Red and Blue States Take Sides in Federal ESG Fight

The conflict between Democrats’ social consciousness and Republicans’ distaste for ‘woke capitalism’ may have a significant effect in 2024

The federal push for ESG regulations is prompting predictable responses from the states. Image Credit: Surasak Suwanmake/Getty Images

The environmental, social and governance (ESG) movement has become one of the most divisive issues among state legislators in 2023. ESG refers to a set of nonfinancial standards for a company’s behavior used by socially conscious investors; ESG investment funds may stop investing or decline to invest in companies that don’t comply with these standards. Generally, Democrats tend to favor ESG because it aligns with policy goals they favor, such as environmentalism and support for marginalized communities. Republicans, to the contrary, tend to dislike ESG, for both political and economic reasons: Should investment managers be making decisions based on factors other than wealth maximization for their clients?

ESG has gained traction among many investment firms and within the federal government, but it is seeing a divided response in the states. Many red states have adopted measures that punish private companies and asset managers for discriminating against non-ESG investment funds. Some states have gone so far as to deny business to certain asset managers who prioritize ESG factors when investing.

By contrast, a number of blue states have adopted measures that encourage private businesses to pursue ESG considerations in their financial decisions. Some of these policies reflect pro-ESG regulations emerging across executive branch departments and independent agencies at the federal level. As evident from state-level trends, the subject of ESG is sharply polarizing, financially impactful and increasingly salient to members of both parties.

ESG in the Real World

ESG policy implications can be grouped into three broad areas: exclusion, integration and risk assessment. Exclusionary ESG ensures that certain industries—for example, tobacco or firearms—are excluded from consideration in an investment portfolio. This tactic is used most frequently by ESG-conscious asset managers and registered investment advisers entrusted with directing people’s financial engagement in secondary markets (such as the New York Stock Exchange and the Nasdaq).

Proponents of exclusionary ESG use “ESG screening,” a judgement-based method for singling out a set of practices, professional sectors and fund types deemed to be undesirable investment vehicles. A number of asset firms have also used ESG screening to exclude industries that violate a public company’s internal sustainability goals or practices. For example, BlackRock CEO Larry Fink pledged to divest from thermal coal producers, a policy set forth in a controversial 2020 letter, “A Fundamental Reshaping of Finance.”

At the same time, Fink phased in a new ESG-centered framework for BlackRock by prioritizing sustainable stewardship over capital returns, simultaneously “launching new investment products that screen [out] fossil fuels.” This method of phasing in a sustainable investing approach is the second method of ESG, called ESG integration. Under ESG integration, investment managers use institutional investors to finance various ESG objectives. Where exclusionary ESG screening excludes practices and industries that are deemed to be antithetical to an environmentally conscious investor or a social justice activist, ESG integration targets investment vehicles that cater to these customers. ESG funds are generally assembled with the expectation of pursuing a set of nonfinancial goals, often divorced from profit maximization.

The third method of ESG is risk assessment, in which ESG issuers and investors shape their decisions based on perceived risks to the environmental or social goals of their investments. For example, an ESG-conscious investor passionate about promoting corporate board equality would hesitate to invest in a company that has long maintained an all-white, all-male board of directors. ESG advocates who want progressive values integrated into the company’s governance structure will likely look elsewhere to invest.

ESG risk assessment has become a major tool for federal regulators. The Securities and Exchange Commission’s proposed climate disclosure rule for public companies, for example, would require firms to quantify and report any financial risks associated with the business’ environmental impact. Also, the Federal Reserve recently requested that the six largest banks in the U.S. “analyze the impact of scenarios for both physical and transition risks related to climate change on specific assets” in their portfolios. This pilot program was launched as part of a united effort among federal agencies to encourage private-sector integration of climate change risk factors when investing.

Most state policies have adopted one or more of these methods of ESG investing.

Florida Leads the Charge Against ESG

ESG is now a battleground political issue, with at least 13 state legislatures considering ESG-targeted policies this year. State officials are also forming alliances to advance their positions, the first led by Gov. Ron DeSantis (R-Fla.). He headed an alliance of Republican officials from 18 states rebuking the Biden administration’s agenda in this area and vowing to “lead state-level efforts to protect individuals from the ESG movement.”

The federal policy that seems to have sparked the most state-level uproar has been the Labor Department’s controversial ESG rule for plan fiduciaries of public and private retirement funds. After Congress’ bipartisan effort to overturn the agency’s rule using the Congressional Review Act, President Biden issued his first veto to protect the rule.

Over the past two years, many states within this Florida-led anti-ESG alliance adopted their own set of executive and legislative mandates against “woke capitalism.” States including Alabama, Idaho, New Hampshire and West Virginia have countered attempts by asset managers to coerce public companies into adopting ESG shareholder proposals.

Florida’s alliance shows the growing political significance that ESG has played in state governance, beyond the realm of corporate boardroom decision-making. The alliance’s joint statement threatened to act by “blocking the use of ESG in all investment decisions at the state and local level, ensuring that only financial factors are considered to maximize the return on investment, protecting retirees and taxpayers alike.”

In addition to spearheading the above alliance, Florida has taken a number of actions against ESG policies on its own. In February, the Florida legislature passed a measure to safeguard citizens’ economic liberty by preventing state treasury officials from considering ESG factors when issuing government bonds. The measure was signed into law by Gov. DeSantis. The law extends prohibitions on state contracts to ESG rating companies, in response to how negative scores have prevented many companies from obtaining loans or establishing credit lines.

Research shows that ESG rating scores among the six preeminent rating companies often diverge on basic factors that contribute to a company’s positive or negative score. Across different providers, inconsistency poses a consistent problem, as correlation between ESG ratings is only 0.3, while the average divergence rate is between 0.58 and 0.71. In other words, various ratings firms only agree on a company’s ESG worthiness one-third of the time and disagree nearly two-thirds of the time. This leads to inconsistency across ranking lists and spurs confusion over which companies best do or don’t exemplify ESG characteristics.

The Florida law also prevents banks that engage in political activism (such as ESG investing) from holding status as a qualified public depository. In Florida, qualified public depository status is essential for banks seeking to accept deposits of public funds. Additionally, financial institutions housed in Florida are prohibited from factoring subjective “social credit scores” (part of the “S” in ESG) as justification for denying loans, bank accounts and credit lines to otherwise financially responsible citizens.

Anti-ESG Measures in Other Red States

In addition to Florida, many other red states are seeking to institute anti-ESG policies. Arizona’s legislature successfully passed a measure similar to Florida’s that banned banks from applying social credit scores when determining whether to approve loans for their customers. But the bill was vetoed by Gov. Katie Hobbs (D-AZ), who claimed that it failed to define what constituted a social credit score with sufficient clarity.

New Hampshire has also taken the lead in legal efforts against federal ESG mandates. The state’s attorney general, John Formella, filed a lawsuit in the Northern District of Texas seeking to overturn the U.S. Department of Labor’s ESG rule. The lawsuit is part of a two-pronged strategy to overturn the controversial rule in Congress and the courts.

In Utah v. Walsh, the plaintiffs are 26 attorneys general in league with private individuals, concerned oil and gas companies and a trade association. They contend that the Department of Labor rule subverts ERISA protections for retirees by allowing fiduciaries to act outside the best interest of their clients when investing in ESG initiatives. ERISA requires that stewards act with the utmost care and prudence to pursue the interests of their clients. The rule allows fiduciaries to factor in ESG criteria when determining present or future risks, thus enabling both ESG risk assessment and ESG integration.

In Oklahoma, state treasurer Todd Russ blacklisted 13 financial institutions because of their own exclusion of investments in fossil fuel companies. The 13 excluded firms were found ineligible for Oklahoma state contracts, such as handling savings for employee pension funds, as a consequence of boycotting fossil fuel companies or failing to reply to an ESG-based questionnaire.

Oklahoma is an example of a red state that financially excludes ESG-conscious asset managers in retaliation for their veiled ESG exclusion of disfavored entities. When it comes to ESG exclusion, Republican state treasurers resort to the same tactics that ESG advocates employ against disfavored firms such as fossil fuel companies, even at the expense of losing business with “woke” financial firms.

Meanwhile, in March, Tennessee Governor Bill Lee signed a bill that prevents the state’s treasurer from investing government funds based on ESG factors. The bill preempts state investments for nonpecuniary reasons. It received overwhelming support (27-4) in the state senate. Tennessee lawmakers estimated, however, that the bill’s requirement to use traditional risk assessments rather than ones informed by ESG theory would not significantly affect state or local revenues. This implies that state policymakers may care more about discouraging investment in “woke” firms than maximizing revenue for the state.

Similarly, the Kansas state legislature recently passed a law barring ESG criteria from being considered for grants of state contracts and investments. Despite not receiving support from the governor, state treasurer Steven Johnson said there was “broad consensus” that ESG criteria should not replace traditional fiduciary principles when elected officials decide how taxpayer money is invested. Both Tennessee’s and Kansas’ laws represent bans against ESG integration.

Blue States Embrace ESG—But Not Always

While less vigorous than anti-ESG developments from red states, blue states have taken several pro-ESG actions. Illinois’ Democrat-controlled legislature passed a bill that requires investment managers to disclose how they have integrated an ESG-centered approach into their investment strategies. Their approach to ESG dictates whether they can be selected as state pension fund managers.

Interestingly, though, ESG does not seem to be enjoying unequivocal popularity in blue states. For example, in May, three New York City pension funds were sued for breaching their fiduciary responsibility when selling billions in fossil fuel assets in 2021. The case is currently pending review in a New York trial court. The retirement planners’ act of ESG exclusion led to the divestment of $4 billion worth of stocks in companies that produce fossil fuels. The move was ridiculed as “a misguided and ineffectual gesture to address climate change,” according to former Secretary of Labor Eugene Scalia. Among those who voted against the move are New York City police and fire pensions, who criticized the decision as recklessly inconsistent with established fiduciary responsibilities. Despite these criticisms, Massachusetts is currently considering enacting a similar policy.

There are also a number of pro-ESG bills currently pending in Democrat-led legislatures. The most widespread and extreme proposals come from Illinois, Massachusetts, New York and Washington state.

Looking ahead to 2024, Republicans possess a slight advantage, with 26 governors to the Democrats’ 24 governors. This advantage is more pronounced when factoring in control of state legislatures, as there are presently 22 Republican trifectas, 17 Democratic trifectas and 11 divided legislatures.

The battle over ESG continues, as red and blue states grapple with this new investment strategy. Much of the state-level divide is fueled by federal rulemaking from administrative agencies and executive branch departments that require the consideration of ESG criteria. The issue of government-imposed ESG integration measures, ESG exclusion among asset managers and social/environmental risk assessment is on the rise. Such policy conflicts will likely only accelerate going forward, and they could have a significant effect on electoral outcomes in 2024.

I am grateful to my colleague Max Laraia, a research associate at the Competitive Enterprise Institute, for his contributions to this piece.

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