Our View on the Department of Labor's ESG Proposal: Sustainability is Essential
Published on MarketWatch(US) on October 9 , 2020.
DOL’s ESG proposal: sustainability is essential
Franklin Templeton: Integrating ESG is good, prudent investing
The Department of Labor’s proposed regulation on “Financial Factors in Selecting Plan Investments,” otherwise known as the DOL ESG rule, takes the misguided view that incorporating ESG factors is not relevant in the pursuit of risk-adjusted returns and requires a trade-off with performance. In short, it makes it harder for ESG investments to be included in retirement plans and prohibits them from being selected as a qualified default investment alternative ‘’QDIA’’ in 401(k) plans.
The DOL uses the term “non-pecuniary,” which means they are unable to be quantified, and effectively defines ESG considerations as return concessionary, meaning they are trading off performance by taking ESG into account. As such, this singles out every application of ESG with a broad reach. Essentially, the DOL says it aims to safeguard retirement security, but instead the proposal disadvantages the end saver. This harms investors by ultimately limiting investment choice.
In addition to the risks that it poses for the end saver, the proposal would require substantial new due diligence, documentation and ongoing monitoring for plan sponsors, and would increase the burden of implementation costs and heighten the litigation risk faced by fiduciaries. In short, the proposal would make it less likely for advisers to consider any form of ESG and would effectively require fiduciaries to ensure that no strategies incorporate ESG factors, both of which serve to limit investor choice.
At Franklin Templeton, we believe the proposal far exceeds the codification of the existing guidance and we strongly urge the DOL to withdraw this rulemaking or otherwise take appropriate steps to address the significant concerns raised by us and numerous other commenters.
Individuals, investment firms and organizations have pushed back on this proposed rulemaking. The proposal attracted 8,737 letters in the short 30-day window for public comments, of which an overwhelming 95% of the comments were opposed. An analysis of public comments by Morningstar, US SIF (The Forum for Sustainable and Responsible Investment) and several other organizations, underscores the great divide between the DOL’s stance and public sentiment.
Considerations regarding risk-adjusted returns for plan participants should absolutely be the guiding focus of private employer-sponsored retirement plans. We wholeheartedly support and agree with the DOL’s continued stance of reminding plan fiduciaries governed by ERISA to be unwavering in their single focus on selecting investments ‘’based on financial considerations relevant to the risk-adjusted economic value of a particular investment or investment course of action," as stated in the DOL ESG rule proposal.
We believe material ESG factors are fundamentally investment-relevant economic issues that are potential drivers of change that can impact the operational resiliency of businesses over the medium to long term, thus impacting investor returns. This makes ESG factors relevant for investors to understand from a risk and return lens. In short, our conviction as a global investment manager is that assessing ESG issues as part of a fundamental active management process makes us better informed investors and helps us fulfill our fiduciary duties in seeking to provide strong investment performance for our clients. Far from trading off performance, ESG integration is additive to the investment process.
This is further supported by a wide body of academic and empirical research that establishes positive links between sustainability as measured by ESG factors and financial performance.
Another compelling reason for the investment relevancy of ESG factors – which is oftentimes overlooked – is that intangible assets today form an increasingly important part of a company’s value. The average value of public company intangible assets in the S&P 500 is estimated to have increased from 17% of market capitalization in 1975 to over 80% in 2015. Intangible assets encompass items such as brand loyalty, reputation and intellectual capital. ESG indicators capture such intangibles and thus provide a fuller assessment of a company’s true intrinsic value.
Sustainability is a key factor in uncovering this intrinsic value for an organization. In addition to considerations around corporate governance and environmental impact, sustainability considers a company’s management of social issues like human capital management and worker safety, which can result in higher production quality and higher productivity from engaged employees. Such ESG factors provide a wider pool of information on which investment managers can draw from to provide a measure of sustainability to assess the future preparedness of companies, managing what are often longer-term strategic risks that can impact a company’s competitive advantage and ultimately its sustainable earnings power.
ESG factors give an indication of how well businesses operate, which support value creation and can lead to creating brand equity and competitive positioning. On the “E” side, the more efficient a company is on managing its energy and water use, for example, can lead to benefits such as lower cost of capital. All this points to how well companies are managing to ESG considerations which ultimately result in well run businesses that have a higher likelihood of sustaining cashflow and returns back to investors.
The concept of materiality is central to the application of ESG. Not all ESG factors will be financially relevant, or material, to an investment case. We are guided in our identification of materiality by industry recognized standards such as those promulgated by the Sustainability Accounting Standards Board (“SASB”), in addition to our own proprietary sources. Franklin Templeton is a strong advocate of SASB standards as providing measurable, comparable, and useful disclosure on ESG factors.
Integrating ESG into core investment processes is an increasingly relevant component of fundamental research and investment decision making. It is simply good, prudent investing. The 95% of public responses from American savers also seem to indicate so. We hope the DOL listens.
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