Governments, not markets, Impel ESG

From an obscure academic topic to a major campaign issue, ESG (Environmental, Social and Governance) investing has exploded onto the political scene. Projections show that ESG fund assets will grow from around $20 trillion in 2022 to a staggering $40 trillion in 2030.

Our new leaflet in Santa Clara Journal of International Law examines whether market forces or government interventions are driving ESG growth. We conclude that government policy, not investor preferences, primarily drives ESG.

Governments around the world have imposed numerous ESG-related regulations, and many more are pending or under consideration. In fact, governments are activating a surge in ESG risk as forward-looking investors seek to exit soon-to-be sanctioned sectors such as oil, natural gas and firearms.

On a level playing field, ESG-weighted portfolios compete with market-tracking index funds that provide better diversification and risk reduction. Government regulations mandating climate-related disclosures benefit ESG funds by limiting options for investors, making securities in ESG portfolios more attractive than they would be under (more) perfect competition.

Whether market pulls or government pressures drive ESG also influences the interpretation of the emerging “anti-ESG” movement. Do some states restrict or prohibit the investment of state dollars, including public pensions, in ESG, limiting investor freedom or protecting investors from predation by other governments?

We document a variety of government actions promoting ESG integration in financial markets. Governments are unleashing an arsenal of policies, including mandates, regulations, taxes and subsidies.

Government emission reduction commitments under the Paris climate treaty are driving the renewable energy transition in the European Union, Australia and the United States. The European Union and the United States offer various tax credits and subsidies for clean energy projects and energy efficiency improvements.

The Biden administration is subsidizing wind, solar, electric vehicles and charging stations and imposing stricter emissions standards for new vehicles and power plants. President Biden’s executive order led to ESG action by the Financial Stability Oversight Council, the Securities and Exchange Commission, and the Department of Labor.

Additionally, most states have renewable portfolio standards requiring utilities to obtain a significant portion of their electricity from renewable sources such as wind and solar power, with some states setting a goal of generating power from 100% renewable sources.

On the other hand, governments also impose disincentives such as taxes or bans on the sale of crude oil, plastic packaging and fertilizers.

The European Union is leading the way on ESG with its Green New Deal, climate law and new reporting standards to reduce emissions. The European Sustainability Reporting Standards impose mandatory ESG disclosures and audits. Similar mandates for disclosure of climate data, diversity metrics and sustainability practices have been implemented or proposed in the UK, France, Canada and Australia.

Governments are increasingly mandating disclosure of ESG data such as greenhouse gas emissions and board diversity. While private organizations such as the Climate Disclosure Standards Board seek voluntary standardization of ESG ratings, governments enforce disclosures. More than 60 jurisdictions, including all G20 members, mandate ESG disclosures, mainly through financial regulation or stock exchange listing rules.

Efforts such as the Task Force on Climate-related Financial Disclosures, supported by major financial institutions and institutional investors, demonstrate the global push to increase climate-related disclosures in the financial sector.

ESG requirements for listed companies have become commonplace. Both NASDAQ and Dow Jones have introduced board diversity policies and sustainability metrics. Exchanges are technically private, but they are highly regulated, and governments have imposed these rules. European stock exchanges have imposed similar rules.

Financial markets were highly regulated long before ESG emerged. We therefore examined whether the regulations merely granted regulatory permission to investors interested in socially responsible investing. The Department of Labor’s authorization of ESG retirement investments is one of the few compliance measures, although it raises questions about fiduciary duty. For the most part, the regulations resemble the SEC’s climate reporting mandate.

Last year, leading financial institutions withdrew from ESG, resulting in a net outflow of funds from ESG funds. This divestment suggests that financial institutions may have overestimated market demand for ESG solutions. This also confirms our assessment: governments have been taking care of ESG all along.