US academics challenge whether ESG investing must be fiduciary duty

Two US law professors have challenged one of the key narratives deployed by the Principles for Responsible Investment (PRI) and others in favour of ESG investing.

According to Max Schanzenbach, of the Northwestern Pritzker School of Law, and Robert Sitkoff, at Harvard Law School, the argument that ESG investing by pension trustees is mandated under fiduciary principles was usually based on a “syllogism” riddled with errors.

Writing in an article destined for the Stanford Law Review next year, the professors argued that the reasoning behind this position typically followed three steps: “(1) ESG factors are related to a firm’s long-term financial performance; (2) the duty of prudence requires a trustee to consider material information; and (3) therefore a trustee must consider ESG factors”.

The first error, according to the professors, was the conflation of a relationship to company performance with an investment profit opportunity, given that “a prudent trustee could conclude that she cannot cost-effectively exploit [the ESG factors] for profit”.

Another problem with the reasoning, they said, was the assumption that ESG factors would always be underpriced and therefore associated with higher returns.

Like any other investment factor, however, an ESG factor “can work in both directions” and hence also be overvalued, so a trustee could actually with reason employ an “anti-ESG” strategy if they concluded that companies with low ESG scores were undervalued.

“Indeed,” the professors said, “on the logic of the PRI and others that a trustee must pursue profit from active use of ESG factors, such an analysis would mandate an anti-ESG strategy.”

The academics also took issue with the argument that ESG factors could better assess long-term risk, saying that this argument “rests on the unstated assumptions that financial markets have both mispriced ESG factors and, further, will not adjust for mispricing ESG factors over time”.

“All told, mandating a long-term ESG perspective for trustees or other investment fiduciaries is manifestly contrary to both law and economics,” they added. The law they referred to was US trust law, which governs pension funds under the Employee Retirement Income Security Act (ERISA). The authors acknowledged that rules could differ overseas.

The draft article can be found here. Schanzenbach told IPE that the professors were not anticipating significant substantive changes to the text before its final publication.