ESG and the States
The Environmental, Social, and Governance (ESG) approach to investing has become ubiquitous in corporate America, prompting many elected officials to weigh in on the movement. For ESG's advocates, mostly on the political left, it's a benign, helpful business trend. U.S. senator Tina Smith, a Democrat from Minnesota, describes a bill favored by many supporting the movement as a "neutral, free-market approach" that provides "basic legal certainty" surrounding ESG efforts. Delaware's Democratic state treasurer Colleen Davis says that efforts to support ESG are simply a matter of providing "factual information." To Lena Gonzalez, a Democratic state senator in California, having the state divest from companies that don't meet the environmental standards she supports is just a way of being "thoughtful in our approach to the environment" and "putting our money where our mouth is."
Many on the right, however, sharply disagree. U.S. representative Andy Barr, a Republican from Kentucky, writes that the ESG movement is "jeopardizing the economic security of investors, politicizing our capital markets and private enterprises, and threatening the stability of our energy supply." Alabama's Republican attorney general Steve Marshall likewise believes that ESG is "the left's new way of imposing [its] worldview on the country." Some go even further. Marlo Oaks, Utah's Republican treasurer, says that ESG efforts "open the door to authoritarianism."
For all the forceful rhetoric surrounding ESG efforts, the back-and-forth has not offered much clear thinking about what ESG is, how it works, or what constitutes an ESG regulation or law. And while federal officials vigorously debate the topic, as they did during a series of hearings in the House of Representatives this past summer, most ESG legislative proposals and activities are taking place at the state level. This is where clarity has been most lacking.
Defining corporate ESG policy, outlining its popularity, exploring related state-level public policies, describing their effects, and explaining how state governments — and legislatures, in particular — can navigate the minefields it presents would bring insight to these discussions. A more comprehensive understanding of ESG will enable state policymakers to both avoid its pitfalls and maximize its potential upsides. They can do the former by reinforcing the fiduciary guardrails around public funds and avoiding proposals that grant officials broad powers to second-guess business decisions. And they can do the latter by investigating ways that the ESG movement, at its best, can replace government coercion in confronting complex social problems.
WHAT IS ESG?
ESG's antecedents date from the beginning of Western civilization. The wealthiest men in ancient Athens supported triremes for the navy as well as dramatic productions to entertain and enlighten the polis. Medieval barons not only performed obligatory military service for their liege lords but, in order to keep their bonded labor forces alive and relatively happy, also handed out grain in lean times, provided for the sick, and supported wedding celebrations. Industrialist Andrew Carnegie helped define much of modern philanthropy when he preached a "gospel of wealth" and gave away almost his entire fortune to support schools, research institutes, and libraries. Inspired in part by Carnegie and other industrial-age titans like Henry Ford, management thinkers from the 1920s onward preached a concept of "corporate social responsibility" or "corporate citizenship" that asked large enterprises to think of themselves as responsible individuals. They should therefore do many of the things that are expected of good citizens, including improving their communities, donating to charities, and advocating public policies that serve the common good.
"Environmental, Social, and Governance" is thus the latest evolution of long-established trends. The term comes from a 2005 United Nations report, which describes ESG as attending "to broadly accepted extra-financial interests...in conjunction with...financial interests." Hardly anyone disagrees with this basic idea. Even in his famous New York Times essay, "The Social Responsibility of Business Is to Increase Its Profits," no less a free-market authority than Milton Friedman wrote that companies must not only obey the law, but also conform to "the basic rules of the society, both those embodied in law and those embodied in ethical custom." To some extent, responding to these preferences of "ethical custom" is a natural, value-creating endeavor for most every business enterprise.
But ESG goes further than movements of the past. It's not just another name for "philanthropy" or even a rebranding of "corporate citizenship." Instead, modern ESG thinkers, managers, and consultants tend to emphasize a broad array of obligations that look at every aspect of a business's role in the world. These can, of course, have tremendous relevance to the bottom line of any enterprise. The consulting firm McKinsey describes ESG activity as a business tool intended "to manage, and address, massive...externalities." It adds that a company's failure to take ESG into account might mean "their forecasts — and indeed, their core strategies — may not be achievable at all." In short, ESG supporters propose making initiatives previously considered "nice and good," or even "obligatory as a matter of custom," into business responsibilities that firms should fulfill if they hope to thrive in the long term.
Although the lines between the three components of ESG can be blurred at times, each one largely meets the common-sense definition of the term. Environmental factors covered under ESG include compliance with environmental laws, voluntary environmental standards (such as a promise to buy more clean energy), and efforts to mitigate broader environmental impacts, such as a firm's past carbon-dioxide emissions. Social factors include the ways a firm treats its employees, participates in society as a corporate citizen, takes positions on social issues, and engages in outreach to groups that have faced past prejudice. And governance issues speak to how a company runs itself. They deal with matters such as the composition and independence of the board, compliance with laws, internal financial controls, and how firms invest (or don't invest) for long-term value creation.
THE MOVEMENT SPREADS
ESG programs have become nearly universal at sizable firms. According to the consulting firm Deloitte, 99% of companies surveyed said they either had or were planning to establish a cross-functional ESG-related team. Significant majorities in the same survey also said they were going to invest more in tools to measure ESG efforts. And the programs are making a greater impact than ever in the C-suite: A recent report from PricewaterhouseCoopers (PwC) found that the number of chief sustainability officers (the common title for the person heading ESG initiatives from the C-suite) tripled between 2021 and 2022.
Firms launch ESG efforts for a wide variety of reasons, the first of which is responding to consumer demands. Polling by PwC finds that supermajorities of consumers (83%), executives (91%), and employees (86%) endorse ESG principles. More than 60% of consumers likewise say they are willing to pay more for environmentally friendly products, while 75% say the environmental impact of the goods they buy concerns them. (Only small minorities, however, know what the term "ESG" actually means.) Majorities or near majorities of executives and other senior personnel also polled by PwC believe that ESG will have several benefits for their businesses, including better retention of talent. Such initiatives enhance a firm's public reputation and its perception in financial markets, which increasingly affect the opportunities for new ventures in the extractive and emitting industries, for example. Indeed, rating agencies have long looked at governance issues when evaluating default risk for corporate bonds, and they now also take environmental factors into account.
Given that many politicians also favor ESG activities, firms that engage in them might receive preferential treatment by those same politicians. The desire to stay in political leaders' good graces certainly influences some corporate managers. A large majority of CEOs surveyed by Deloitte last year said that regulation was behind their push to engage in ESG efforts. That said, the data are pretty clear that some part of the ESG movement is driven by market forces largely independent from politics. As such, there's no doubt that the market really does want ESG in some way. Investors have poured more than $2.7 trillion (just a little less than the GDP of the United Kingdom) into "sustainable" mutual funds that follow ESG principles. In short, ESG itself is a big and important enough business that it's simply not going to go away. And this has resulted in a flood of new state legislation.
THE STATE OF PLAY
Based on material collected by the the Harvard Law Forum on Corporate Governance and elsewhere, it's possible to divide ESG laws into four categories.
First, broad anti- and pro-ESG policy laws are just what they sound like: general policies — statewide statutes, rulings from top officials, or more limited guidance issued by pension funds or boards — that either seek to discourage or encourage the state to pursue ESG investments and contracts. A representative anti-ESG policy can be found in a memo from Indiana's attorney general: He quoted a law that required state funds to be used "solely in the interest of the beneficiaries," and that investing "to further general environmental, social, or governance goals, violates" fiduciary duties in existing statutes. On the other hand, the Oregon Investment Council (which oversees public pension funds in that state) has a pro-ESG policy. It reads: "The consideration of ESG factors...is important in understanding the near-term and long-term impacts of investment decisions."
Boycott bans, by contrast, seek to discourage ESG-driven divestment activities. States engaging in boycott bans bar interaction with companies that divest in certain industries — particularly in politically powerful industries like fossil fuels and firearms. Texas's 2021 law, for example, allows the state comptroller to make rulings as to whether companies "boycott" fossil-fuel industries (more on this below); if firms do have boycotts in place, they are blacklisted from state business. Similar laws have required Arizona government contractors to certify that they don't boycott firearms manufacturers and those doing state business in Kentucky to limit their fossil-fuel divestment.
Divestment, board, and disclosure mandates — the third of the four major ESG categories — aim to require or encourage many of the same policies that boycott bans prohibit. Maine's law, which requires divestment from fossil fuels within six years of its passage, is the most sweeping of these and the most directly connected to the ESG movement. Others are more limited: California, for example, forbids state-sponsored travel to any place state regulators judge to be discriminating on the basis of "sexual orientation, gender identity or gender expression." (This includes almost every state that voted for Donald Trump in 2020.) The Golden State also imposes gender quotas on the governance boards of major public companies.
Some policies that might be considered ESG-related if they were introduced today predate the current movement. For example, over 25 states — including some decidedly Republican-leaning ones like Texas and Ohio — have a renewable portfolio standard that directs investment toward forms of energy that emit less of the carbon dioxide that causes climate change. More limited state-level boycott bans — including 35 laws blacklisting companies that boycott the state of Israel — would also probably fall under the ESG banner if introduced today.
A review of ESG laws makes clear that, despite the movement's name, nearly all of the ESG policies enacted or under consideration deal only with the environmental and governance parts of the ESG agenda. The "social" component of ESG for most companies consists largely of philanthropy that supports uncontroversial charities, local schools, parks, workforce recruitment, civic associations, and volunteer fire departments. Nobody objects to these charitable activities, and they are not really public-policy issues or topics discussed under the ESG label in business schools. Businesses do get involved in more controversial social issues — including abortion, civil rights, and gender identity — that may be relevant to the ESG movement, but such issues haven't been the topic of much lawmaking.
Many efforts to respond to businesses' positions on social issues — the most prominent being Florida governor Ron DeSantis's dissolution of the special district controlled by the Walt Disney Company in his state after the company objected to his policies on sexual orientation and gender identity — have been simple acts of hardball politics. Another example is when states question companies' investments in firearms makers (only two of which are traded on public markets). But even in these cases, scrutiny of the companies has usually become inseparable from broader debates about the issue, and any bills related to it tend to reflect these general discussions rather than anything specific to a business.
PERVERSE INCENTIVES
The laws that have been proposed are a mixed bag, but the results of the more sweeping ones appear to be far more harmful than beneficial. Broad anti-boycott bills are a recent development, so there's no long-term evidence of their impact. That said, the law in Texas — one of only a handful that have been in effect long enough to measure their influence — caused nearly all of the largest municipal-bond underwriters to leave the state market. This exodus imposed costs of between $300 million and $500 million on the state, according to a research team at the University of Pennsylvania's Wharton School. The corporate environmental-advocacy group Ceres says that proposed laws similar to the Texas model in Kentucky, Florida, Louisiana, Oklahoma, West Virginia, and Missouri could have a total cost of as much as $708 million related to bond underwriting. The long-term predictions are even grimmer: Kansas's pension fund predicts a 10-year loss of $3.6 billion, and Indiana's a loss of $6.7 billion, as a result of anti-ESG bills that would place significant limits on investing activities.
The opposite of anti-boycott bills — divestment mandates — have a much longer history. They have also imposed significant costs and have rarely, if ever, accomplished their stated purposes. An analysis prepared for the giant California Public Employees' Retirement System (CalPERS) shows that a tobacco-divestment policy — in place since 2001 and the longest-standing major initiative of its kind in the country — has cost the fund $3.7 billion since 2001. CalPERS's sister fund, the California State Teachers' Retirement System (CalSTRS), finds even worse results: a total loss (as of December 2022) of more than $9.5 billion as a result of divestment mandates.
Even more troubling is the fact that these proposals may work against their proponents' stated purposes. Researchers at the Stanford and University of Pennsylvania business schools find that "the impact on the cost of capital is too small to meaningfully affect real investment decisions," and some evidence indicates that they may be counterproductive. A major 2009 study published by Harrison Hong and Marcin Kacperczyk in the Journal of Financial Economics, for example, determined that "sinful" stocks — those in firms related to alcohol, gaming, or tobacco — have better financial returns than similar stocks in other industries. The authors wrote that these companies are "neglected by norm constrained investors," thus making them good for investing plays. Widespread opposition to fossil fuels could well create the same situation in that industry, according to an analysis by Tom Johansmeyer in the Harvard Business Review. In other words, if anti-boycott laws continue to proliferate, they may have the same perverse incentives as the divestment mandates that preceded them.
Some types of anti-boycott or divestment bills may not do any discernible harm. Narrow anti-boycott bills in particular have impacts that are probably not measurable in economic terms and thus should be regarded as political statements. For example, most of the Russian divestment policies that dozens of states passed following that country's invasion of Ukraine haven't been implemented. Given existing federal sanctions and the minimal levels of American investment in Russia, they are also largely redundant or unnecessary. In these cases, it's worth asking: What have these laws really accomplished?
The problem with all sweeping divestment and anti-divestment proposals is simple: They limit the number of providers and investment strategies that states can use. All other things being equal, this lack of financial diversity will rule out some profitable investment strategies and raise the cost of capital. And it will hurt returns over time.
CalPERS's data may offer a hint of what is likely to happen. The retirement system's most recent study on divestment covered the 2017-2020 period, when gas and wind power displaced coal. As a result of California's mandate to divest in thermal-coal producers, $350 million was added to the fund's bottom line. But ESG-mandate proponents should not take this as a vindication of their ideas: The same policy resulted in the fund completely missing out on a big run-up in coal companies' value during 2022, when high natural-gas prices helped them increase profits and revenue. The right manager might have identified this possibility and made some thermal-coal investments, but the divestment mandate made this impossible. In the long term, even blanket divestment or anti-boycott policies that appear to be productive based on short-term results or back-testing will likely run into similar problems.
THE CASE FOR FIDUCIARY STANDARDS
In light of the damaging financial consequences of extensive ESG policies, what should state legislators be thinking about instead?
As legal fiduciaries of state-employee retirement funds as well as moral fiduciaries of all taxpayer dollars, state officials have an obligation to put financial interests ahead of anything else. Thus, they should never allow ESG to be the sole factor driving their investment decisions. The law is pretty clear on that already: As the U.S. Supreme Court wrote in its 2014 decision Fifth Third Bancorp v. Dudenhoeffer, the "benefits" to be pursued by pension-plan fiduciaries as their "exclusive purpose" do not include "nonpecuniary benefits." Any state that defines itself as a fiduciary of pension funds — and it's not quite clear how many do — is bound by these precedents. What's more, all governments have a moral responsibility to be good custodians of public money.
Private-sector firms thus clearly violate the law if they put non-pecuniary objectives first in managing employee-pension funds. A 2020 rule on pension plans issued by the Trump administration's Department of Labor — as well as some slight modifications made by the Biden administration in 2022 — affirmed this standard, which is deeply embedded in statutory and common law. For state business that is not related to formal obligations as a monetary trustee, state governments will take some non-financial factors into account. They might ensure that government largesse is spread around a state geographically, or create preferences (sometimes under court order) for groups who have historically faced discrimination. That said, elevating non-pecuniary factors for vague reasons of "environmental protection" or "social justice" will rarely, if ever, serve the interests of taxpayers or public-sector retirees.
States concerned about ESG activities can and should take clear action to protect taxpayers by defining fiduciary standards. This is important because the major provisions of the law governing private retirement plans — the 1974 Employee Retirement Income Security Act (ERISA) — do not apply to states. And while all states have laws governing their pension plans, their fiduciary standards are more nebulous.
In this context, North Dakota's 2021 ESG law is a good model for what states might consider as a starting point. It forbids state investments in ESG funds or other "social investments" unless "the state investment board can demonstrate a social investment would provide an equivalent or superior rate of return compared to a similar investment that is not a social investment and has a similar time horizon and risk." This bars the state from investing its assets in the Democratic Large-Cap Core Fund, or DEMZ, for example — an exchange-traded fund that "only includes companies that have made over 75% of their political contributions to Democratic causes and candidates" — because it obviously considers non-pecuniary factors. On the other hand, it places no limits on purchasing shares in, say, an actively managed energy-oriented mutual fund that has good returns, even if it is reducing its fossil-fuel holdings in anticipation of greater growth in the wind-power sector as society reduces carbon-dioxide emissions.
Laws that define such standards and establish who serves as a plan fiduciary have several additional advantages. First, because major ERISA provisions don't apply to states, the extent to which definitions of "fiduciary" apply to state governments remains untested. Some state courts, in interpreting state statutes, might grant significant deference to investment managers in determining what fiduciary duty consists of, or even find that no such duty exists at all. Defining standards clearly in a statute removes any ambiguity.
While the North Dakota approach is laudable for its simplicity and sufficient for most states, state legislatures probably do no harm by going further. Measures such as the State Government Employee Retirement Protection Act proposed by the American Legislative Exchange Council (ALEC) served as a significant source for laws in Montana and Arkansas. These attempt to replicate most of ERISA's major provisions and add additional safeguards, some of which arguably go beyond ERISA. Others, such as Florida's H.B. 3 "anti-ESG measure," dress up the same basic message in partisan red-meat language. Like the North Dakota and ALEC model laws, Florida asks state managers to carry out their fiduciary duties by considering only those pecuniary factors that affect investment returns.
One thing all such laudable ESG-related laws have in common is that they target investments rather than trying to blacklist investment managers. While some small firms and hedge funds may pursue a single strategy or type of strategy, all sufficiently large money managers pursue a vast number of different — and often contradictory — investment approaches to meet a variety of client needs. Certain categorical statements, such as "none of our funds will ever invest in any company that has any involvement with the firearms industry," may reflect a stance that puts a social position ahead of returns on investments. But broad commitments to, for example, working toward lower carbon-dioxide emissions or mitigating violence will not necessarily affect the behavior of any given fund, portfolio, or investment manager.
Beyond clarifying guidelines for pension funds and other state investments, state legislatures should attempt to limit financial regulators' ability to impose new ESG-related mandates on companies without specific statutory authorization. These regulators oversee insurance, banking, and other markets, and exist primarily to ensure that institutions can fulfill their financial promises and protect consumers. Efforts to attend to other factors can undermine these basic responsibilities. As such, ventures like California insurance regulators' rules requiring burdensome disclosures — likely as a prelude to efforts that would prevent insurers from investing in disfavored energy industries — as well as New York state banking regulators' efforts to deny banking services to the National Rifle Association, should be slapped down as clear overreach. While the statutes differ in every state, legislatures should review the duties of their financial-services regulators in particular and, where necessary, remove individual political discretion in allowing them to "discover" new types of risk factors before they are widely accepted and, ideally, embedded in statute. At minimum, they should forbid pension managers and regulatory officials from creating new risk factors from whole cloth, issuing blacklists based on their own authorities, requiring regulated industries to disclose data in a politically motivated manner, or otherwise usurping what should be the legislature's prerogative.
Fiduciary-standard laws are clearly a necessary step to confronting the financial risks that come from ESG guidelines. But as long as politicians seek to win elections and cater to various interest groups, some types of laws targeting disfavored industries and causes are inevitable. That said, divestment mandates, particularly symbolic ones, are a bad way to do this. Even the most unobjectionable divestment initiative creates an opening for pernicious policies on other issues in the future.
Legislators who desire to make a political point, therefore, might search for ways to do so without imposing a universal mandate on all businesses seeking state contracts or investments. Rather than taking symbolic action to "boycott Russia" through divestment efforts that probably won't do anything at all and are difficult to implement in any case, for instance, political leaders might consider efforts ranging from the puckish (renaming a state road that houses a Russian consulate after imprisoned opposition leader Alexei Navalny) to the meaningful (creating state-university scholarships for Russian dissidents). These actions might involve more thought and money, but they avoid the slippery slope of setting up blacklists that undermine legislatures' moral role as guardians of taxpayer dollars.
State lawmakers have many options for upholding their fiduciary duty, but there is one thing they shouldn't do: use reasonable concern about ESG efforts to second-guess corporate-management decisions, cede power to other state officials, or rule out doing business entirely with certain companies because of a single statement or policy. Texas's existing law, the most sweeping and well studied to date, provides a clear example of a bad policy. It allows the use of publicly available information "appropriate in the comptroller's judgment" to create a list of financial companies that so much as "limit commercial relations" with other firms that engage "in the exploration, production, utilization, transportation, sale, or manufacturing of fossil fuels." It permits this to be done if the company acts "without an ordinary business purpose," but leaves that phrase undefined in its own text. If the comptroller decides that a firm is "boycotting," it is placed on a blacklist that now includes major financial companies such as BlackRock and UBS.
Even if this were a good fiscal policy, the Texas law simply cedes too much power to other state officials for legislators to tolerate. In fact, the law creates near unlimited discretion that could be misused to stop the state from doing business with almost any company. Already the Texas comptroller has decided that membership in three coalitions — Climate Action 100, the Net Zero Banking Alliance, and the Net Zero Asset Managers Initiative — should be judged as evidence that a firm is engaging in a boycott of fossil-fuel industries. The plain language of the law, however, is more reasonably read as requiring companies to engage in investment-related actions, rather than simply making public statements about their intentions.
The Texas blacklist also assumes that participation in these coalitions lacks "ordinary business purpose" even though reducing carbon-dioxide emissions could have a wide range of bottom-line benefits, from investment in sectors likely to grow as fossil-fuel use declines to premium pricing from a public-relations boost. This state of affairs could get worse: Because the law's plain language clearly allows the blacklisting of a company that simply limits its activities, the Texas comptroller might decide that most any rebalancing of a company's portfolio away from fossil-fuel investments is "without an ordinary business purpose."
Indeed, because all larger investment firms rebalance portfolios continually, this probably means that any sufficiently large financial manager could be blacklisted at almost any time if the comptroller decides that its decision lacked "ordinary business purpose." Such moves would be hard to challenge in court because the law clearly allows the comptroller — not the legislature or some other body — to decide what is "appropriate" in making a determination. Likewise, a firm that has an ESG-oriented fund that it offers only to private clients could conceivably be placed on a blacklist simply for carrying that fund even if a state agency wants to buy the same company's low-cost index fund.
Many decisions that fall under the ESG umbrella can and do serve significant business purposes. State officials are unlikely to recognize this; they are in a poor position to know exactly why firms make decisions or how companies determine what's in their business interests. Granting state officials the authority to interpret these decisions, whatever the intentions, equips them with enormous arbitrary power to punish enemies and reward friends. These officials, therefore, should not be making ESG concerns their main objectives or trying to second-guess private-sector actions. State lawmakers would do better to require officials to focus on states' own fiduciary duties.
If the mere signing of a pledge also results in a company being blacklisted, then the law would make companies reluctant to exercise their constitutionally protected right to speak out on issues of public concern. This may well lead to constitutional challenges that, given recent affirmations of corporate-speech protections, could plausibly succeed. (Such challenges, of course, are also a risk for conventional hardball politics, like DeSantis's efforts against Disney.) Regardless, purely private and voluntary matters involving ESG should be considered beyond the scope of governmental decision-making, particularly at the state level. If an act is so bad that merely engaging in it makes a company ineligible for all state investments and contracts, then legislatures are better off simply outlawing the behavior or directing the executive to enforce existing laws against it than taking the halfway step of blacklisting firms.
VALUE BASED VERSUS VALUES BASED
ESG can do some good if it is based on the same criteria as most other business decisions — the creation of economic value — rather than the values of investment managers. In this context, state governments should also appreciate what the ESG movement could potentially accomplish. At its best, the ESG movement makes the externalities of business behavior more apparent and thereby allows firms to mitigate them through voluntary market activity rather than mandates. An ideal ESG system could provide what Nobel laureate Ronald Coase famously described: a market characterized by near-perfect information, well-defined property rights, and no transaction costs, which would allow it to regulate its externalities entirely without coercion. Such situations almost never exist in pure forms outside of localized environmental problems. But Coase's fundamental insight — that markets can handle externalities when the right rules and measures are in place — remains a vitally important economic principle.
ESG holds some promise in leading society to a better way to deal with problems, so long as firm leaders remain focused on the creation of value rather than the exercise of their own preferences. Indeed, many defenses of ESG from the left are couched in terms that would have been familiar to Coase. Writing in the Wall Street Journal, former vice president Al Gore and his business partner David Blood emphasize "developing comparable data sets on impact, robust standards, and measurement and reporting norms" in their discussion of ESG investing and fiduciary duty. They make the obvious point that "negative environmental and social effects are headwinds on future business success; positive effects are tailwinds."
Insofar as voluntary ESG efforts point companies in the right direction, they have the potential to limit the role of the state. In theory, at least, a sufficiently robust system of corporate commitments backed by honest, objective data could significantly limit the need for the government to even regulate a wide variety of environmental and social outcomes. Consumer- and investor-protection agencies, for the most part, already can regulate misleading claims. A company that falsely declares to have reduced its carbon-dioxide emissions should face the same types of sanctions as one that lies about its earnings.
Private efforts to define ESG metrics in a rigorous way — a project spearheaded most prominently by the SASB Standards, which are now part of the International Sustainability Standards Board — deserve to be lauded. That said, governments would do best to follow rather than lead markets in deciding which ESG standards — if any — have such bottom-line relevance that their disclosure reporting must become a matter of law or mandates. Such disclosure mandates, if they are to exist at all, are best issued at the federal level for simple reasons of efficiency. States should not tie the hands of investment and contract managers by demanding that any single metric in isolation — be it carbon-dioxide emissions or, for that matter, returns over the past year — be the only reason to decide on a business relationship or investment decision.
For now, the ESG movement is simply too new for state governments to adopt useful interventions. If legislators think they must provide guardrails or guidelines, they should do so in a fashion that preserves their own power and allows for a diversity of investment approaches. States can and should use their "soft power" — convening experts, employing the prestige of public universities and special recognitions — to explore ways of measuring ESG outcomes. In time, these metrics might well serve as important ways to allow the market, rather than the state, to ensure environmental protection and other important outcomes.
The evidence remains unclear about whether ESG strategies serve investors better than others, but nothing suggests they are always worse. Because ESG objectives and strategies are diverse, the financial performance of related investments varies and will always do so. ESG funds, on average, "have consistently ranked around the middle of their peer groups," according to the financial-services company Charles Schwab. In the three-year period between 2019 and 2021, Schwab found that ESG funds slightly outperformed U.S. equities as a whole. In 2022, as oil and gas stocks did well in a down market, these same funds slightly underperformed the overall U.S. stock market. Purely values-based ESG will likely compromise long-term risk-adjusted returns but could yield the environmental or social impact sought by an individual investor. Pecuniary-only ESG funds may seek opportunities like those in the low-carbon transition, or those with a longer investment horizon or a lower risk profile; empirical evidence suggests this is a valid strategy. ESG may not be for everyone, but the vast amounts of money already being spent on it suggest that it should remain on the table.
In short, value, not values, should be at the heart of such public-sector investment decisions. Exercises in purely values-based ESG should be an option for private investors, of course. But states shouldn't support or even engage in it, except perhaps when it comes to defined-benefit retirement plans in which employees select their own investments from a broad universe of choices. Trying to ban firms from state business for boycotting favorite industries, or requiring widespread state divestment, has the same problems as entirely values-based ESG investments and divestment mandates: These practices will almost always be done without knowledge of any firms' specific circumstances and in a manner that hurts long-run returns and is clouded by individual preferences and political concerns. ESG-related factors often do directly influence pecuniary ones. As such, outright barring their use is likely to decrease risk-adjusted returns.
For all of the hype and consternation related to this investment approach, ESG metrics are best considered as a type of management tool that's neither good nor bad in itself. State governments should prevent the abuse of ESG investing through strong, sweeping, and clear fiduciary standards, but legislatures should neither require divestment nor write vague anti-boycott laws. Doing so could close off the ESG movement's potential to facilitate voluntary, market-based, and limited-government solutions to a variety of important societal problems.
