A more measured approach as states navigate ‘environmental, social and governance’ mandates

State policymakers across the political spectrum have increasingly created rules and mandates targeting environmental, social and governance (ESG) investment strategies in recent years. In 2024 alone, more than two dozen ESG bills have been introduced – some favorable to the concept, but more opposed – and six so far are now law.

ESG investment strategies have traditionally focused on the long-term impacts of investing in industries that may be economically, environmentally, or politically undesirable—with the ultimate goal of limiting financial exposure to potential risks. In contrast, some efforts by state policymakers around ESG have confused this traditional use with what is known as impact investing, a strategy that aims to achieve certain social or environmental outcomes.

This year, for example, Idaho lawmakers joined those in more than a dozen other states, including Texas and Florida, in banning government entities from doing business with certain companies that use ESG considerations in their approach. their investment. On the other end of the spectrum, Oregon’s pension fund is planning to move away from coal after lawmakers passed legislation as part of an effort to have a net-zero pension portfolio by 2050.

But 2024 has seen an evolution towards a more measured approach – on both sides of the issue – with a growing recognition that strict pro- and anti-ESG investment mandates can lead to unintended costs and administrative challenges. For example, Oregon’s investment bill is a narrower version of previously proposed legislation that called for divesting all fossil fuel investments.

The legislation also states that the investment or reinvestment must be carried out without monetary loss to the system. Meanwhile, in Maine, the state retirement system is pushing back a looming deadline to divest from all fossil fuels by January 2026, because an analysis by the pension fund found that the accelerated timeline could result in loss to plan beneficiaries.

Florida last year enacted one of the broadest mandates curbing ESG considerations with a law that, among other things, prohibited state and local entities from using credit rating agencies that issue ESG scores to governments. And this year, a state transportation bill deemed ESG-related factors, such as goals focused on social justice or federal carbon emission reductions, financially irrelevant to the transportation planning process — and banned them. to be considered. But that language was removed in later versions before the bill was signed into law in April by Gov. Ron DeSantis (R).

Meanwhile, in New Hampshire, a bill that would have made it a criminal offense for the state pension system to use ESG investment strategies was swiftly rejected by lawmakers in February.

These developments come as more information emerges about the potentially higher costs associated with aggressive legislative policies for or against ESG investing, largely due to the unintended administrative and financial challenges that follow. For example, boycotts that prohibit business ties with banks that embrace ESG investment practices can limit governments’ underwriting options, leading to less competition and higher borrowing costs for states. At the same time, policies that require rapid divestment of state assets by certain businesses and industries, such as fossil fuels, may also come with significant upfront costs and fees for such transactions.

More broadly, ESG mandates can potentially impede the ability of government finance officials to act in the best interests of their constituents. This could then increase the fiscal risk around the states’ two biggest liabilities: their pension liabilities and debt.

Retirement investment obligation

Separate from direct investment direction, evaluating ESG factors can illuminate material risks and opportunities – such as a company’s record on employee relations or compliance with environmental regulations – that should be considered as part of any decision-making process. financial. Public pensions, which have a much longer investment horizon than individual funds, tend to approach ESG considerations from this perspective, using them to inform overall investment and risk management strategies. For example, experts largely agree that changing environmental conditions pose a systemic risk to the broader financial system and, in turn, to the more than $5 trillion in assets invested by public pension funds.

State policymakers, however, have largely viewed ESG through a “social impact” lens, which has prompted policies that either prohibit or require certain ESG-related investments. Not only is this view potentially out of alignment with the fiduciary role of pension systems to act in the best interests of its beneficiaries, it also risks leaving money on the table. For example, a 2022 report by Wilshire Advisors noted that the transaction costs and impact on investment returns of the 2001 divestment of the California Public Employees’ Retirement System (CalPERS) from tobacco would be roughly equivalent to $4 billion in lost profits two decades later. However, according to CalMatters, the system’s investments from thermal coal and Iran “have translated into small benefits” for the system.

For his part, Oregon Treasurer Tobias Read (D) has called climate change “a pressing risk to investment returns,” but he has also opposed state legislation that created investment mandates, Oregon Capital Insider reported. When lawmakers impose such requirements, “the investment environment becomes more complicated,” Read said. “Our only responsibility at the treasury is to achieve strong income for the Public Employees’ Retirement Fund.”

Rising costs in the bond market

When it comes to the cost of issuing debt, municipal market investors tend to see climate change as a potential risk to the government’s ability to meet bond obligations. And that could then lead to lower bond values ​​for investors and higher interest rates for government issuers in the future.

Other studies show that ESG-related legislation prohibiting certain investments can also increase costs as municipalities and other government entities seek alternative underwriters for issuing municipal bonds and, in some cases, take on increased borrowing costs.

In Texas, a 2024 study estimated that government entities have paid an extra $270 million a year in bond interest and transaction costs since the state passed a pair of laws in 2021 that restricted government entities from working with financial firms seen as friendly to firearms and fossil fuel industries. The study, commissioned by the Texas Chambers of Commerce and Business Association Foundation, estimates the total lost economic activity associated with higher costs to taxpayers at nearly $670 million annually.

“These findings illustrate that when the government tries to mandate values ​​(regardless of what type) for business, the market loses and taxpayers bear the consequences,” the study authors wrote.

The study builds on previous work that found that severing bank ties could limit the government’s underwriting options, leading to less competition and higher borrowing costs. A 2022 study estimated that Texas local governments paid between $260 million and nearly $500 million in higher borrowing costs in the first eight months the laws were in effect. Florida, Kentucky, Louisiana, Missouri, Oklahoma and West Virginia also now have laws prohibiting ESG considerations that extend to government borrowing. A separate analysis for a coalition of nonprofits in 2023 estimated that governments in those states may have paid between $264 million and $708 million in higher borrowing costs over a 12-month period.

A similar study released by the Oklahoma Rural Association in April found that implementation of the state’s Energy Discrimination Elimination Act has meant about $185 million in additional costs to state and local governments in the law’s first 17 months. This year, lawmakers have proposed legislation that would clarify that the requirements do not apply to municipalities.

Final thoughts

Different interpretations of ESG by legislators and financial practitioners can lead to confusion and politicization. Recent laws regulating ESG investing, whether with a favorable or unfavorable view, may aim to mitigate exposure to financial risks for pension funds and other critical state investments, but in practice, some laws are having the opposite effect . These conflicting results make implementing ESG mandates even more challenging, as evidenced by a recent decision in Oklahoma that struck down the state’s energy law. In her ruling, Judge Sheila Stinson wrote that it is highly likely that “the law’s stated purpose of opposing a “political agenda” is at odds with the pension system’s constitutional purpose” to act in the best interest of good of its beneficiaries.

These recent developments underscore the fact that policies that limit investment options often force officials to make sudden and unanticipated changes in investment and borrowing strategies and approaches. Upfront transaction costs and administrative challenges could ultimately mean greater costs for taxpayers to meet states’ pension obligations or finance needed public investments through bonds. The growing difficulties associated with implementing these rigid mandates are prompting at least some officials to moderate their policy approaches to ESG in the public finance space.

Fatima Yousofi is a senior officer, Liz Farmer is an officer, and Stephanie Connolly is a senior fellow with the state fiscal policy project of the Pew Charitable Trusts.