The U.S. is witnessing a growing state-level patchwork of regulations designed to spur sustainable ESG investments. In Part 1 of a two-part series on ESG, Kirkland & Ellis’s Ali Zaidi says while federal regulators are fairly silent, states seem eager to fill a regulatory signaling void—becoming the stateside regulators to listen to on ESG matters.
Discerning investors and fund managers can finally hear stateside regulators signaling on sustainable investment— but only if they are listening in the right places.
Today, more than the federal government, certain states are leading on procedural and substantive regulation designed to spur sustainable investment. These states are leaning into the market’s growing focus on managing capital using environmental, social, and governance (ESG) factors and, in turn, making ESG an even more important consideration for those raising and managing funds across the liquidity spectrum.
The approach may seem unusual for those familiar with the European and Japanese regulatory approach to scaling up sustainable investment. Rather than a single national framework, the U.S. is witnessing the development of a state-level patchwork. If the international experience on ESG has been systematic, in the U.S. it feels a bit stochastic.
Yet, through regulation of pension systems, trust funds, and board composition— using disparate tools in different ways—states are signaling something clear: Even if the federal government is standing still on ESG, they are not.
Lessons from California
Perhaps the best known state signaling has been by California’s leading pension systems: the California Public Employees’ Retirement System (CalPERS) and California State Teachers’ Retirement System (CalSTRS).
For over a decade, California has been integrating ESG factors into the way it has managed these funds, and, in more recent years, has become growingly specific about how it considers ESG. This approach has shaped not only the funds in which California invests (e.g., through demands on investor agreements and in side letters) but also the broader market. For example, CalSTRS “21 Risk Factors"—which form the core of its ESG policy and have existed for over a decade (undergoing the last significant revision in 2018)—have come to serve as a benchmark for a number of asset managers who are incorporating CalSTRS’ leadership into their approach to ESG integration.
But California is not alone in leveraging regulation of its pension systems to advance sustainable investment. The trend has manifested in other states, including Connecticut, Illinois, New Jersey, New York, Oregon, and Washington. In fact, certain city-managed pension systems have also taken up this approach, including Boston, Chicago, New York, and Seattle.
Illinois Action Could Be National Model?
Among these leading states, Illinois took significant new legislative action recently that could serve a national model. Signed into law last month, the Sustainable Investing Act, also known as HB 2460, becomes effective in January 2020. Rather than focus on any one agency, the new law requires all public or government agencies involved in managing public funds to “develop, publish, and implement sustainable investment policies applicable to the management of all public funds under its control.”
The new law draws a broad definition of public funds, including “current operating funds, special funds, interest and sinking funds, and funds of any kind or character belonging to or in the custody of any public agency.”
Beyond signaling high-level principles, however, the law is careful to defer the particulars to agencies. Instead of legislating something akin to CalSTRS “21 Risk Factors,” the law provides this guidance to agencies: a “sustainable investment policy should include material, relevant, and decision-useful sustainability factors [and such] factors may include, but are not [to] be limited to: (1) corporate governance and leadership factors; (2) environmental factors; (3) social capital factors; (4) human capital factors; and (5) business model and innovation factors.”
The coming months will show how exactly each Illinois agency implements this mandate, with each agency given discretion under the new law—but all facing the same end of the year deadline. Growingly, implementation of such initiatives has become a multi-stakeholder process, especially as public leaders seek both to maximize the leverage of ESG policies and minimize the political risk associated with such strategies.
Whether in Illinois or elsewhere, stakeholders are likely to see the sort of request for proposals (RFP) that just concluded in New Jersey. Titled an RFP for “Environmental, Social and Governance Ratings Research and Related Services,” the call sought to enlist the support of private sector experts in implementation. Such calls themselves provide a weak regulatory signal— shaping in a soft way how the broader market approaches ESG.
Certain leading states are also looking to extend their ESG energy beyond public funds. Although more permission than mandate, Delaware passed a law in its last legislative session clarifying that ESG consideration could be appropriate in the management of an estate’s funds.
Specifically, Delaware added the following to its Code: “when considering the needs of the beneficiaries, the fiduciary may take into account the financial needs of the beneficiaries as well as the beneficiaries’ personal values, including the beneficiaries’ desire to engage in sustainable investing strategies that align with the beneficiaries’ social, environmental, governance or other values or beliefs of the beneficiaries.”
Taking Aim at Climate Change and Diversity
Such laws show states using their regulatory powers to broaden the reach of ESG even where the federal government may not be facilitating the same. Many of these states do not seem content with regulatory signaling on ESG process alone. Instead, they are advancing sustainable investment through substantive regulation as well, taking initial aim at climate change and gender diversity.
For example, legislation pending in Massachusetts, Minnesota, New Jersey, New York, and Vermont seeks to restrict investment of publicly managed funds in fossil fuels. These legislative efforts build on what several dozen cities have already done—the largest among them being Denver, Minneapolis, New York, and San Francisco. Led by California’s groundbreaking legislation mandating gender diversity on corporate boards—with an initial deadline at the end of this year—a number of other states are working to scale up this substantive regulatory approach to advancing sustainable investment.
In Michigan, SB 115 would impose requirements similar to California on its domestic corporations (albeit on a later timeline), mandating one female director by the end of 2021 and scaling that requirement up by 2023 based on the size of the corporation. In New Jersey, S3469, and its counterpart A4726, seek to establish requirements that are substantially the same as California and Michigan.
Other states are pursuing softer signaling, such as Pennsylvania’s proposed resolution to “encourage” increased gender diversity, and Illinois, Maryland, and New York’s proposed bills that would merely push for greater data collection and transparency. Using disparate tools in different ways—the efforts by these states are signaling something clear: Even if the federal government is standing still on ESG, they are not.
To be sure, states are limited in their ability to marshal the sort of market-wide consistency of ESG practice that investors increasingly seek and that the federal government can best provide. However, with their massive fiscal footprints and regulatory reach, states can continue to move the needle. In the near-term at least, with federal regulators fairly silent, the states seem eager to fill the regulatory signaling void—becoming the stateside regulators to listen to on matters of ESG.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Ali Zaidi is of counsel in the Washington, D.C., office of Kirkland & Ellis, and focuses his practice on identifying, mitigating, and managing climate and environmental risks and is a leader in the firm’s Sustainable Investment & Global Impact Group. Zaidi previously served as associate director for natural resources, energy, and science in the White House Office of Management and Budget and deputy director for energy policy in the White House Domestic Policy Council.