Biden's First Veto Protects and Promotes ESG

What at first appears to be deregulation is actually economic activism in disguise.


In a dispute with Congress over the proper role of environmental, social, and governance (ESG) in retirement investing, President Joe Biden chose to promote progressive environmentalism. On Monday, Biden vetoed a congressional resolution to nullify a recent Labor Department rule issued that explicitly allows retirement managers to weigh ESG factors in investment decisions.

Congress attempted to employ the Congressional Review Act, a statute that allows legislators to review certain administrative rulemakings with a simple majority in each house. Republicans voted in favor, and all but two Senate and one House Democrats against. Only defections by Sens. Joe Manchin (D–W.Va.) and Jon Tester (D–Mont.) carried the resolution through the Senate.

At first glance, this could seem like a case of anti-ESG Republicans attempting to block deregulation that allows investors more freedom—that's Biden's narrative. But this framing is incomplete. In truth, the president is shrouding the fact that he is acting at the edges of his statutory mandate, consistent with his administration's long-standing commitment to the bureaucratic furtherance of progressive environmental policies.

The Biden administration and Democrats generally argue that ESG-based investing harmonizes market capitalism with social-justice policy preferences; profitable clean energy stocks are a classic example.

Republicans say ESG investing can violate the fiduciary legal obligations of retirement funds, which should maximize returns for their clients, not engage in activism by divesting from lucrative but controversial industries or funding eco-friendly but economically suboptimal companies. 

The result is a partisan fight over how federal regulations and case law have defined fiduciary duty and whether investing models that consider nonfinancial criteria satisfy the "prudence and loyalty" requirements of the Employee Retirement Income Security Act (ERISA). 

In 2020, the Department of Labor under then-President Donald Trump issued a rule reaffirming that placing "non-pecuniary" interests above pecuniary interests was not prudent. The department published a rule requiring that fiduciaries covered by ERISA—i.e., the firms that manage private defined contribution plans and defined benefit retirement plans—must "select investments and investment courses of action based solely on financial considerations relevant to the risk-adjusted economic value of a particular investment or investment course of action." Trump's rule held that if two good investments graded equally on likely risks and potential returns, ESG factors could serve as a tiebreaker, but, like the vice president's vote in the Senate, should have no deciding force absent a deadlock.

Although Trump's Labor Department initially proposed policies outright unfavorable for ESG, it moderated to the neutral final rule, which didn't actually ban ESG investing but made clear that any ESG factors must be coincident with optimal financial gain and risk mitigation. 

The Biden administration argues its predecessor had "a chilling effect" on ESG investment, which, it says, "can improve investment value and long-term investment returns for retirement investors." To that end, the 2022 rule "amends the current regulation to delete the (the 2020 rule's) 'pecuniary/non-pecuniary' terminology based on concerns that the terminology causes confusion and a chilling effect to financially beneficial choices," the Labor Department explains

While it excises the offending terminology, however, the 2022 rule leaves largely intact the definition underlying "pecuniary factor,"—i.e., "a factor that a fiduciary prudently determines is expected to have a material effect on the risk and/or return of an investment" (emphasis added). Instead, the new rule states, fiduciaries must invest "based on factors that the fiduciary reasonably determines are relevant to a risk and return analysis" (emphasis added). The two standards diverge more in intent—and likely application—than in language.

Lest investors mistake the operative political considerations, the 2022 rule clarifies that such analysis "may include the economic effects of climate change and other environmental, social, or governance factors on the particular investment or investment course of action." 

"The Biden Rule, like the Trump Rule, confirms the permissibility of ESG investing in pursuit of improved risk-adjusted returns in accordance with prudent investor principles without mandating such an investment strategy," argue Northwestern's Max M. Schanzenbach and Harvard's Robert H. Sitkoff. "ERISA fiduciaries who did not use ESG factors prior to 2022 should feel no greater urgency to begin doing so now. And ERISA fiduciaries who are investing for collateral benefits continue to run the same fiduciary risk as before."

Though much of the partisan debate has centered on these core principles of fiduciary duty, the Biden rule does indeed contain other noteworthy policy changes. "Specific restrictions on making ESG considerations a part of investment decisions have been removed, allowing 401(k) plans under ERISA to insert ESG metrics into their risk and return evaluations," reports Zachary Christensen, a managing director for the Pension Integrity Project at the Reason Foundation, the nonprofit that publishes Reason. "The rule also reverses the restrictions on proxy voting that were applied in 2020, opening up possibilities for retirement plans to use stakeholder positions to shape the decisions of the companies they are investing in, even if the matter is unrelated to economic outcomes."

Nevertheless, politicians—the president among them—have exaggerated the new rule's immediate policy impact. "It simply states that if fiduciaries wish to consider ESG factors—and if their methods are shown to be prudent—they are free to do so. … The Republican rule, on the other hand, ties investors' hands," Majority Leader Chuck Schumer (D–N.Y.) wrote last month in The Wall Street Journal

Republicans, meanwhile, continue to insist that Democrats are subordinating the primary aim of retirement investments, which is to ensure that investors can securely retire. "In a time when Americans' 401(k)s have already taken such a hit due to market downturns and record high inflation, the last thing we should do is encourage fiduciaries to make decisions with a lower rate of return for purely ideological reasons," Sen. Mike Braun (R–Ind.), the resolution's Senate sponsor, said in a statement.

But the Trump rule did not "tie investors' hands," nor does the Biden rule allow them "to make decisions…for purely ideological reasons." And the president's pretense that the resolution would "mak[e] it illegal to consider risk factors MAGA House Republicans don't like" is flatly mendacious.

"Much of the confusion that the 2022 Biden Rule endorses ESG investing, and that the 2020 Trump Rule opposed it, traces to the original proposals for those rules," Schanzenbach and Sitkoff argue. "The Biden Proposal favored ESG factors by deeming them 'often' required by fiduciary duty. The Trump Proposal disfavored ESG factors by subjecting them to enhanced fiduciary scrutiny. However, following the notice-and-comment period, the Department significantly revised those proposals before finalization."

In the end, the Biden rule does serve, however, a clear, extra-statutory purpose: to promote ESG. The Labor Department is explicit on this count. A quick scan of its Federal Register entry counts 516 uses of the initials ESG. It's an advertisement that the executive branch—for the moment, at least—wants more ideologically progressive investing.

Biden's mandate within the ERISA framework is to protect the citizenry's retirement funds from unscrupulous investors, not advocate his preferred strain of investing. ESG-friendly investments may coincide with optimal investment returns—e.g., innovative, environmentally friendly technological ventures—yet often they don't. Investment decisions are made best by market participants, not technocrats. ESG-focused investing in ERISA-regulated retirement funds is perfectly legal as long as it's profitable.

"Over the past five years, global ESG funds have underperformed the broader market by more than 250 basis points per year, an average 6.3% return compared with a 8.9% return," Terrence Keeley, chief investment officer of 1PointSix LLC, wrote in September.  "This means an investor who put $10,000 into an average global ESG fund in 2017 would have about $13,500 today, compared with $15,250 he would have earned if he had invested in the broader market."

This is due to unavoidable economic tradeoffs: If investors avoid profitable ventures for noneconomic reasons, returns tend to dip. For instance, "Last year, tech stocks fell by more than 30% while the energy sector, including oil and gas firms, gained nearly 60%," Keeley explained last month. "Yet because of their net-zero pledge, ESG funds continue to overweight the former and underweight the latter."

Biden's Labor Department positioned itself as a deregulator. But the new rule has left untouched the ERISA regime itself—which everyday Americans (correctly) assume imposes a fiduciary duty—seeking instead to obscure those underlying economic realities inconvenient to the president's pet causes.