Will the US Department of Labor’s ESG rule be rescinded?

The DOL’s rule to discourage ‘non-pecuniary’ ESG investing was widely seen as a Trump-era attack on sustainable finance. But what will its future be under new US President, Joe Biden?

The US Department of Labor’s ‘ESG Rule’ received more backlash from the sustainable investment industry than any other anti-sustainability rule introduced under former US President, Donald Trump.

The rule, officially known as Financial Factors in Selecting Plan Investments, seeks to overhaul the Employee Retirement Income Security Act (ERISA) – the rules that govern employer-backed pension funds – “in light of recent trends involving ESG investing”. The DOL said it was “concerned” that those trends may prompt investors to “choose investments or investment courses of action to promote environmental, social, and public policy goals unrelated to the interests of plan participants and beneficiaries in financial benefits from the plan”. And so it wanted to clarify that fiduciaries should steer clear of such investments or actions unless they could prove they wouldn’t hurt returns. 

Its anti-ESG credentials were never in question. “ERISA doesn’t task retirement plan managers with solving the world’s problems,” wrote former US Secretary of Labor Eugene Scalia in an op-ed for the Tampa Bay Times, a local newspaper in Florida – a state whose population includes a huge proportion of retirees.

The final rule came into effect in January this year, and largely eschewed the use of the abbreviation ESG, instead opting for the phrase ‘non-pecuniary’ (it isn’t clear whether the DOL makes a distinction between ‘non-pecuniary’ and ‘non-financial’). Nonetheless, many believe it still makes incorporating ESG in investment portfolios much more difficult for ERISA fiduciaries.

‘Even if the rule is rescinded, investors are still going to have to prove that ESG investments are better than a non-ESG equivalent and prove a higher return and/or lower risk’ – Moody’s Owais Rana

Newly-elected President Joe Biden has promised to be more supportive of responsible and green investment endeavours, and has ordered a review of more than 100 environmental rules introduced under his predecessor. It’s a move that’s likely to result in the ESG Rule being undone, but this could take more than a year.

“Irrespective of whether the Biden administration is going to change the DOL ruling, the industry is having to deal with the rule at the moment,” observes Owais Rana, who works with consultants and asset management for Buy-Side Solutions at Moody’s Analytics. “And fund managers and plan fiduciaries are still going to have to justify ESG investments’ position within their portfolios. They are still going to have to be compliant with providing the new disclosures that are required.”

He says that a lot of work is currently being done by asset managers and their legal teams to ensure compliance before the deadline of April 2022. “Everyone wants to be safe and not be caught off guard by speculating whether this is going to go away or not. Everyone is putting in place material disclosures and the right compliance procedures so that they will have all the right documentation.”

These worries about ESG investing could mean US pension funds are missing out on major opportunities to make money for their schemes. According to a report released last month by Morgan Stanley, US sustainable equity funds outperformed their conventional peers by an average of 4.3% last year. 

When the ESG Rule is eventually reviewed, there are three possible conclusions:  

  1. Get rid of the rule altogether and retain focus on making money above all other considerations. 
  2. Leave the rule in place because it isn’t as bad as everyone made out.
  3. Rewrite the regulations to remove any ambiguity or vagueness. 

According to a blog by law firm K&L Gates, because the final rules came into effect before Biden’s inauguration, the new administration “may rescind or amend the final rule by undertaking a new notice-and-comment rulemaking and providing a rational justification for why the rule is no longer appropriate in its current form”. This process can limit the possibility of removing a rule altogether, but it does allow it “to implement well-reasoned alternatives”.

When it comes to overturning the rule, though, Rana says it is important to keep in mind that it is not really about preventing ESG investments. 

“In terms of the financial outcome being the most important thing when making investment decisions, the rule has always been there,” he says. “This new rule is not saying you can’t invest in ESG, it is just saying if you are going to invest in ESG, don’t forget the rule that is already in place – you need to prove that, if your philosophy is going to be led by ESG investments, those ESG investments will provide either a higher return or a lower risk, or both, compared to an equivalent non-ESG investment.”

Because of the confusion surrounding the definitions of ‘pecuniary’ and ‘non-pecuniary’, all of Rana’s clients have told him they are seeking legal advice to better understand what the final regulations actually require them to do.

“Even if the rule is rescinded,” he says, “investors are still going to have to prove that ESG investments are better than a non-ESG equivalent and consultants will still have to be able to prove a higher return and/or lower risk for the products they are marketing where ESG is being promoted, as will any financial advisors and other stakeholders and constituents of the investment process.”

The final rules permit investors to consider only pecuniary ESG factors, which has been taken to mean those that are financial material to investments. But, in its paper Is the ESG Boom here to Stay?, ISS Market Intelligence says the rule “leaves some wriggle room to allow consideration of non-pecuniary ESG factors as a tie-breaker between two comparable investments”. This pecuniary standard is also applied to third-party ESG ratings, notes ISS Market Intelligence, and performance benchmarks, “meaning that both must be built using factors with material risk/return impact”.

On whether the rule will be cancelled, ISS Market Intelligence notes “the rushed rule-making process as well as the unusually abbreviated period for public comment and agency response make the rules vulnerable to court challenge”.

K&L Gates also says that changes to the final rule allowed it to narrowly avoid being a “major rule” – this is what allowed the rushed process – and these changes actually made it more difficult to reverse. But it predicts that change, although it will take time, is more than likely.