The political divide over the role that environmental, social and governance factors should play in state pension investments stands to deepen as Republicans gained some ground in the midterm elections and the Labor Department issued a new, pro-ESG rule for retirement plans.

Certain Republican-controlled states, such as Florida, in recent months have launched or proposed rules that require state pensions and treasuries to consider only “pecuniary factors”— which can have a material effect on investments’ risk and return — in their investment decisions, as they believe investments based on ESG considerations violate those entities’ fiduciary duties. Other states, including Texas, have blacklisted asset managers for allegedly boycotting sectors such as oil and gas, coal and firearms, effectively barring them from investing with such managers.

Republican victories in the midterm elections, including the party’s renewed majority in the House, stand to continue the momentum of the political backlash against ESG-focused investing, said Joshua Lichtenstein, a partner at law firm Ropes & Gray who specialises in pension and benefits regulation.

“If you look at the trend line, we’re seeing what I’d describe as more escalation on the anti-ESG front,” Lichtenstein said. “I think we can expect to see probably more of this activity coming from Republican-led states.”

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He added, however, that the new rule issued by the Labor Department last week could make it more difficult for state pensions to ignore ESG factors. The rule allows retirement plans that are covered by the Employee Retirement Income Security Act of 1974, or Erisa, to consider ESG in their investments. ESG issues could present material risk or opportunities to companies, so a prudent fiduciary should consider those issues alongside other economic factors when evaluating investments, according to the rule. It reverses a 2020 Trump Labor rule that largely prevented retirement managers from considering ESG factors.

“The state pension laws are basically all copies of portions of Erisa, and the DOL rule is a regulation on how you’re supposed to interpret the duties of prudence and loyalty under Erisa,” Lichtenstein said. “When you have the Labor Department give its interpretation of that language and it’s more pro-ESG, and then you have other states taking the opposite interpretation of the meaning of the exact same words, you’re creating a conflict.”

Meanwhile, several Democrat states, such as New York, have supported the incorporation of ESG-related goals, particularly carbon-emission reductions, into state pensions’ investment policies, while encouraging them to divest from fossil-fuel sectors. The Republican and Democrat states’ conflicting stances on ESG create difficulties for asset managers whose funds have backers from both sides, said Shivaram Rajgopal, a professor of accounting and auditing at Columbia Business School.

“If I am a private equity fund that has operations in 14 states, of which seven are red and seven are blue, what do I do?” Rajgopal said. “It’s very hard to have one set of policies for my businesses in one area and a different set of policies in other areas.”

Investment firms may respond by changing the way they communicate their strategies to put less emphasis on ESG, said Tamara Close, founder and managing partner at Close Group Consulting, which helps asset managers and investors integrate ESG into their strategies. Fund managers could also make it less definitive that they are reducing their investments in certain sectors, she said.

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“They may just stop explicitly stating these exclusionary policies,” Close said. “Maybe we’re [also] going to see a drift away from the labelling of an ESG fund.”

Playing down their ESG focus, however, could hinder asset managers’ expansion in states and countries, particularly in Europe, that are more favourable to ESG, fund managers said. On the other hand, restrictions on ESG could deprive some state pension funds of access to managers that stick to their ESG policies, according to Close.

“We may end up with a situation where purely domestic players can adapt to policy requirements in certain states. But in the longer term, it will constrain growth in other states and countries,” said a senior professional at one private equity investor that manages a climate-focused fund.

Resistance to ESG-focused investing partly reflects growing concern over the rise of so-called greenwashing, or the exaggeration of ESG-driven benefits, by fund managers. Regulators around the world, including the Securities and Exchange Commission, have sought to crack down on greenwashing.

Still, a general ban on ESG isn’t the best answer to improve it, Lichtenstein said. Instead, he said, Republican states would do better if they were more specific about which investment practices they want to suppress.

“This broad brush isn’t doing anybody any favours. It makes the line look starker, but it also makes the line somewhat nonsensical,” he said. “If parties on the restriction side were more deliberate about defining what they want to restrict instead of using the [broad] ESG term, I think you could wind up with probably a result that would be more liveable for everybody.”

Write to Luis Garcia at luis.garcia@wsj.com

This article was published by The Wall Street Journal, a fellow Dow Jones Group title. For more of the latest ESG news, sign up to FN’s weekly sustainable finance newsletter here.

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