nauman, a Financial Times reporter and producer of Moral Money, the FT’s newsletter on ESG and impact investing trends. Those three types of investors are “Change the world,” or those who want to use their money to make the world a better place; “Do no harm to the world,” where they try to avoid being the problem in terms of climate issues or social ills; and “Do no harm to our portfolios,” where they seek to incorporate ESG into their investment decisions to mitigate risk.

Values vs. Value

What is not clear, however, is whether ESG investors are pursuing “values,” such as protecting the environment or working to control gun violence, or “value,” as in protecting the profits from their investments, according to Wharton management professor Witold Henisz, who is also founder of the ESG Analytics Lab at the school and director of the Wharton Political Risk Lab. He noted that estimates of assets under management that claim commitment to ESG principles range between a few trillion and $30 trillion to $40 trillion. “That’s astounding, and it could be revolutionary. It could help us deal with things like climate risk, racial justice, social justice, and other issues,” he said. He made a presentation at the conference titled “ESG Objectives and Outcomes.”

“There are many different viewpoints in this debate, and battles rage over how we should define and think about ESG criteria when shaping pension decisions.” –Olivia S. Mitchell

It is also unclear whether ESG adoption by investment managers is sustainable. “There’s a nagging sense that we may have gotten ahead of ourselves, that maybe this is hype, a fad that’s ahead of the reality,” Henisz continued. “Maybe there really aren’t $30 trillion to $40 trillion dollars of assets chasing ESG and maybe they’re confused. And some of that confusion relates to what they actually mean by ESG. Do they mean ‘value’ or do they mean ‘values’? Are they investing for higher returns or are they investing according to some social or environmental outcomes?”

Justifying ESG investing has not been easy for pension funds and their trustees, said Amy O’Brien, head of responsible investing at Nuveen, an asset management firm that is a subsidiary of TIAA (Teachers Insurance and Annuity Association of America and College Retirement Equities Fund). “It’s been hard in some cases to make the business case [for ESG investing]. A lot of pension funds have struggled, at the board level, in finding that right balance between social responsibility and the fiduciary duty to act to maximize return on behalf of our participants.” O’Brien and Brett Hammond, research leader at the American Funds of the Capital Group, presented a paper titled “Pensions and ESG: An Institutional and Historical Perspective.”

Pension funds are ideally positioned to incorporate ESG, according to Stéphanie Lachance, managing director of Responsible Investment at the Public Sector Pension Investment Board (PSP Investments) Canada, and Judith C. Stroehle, senior research fellow at the Said Business School, University of Oxford. “The inherent long-term investment time horizon and the diversified portfolio structures are two of the principle enablers of ESG at pension funds,” they wrote in their paper “The Origins of ESG in Pensions: Strategies and Outcomes.”

Finding the Right Opportunities

For investors, identifying corporations that espouse and act in accordance with ESG principles is a challenge. ESG ratings vary widely, for instance: It is not uncommon for a company to receive a high ESG rating on some criteria but a low score on others. Investor estimates of expected returns also vary by the metrics they use.

“Slide number five in my talk is the confetti plot,” said Roberto Rigobon, professor of applied economics at MIT’s Sloan School of Management and co-director of Sloan Sustainability Initiative, where he leads the Aggregate Confusion Project, a research program aimed at improving the quality of ESG measurement and decision-making in the financial sector. “Companies that can be on the top 10% for one rater may be in the bottom 10% for another rater. This creates a complication when you are trying to decide how to construct a portfolio.”

“There’s really no need to be confused by ESG data or by ESG ratings,” said Linda Eling-Lee, managing director and head of research at the ESG Research Group at MSCI, a provider of investment data and analytics services. She presented a paper titled “What Does ESG Investing Really Mean? Measuring Materiality.” “The key to cutting through a lot of the confusion is to understand what your objective is as an investor, which may be different from another investor. Yes, ESG has multiple different dimensions. For example, one of those dimensions can reflect personal values, which are idiosyncratic to the investor.”

ESG datapoints should be viewed as “ingredients that can be assembled to capture different dimensions of ESG,” Eling-Lee continued. “However, because these are multidimensionial, you can’t reflect all of the different dimensions at the same time in a single score or one single rating.”

The time horizons are critical when an investor chooses to weigh the outcomes of companies that claim commitment to ESG principles, Eling-Lee said. “If you are in a long-term universal pension fund, some of the slow-burning issues like environmental management and some social issues take multiple years. But you do see this cumulative advantage that companies have over time when they are superior on some of those issues.”

That said, ESG ratings are strongly indicative of how well companies do on several fronts, according to Eling-Lee. “We have found is that over our 13-year history of ESG ratings, companies with higher ratings are more competitive than their industry peers,” she said. “They tend to have higher profitability, and they pay greater dividends over time. On downside risks, we have been able to find evidence very consistently across different markets and across different time periods that ESG ratings can approximate inferior risk management that can precipitate negative events. We found that the lowest-rated companies over the next three years are three times more likely to experience a very severe stock price drawdown compared to their highest-rated peers.”

“The key to cutting through a lot of the confusion is to understand what your objective is as an investor, which may be different from another investor.” –Linda Eling-Lee

Stock prices of companies with high ESG ratings have also shown lower volatility, and they have tended to be potentially less susceptible to systemic shocks in the economy, Eling-Lee continued. “That was demonstrated in part last year through the Covid crisis, where we did see higher-rated companies perform better and they were more resilient.” Nevertheless, investment performance over a 13-year period may not predict the future with a great deal of accuracy.

The Challenge with Data

Much can be achieved if data models that capture ESG values and value are refined, Henisz said. “We need third-party validation of proprietary data. We need to prove or test whether ESG investments pay, and when they pay, when do they impact growth? When do they impact cost reductions, productivity uplift, and idiosyncratic or systemic risks? What are the contingencies that drive that? Investor demand? Asset manager incentives, stakeholder interest, the availability of technological options, anti-competitive barriers in the industry, or corporate enterprise risk management? We need to undertake this kind of rigorous assumption using model uncertainty analysis of all ESG studies.”

“Even the studies that use the best available data are not convincing the skeptics,” Henisz continued. That is because “the time horizons aren’t long enough, the assumptions aren’t clear, and the processes aren’t transparent. We need to have good data, but we also need to make progress from where we are if we’re going to mainstream this [pursuit of ESG values].”

“What pension funds want is investments that will do well in the long run, but ESG metrics are not necessarily focused on long-run resiliency,” said Mitchell.

Eling-Lee acknowledged the need to gather more and better data on ESG adherence by companies. She noted that a common perception is that ESG data consists primarily of corporate disclosure, yet “that’s simply not true,” she said. “We still need to be developing a lot of alternative data sources on ESG information about companies.”

Not all companies voluntarily release data on their ESG performance, Henisz said. He pointed to ExxonMobil’s latest disclosure of its emission reduction plans as the outcome of pressure from Engine No. 1, an activist investment firm: “That’s not random. That choice of disclosure occurred at that moment for a specific reason.”

Meanwhile, efforts continue to refine data capture and metrics. Up next are “cutting edge developments” in measuring for climate risk for companies and for portfolios, said Eling-Lee.

Henisz noted that “it’s critically important to do it now,” and not just because of the increased attention to ESG principles. “The price of oil is about to go up, and it’s likely that ESG funds will underperform in the next 12 months,” he said. “It could be very much the case that in 12 months, if we don’t develop more conclusive proof that this works, people will think of this moment as a fad.”

“We need third-party validation of proprietary data. We need to prove or test whether ESG investments pay, and when they pay, when do they impact growth?  –Witold Henisz

Wharton finance professor Christopher Geczy offered a new way to understand the utility investors could derive from ESG and its impact, in a paper titled “Would ESG Investment Enhance Pension Performance? An Expectations Perspective” that he co-authored with John B. Guerard, chairman of the Scientific Advisory Board at McKinley Capital Management, an investment research and advisory firm. Geczy is also academic director of the Wharton Wealth Management Initiative. “It is a way of understanding information that’s not reported under traditional GAAP accounting [formats],” he said.

In another paper, Geczy and his colleagues Robert F. Stambaugh and David Levin constructed optimal portfolios of mutual funds whose objectives include socially responsible investment (SRI). “Comparing portfolios of these funds to those constructed from the broader fund universe reveals the cost of imposing the SRI constraint on investors seeking the highest Sharpe ratio,” the paper stated. (The Sharpe ratio allows investors to understand the return on an investment compared to the risks associated with it.)

Pressure to Change

Several pension funds and other industry participants have taken decisive steps to persuade companies to commit themselves to ESG principles. For instance, two New York City pension funds recently moved to divest from oil companies. BlackRock, the world’s largest asset manager, announced that in 2020, it had achieved its goal of having 100% of its active and advisory portfolios ESG-integrated. More recently, BlackRock CEO Larry Fink went a step further, asking client companies “to disclose a plan for how their business model will be compatible with a net-zero economy.” Eling-Lee pointed to a recent MSCI “call to action” statement, where it called on “all capital-markets participants to play a vital role in the net-zero revolution to keep global temperature rise well below 2 degrees Celsius.”

Such pressure from investors “actually works — it drives change in companies, and it drives value,” said Henisz. However, that terrain can be expensive for investors in terms of fees, he noted. He pointed out that, while average fees are trending down for mutual funds and ETFs (according to a Morningstar study), this is not the case with funds that pursue “engagement” on ESG principles with companies.

“During times of cost pressure on portfolio managers, it’s easier for fund consultants to highlight the higher cost of ESG, rather than values.” –Olivia S. Mitchell

“ESG funds that pursue exclusionary strategies (or exiting from investment) — not engagement — are gaining market share in terms of the share of assets under management,” Henisz said. “That is where the low fees can survive. That’s really problematic if we want to pursue engagement, and if we want to pursue strategies that really work. The second problem is that institutional investors remain hesitant as to whether ESG investing is worth it. The average ESG fund is not overperforming its benchmark on financial performance.”

“During times of cost pressure on portfolio managers, it’s easier for fund consultants to highlight the higher cost of ESG, rather than values,” Mitchell noted.

Regulatory Ambiguity

Pension funds have much ground to cover before embracing ESG investing. As of 2018, only 2.8% of 401(k) plans offered an ESG fund option, Nauman of the Financial Times noted. That low participation can be traced to the changing stances of the U.S. Department of Labor on the appropriateness of social investing in private defined benefit plans covered by the Employee Retirement Income Security Act of 1974 (ERISA). The most recent rule change came in November 2020, where the department held retirement plan fiduciaries to a “pecuniary” standard when selecting plan investment options; nevertheless, it did not specifically mention ESG funds. The Biden administration has promised a review of that rule.

“Historically, it’s been unclear how ESG is perceived under ERISA,” said Nauman. “Across administrations, from the Obama administration and now even still under Biden, it’s murky. And investors or investment management companies are not going to jump in until there is clarity that these products can and will be used, and they won’t get sued. Until there is more clarity around how exactly these will be handled by the regulators in the U.S., we’re stuck in a holding pattern.”