To ESG or not to ESG? Fiduciary duty is the question.


For trustees of pension funds, what does trust law say about ESG investing? 

Some folks[i] claim that ESG investing is a breach of fiduciary duty. Some folks[ii] claim that not-ESG investing is a breach of fiduciary duty. These are not just different positions; they are exclusive. There’s a lot at stake. How did that happen?

Fiduciary duty has two components. Let’s break it down:

  • Duty of loyalty: the trustee must act in the sole interest of the beneficiary
  • Duty of prudence: the trustee must construct a diversified portfolio with risk and return objectives reasonably suited to the purpose of the trust

Claims that ESG investing is a breach of fiduciary duty note that investments intended to benefit third parties (e.g., “society”) violate the duty of loyalty.

Claims that not-ESG investing is a breach of fiduciary duty argue that investments which ignore material environmental, social, or governance risks violate the duty of prudence.

It may now be apparent that the notions of “ESG investing” found in these two claims are different from each other. In particular, they refer to two different uses for comparable—sometimes even identicaldatasets on environmental, social, and governance factors. In their article “Reconciling Fiduciary Duty and Social Conscience[iii]” in the February 2020 Volume of the Stanford Law Review, Northwestern University Law Professor Max M. Schanzenbach and Harvard Law Professor Robert H. Sitkoff could only make sense of the confusion by differentiating the two approaches with these terms: “risk-return ESG” and “collateral benefits ESG”. Risk-return ESG, focused on financial materiality of ESG data, aims to improve return, manage/reduce risk, or both. Collateral benefits ESG invests with the intention of collateral benefits to third parties.

How did we get here?

Around the turn of the millennium, two distinct investment trends quietly collided. On one hand, ethical investing or socially responsible investing. On the other hand, the data revolution. A subset from each coalesced around a new and most meaningless signifier, but which reflected what they shared: a data type. And so ESG was born. Schanzenbach & Sitkoff say ethically-minded investors co-opted the collision, squeezing their ethical concerns onto the risk-return agenda. At worst it was a symbiosis, as the return-focused investors haven’t minded the ethical sheen.

Who will entrust the entrusters?

Let’s have a look at what the regulators, the lawyers, the investors say. Schanzenbach & Sitkoff give three clear conclusions in relation to American trust law:

  • Risk-return ESG can be consistent with fiduciary duty when it is expected to improve risk-adjusted return, and trustees are motivated solely by this consideration.
  • Collateral benefits ESG is a violation of fiduciary duty, at least when trustees are motivated by these collateral benefits. There are exceptions to this, in particular when trustees are ‘authorized’ by their beneficiaries to target these collateral benefits, or if those benefits are consistent with the charitable purpose of the trust. Either way, the “sole interest” of the beneficiary is still a good guide; these exceptions simply rely on a definition of that interest beyond pecuniary terms (though this is impossible where ERISA applies).
  • Whether the duty of prudence requires trustees to consider ESG (risks) is an open question. Schanzenbach and Sitkoff conclude that it probably does not, in the US. There can be effective investment strategies with other investment theses and risk management methods. This is consistent with the US Department of Labor’s 2018 guidance[iv] that fiduciaries “must not too readily treat ESG factors as economically relevant”.

Part of the reason consideration of ESG risks is not a duty of prudence in the US is because the market may already price these risks, akin to an argument for passing investing. At Record, we see that the lack of universal ESG integration means that ESG has more scope to create an investment advantage. This is all the more true when it is used in innovative models or new asset classes—like currency!

In the UK and the EU, the consideration (integration) of ESG risks has been legislated as an investor duty. Both, however, specify that this is with respect to financially material ESG factors: they still mean risk-return ESG.

The European Union is one step ahead, though. By naming and distinguishing the two directions of causality (giving us this handy diagram to boot!) they can regulate the two separately. As above, ESG risks must be integrated, and the form of that integration must be disclosed. In addition, “principal adverse impacts” (negative externalities) must be disclosed.

Source: Official Journal of the European Union

So, the three jurisdictions judge differently on the duty of prudence, with the UK and EU saying ESG integration is necessary, and the US saying it’s OK but not necessary. But they judge the same on the duty of loyalty. You still can’t play with other people’s money to benefit third parties.

Is that case-closed?

The only thing more confusing than taking a single concept and pulling it into two parts is to make some progress with it and then try to put them back together. The truth is, collateral benefits ESG and risk-return ESG do have a lot of overlap, and not just in their datasets. It’s a loopy world—feedback loopy, that is.

Reducing exposure to financially material EGS risks can go hand-in-hand with containing negative externalities of investment. The reason is that many of those risks derive from the externalities themselves, especially in the presence of reputational or policy feedback loops. The mechanism has two configurations. Allocation ESG: allocating capital away from business (or issuer) activity with high ESG risk changes the incentive structure for those economic activities, and directly limits those activities by reducing their supply of capital. Stewardship ESG: engagement, proxy voting, and shareholder resolutions open opportunities for investors to modify the business activity by leveraging ownership rights[v]. Both allocation ESG and stewardship ESG have risk-return and collateral-benefits forms.

How much overlap is there exactly between ESG risks and negative externalities? Possibly less than one would hope. For example: Greenhouse gas emissions is a universal ESG metric. While emissions are certainly an externality, that becomes an ESG risk only where it either reaches some reputational threshold (e.g., the fossil fuel industry) or where there’s a policy such as a carbon tax to internalize the distributed costs of those emissions. In the USA, save for a few power sector programs in a handful of states, that’s a potential future world, not a present world. Even if a carbon tax comes[vi], size and implementation will determine whether it is (was) financially material to the present value of affected assets.

In contrast, for very large investors or groups of investors, negative externalities can become financially material through systemic (e.g., climate, social, market, or behavioral) effects—an aspect underexplored in the literature.

With more overlap, ESG investing becomes a win-win for everyone. With less overlap, we have to continue facing uncomfortable trade-offs. But the complexity of judging ESG risks, externalities, and where they align or don’t, means that even if we achieve some clarity in how fiduciary rules apply in theory, we may be hardly better off applying them in practice. Because, unsurprisingly, the devil’s in the ESG-tails.


[i] Amir Amel-Zadeh & George Serafeim, “Why and How Investors Use ESG Information: Evidence from a Global Survey”, Financial Analysts Journal, Dec. 2018, at 87, 91-92, 91 tbl.2 (finding that 22% of surveyed U.S. investment professionals not using ESG factors believe that doing so would violate fiduciary duty)

[ii] Fiduciary Duty in the 21st Century: Final Report

[iii] Max M. Schanzenbach & Robert H. Sitkoff, “Reconciling fiduciary duty and social conscience: the law and economics of ESG investing by a trustee,” Stanford Law Review, Vol 72. (February 2020).

[iv] U.S. Department of Labor, Field Assistance Bulletin, No. 2018-01

[v] The Business Roundtable (an association of U.S. CEOs) in their version of ‘stakeholder capitalism’ claims this alignment between financial sustainability and stakeholder benefits should be achieved by corporate managers. Their proposal, however, includes no increased accountability to stakeholders (including to investors) other than themselves, so a cynic may not differentiate this from ‘Corporate Manager Capitalism’. See Matt Levine, “Maybe CEOs are Fed Up with Shareholders”, Bloomberg. August 19, 2019.

[vi] Is it inevitable?

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