Investors Seek Consensus on ESG as a Fiduciary Duty

As debate continues, funds such as CalPERS are working environmental, social and governance factors into their investment process.


James Andrus of the California Public Employees’ Retirement System defines fiduciary duty differently today than he did a decade ago, even though the laws governing it in his state and the U.S. have remained constant.

“As a practical matter, the definition of fiduciary duty has not changed,” notes Andrus, a portfolio manager on the global governance team at $286 billion CalPERS. “But the view has developed over the past ten years that if you are a long-term investor, you have to take environmental, social and governance factors into consideration because of the adverse implications of not doing so.”

Mark Carney, governor of the Bank of England, reflected that view in a speech last month at the headquarters of U.K. insurer Lloyd’s of London. “The combination of the weight of scientific evidence and the dynamics of the financial system suggest that, in the fullness of time, climate change will threaten financial resilience and longer-term prosperity,” Carney told members of the insurance industry.

Fiduciary duty laws are meant to ensure that money managers act in the best interests of their beneficiaries. Pension funds widely accept the necessity of such measures, but debates have erupted in recent years around the laws’ true intent as integration of so-called ESG factors has grown more popular.

One central question: Can asset owners and their managers consider nonfinancial factors like a company’s carbon exposure or recent human rights violations, even if immediate effects on financial returns are only part of their motivation?

The authors of a new report published by the United Nations hope to end this debate. Fiduciary Duty in the 21st Century is a follow-up to a 2005 report commissioned by the U.N. from London-based international law firm Freshfields Bruckhaus Deringer. That report got investors’ attention with its statement that making ESG factors part of the investment process is “clearly permissible and is arguably required.”

The 2015 document, whose four authors include Rory Sullivan, a senior research fellow with the Center for Climate Change Economics and Policy at the University of Leeds, goes further. “The conclusion of this report is there’s so much evidence of change in the ten years since the Freshfields report that it’s actually reasonable to say there is a positive duty to consider ESG,” says Nathan Fabian, London-based head of policy and research at Principles for Responsible Investment, a U.N.-led investor network.

In countries such as the U.K., Japan and South Africa, regulators have introduced voluntary stewardship codes whose investor signatories commit to engaging with companies. Next January the Canadian province of Ontario will join Germany, Spain, Sweden and several other nations by requiring pension funds to disclose if they’ve incorporated ESG factors into their investment processes.

But Fabian points out that the market still lacks consensus on whether full ESG integration violates fiduciary responsibility. In the U.S. especially, “a particular set of legal instruments and guidance notes have led to a popular understanding of fiduciary duty in a very narrow frame,” he says.

Andrus and his colleagues at Sacramento-based CalPERS interpret that frame as wide enough to include ESG. As a matter of policy, the largest U.S. public pension fund asks all of its internal and external managers to incorporate these factors into their investment decisions. The emphasis that CalPERS puts on ESG will only grow stronger, says Andrus, who is a member of U.N. PRI’s research and policy committee and was interviewed for the recent fiduciary duty report.

“Going forward, all else being equal, if two managers come to CalPERS, one with ESG capacity and one without, we go with the former,” he explains. “In some cases we’re asking managers to develop ESG capacity.”

Michael McCauley, senior officer of investment programs and governance at the State Board of Administration of Florida, acknowledges that the board of trustees, management and staff who help manage the SBA’s $180 billion in assets “get a little anxious” about the idea of integrating ESG factors into the portfolio.

Staff consider it part of their fiduciary responsibility to monitor companies’ environmental, social and governance policies “at a very fundamental level” so they can keep an eye on financially material risks, McCauley says. But when it comes to using ESG analysis to try to manage for long-term risks, inaccurate predictions are likely in the absence of a crystal ball, he contends.

“I think the long term is really overemphasized,” McCauley says. “It becomes this abstract notion. You can’t model out 15 years; the cone of uncertainty surrounding those estimates is huge. You go out anything more than five to ten years, and it’s like throwing darts.”

Those who call for a rethink of fiduciary duty by pulling in more ESG analysis tend to assume that analysts know what’s going to happen in energy and other industries over the medium to long term, McCauley argues. That can create a compulsion to phase out investments in certain sectors, overlooking their current returns, he says.

For CalPERS’s part, Andrus says that because the pension provider needs to be invested widely across the market for the long term, he and his colleagues consider the health of the economy as a whole. “If you’re concerned about the overall economy, part of what that means is we need clear air, clean water, the lack of climate change and all of those other things in order to be able to fulfill our obligations,” he contends. “If we’re not focused on those things with the companies in which we invest, we’re not fulfilling our fiduciary duty.”

Fabian of the U.N. PRI believes that in the coming years the fiduciary debate will hinge in large part on how clearly ESG issues affect financial value. If the relationship between the two keeps growing stronger, “I think investment practice will overtake that narrow definition,” he says.