Subscribe
Share
Share
Embed
Ropes & Gray attorneys provide timely analysis on legal developments, court decisions and changes in legislation and regulations.
Catherine Skulan: Hello, and welcome to another installment of our Ropes & Gray podcast series on California Law for Asset Managers. I’m Catherine Skulan, an asset management partner based in California, and I am pleased to be joined by Josh Lichtenstein, a benefits partner and head of the ERISA fiduciary practice based in New York.
In our last two episodes in this series, my colleagues and I discussed recently enacted California laws that fall under the environmental, social and governance (“ESG”) banner, and how those laws relate to asset managers and their portfolio companies. Hopefully, you were able to catch those episodes. Note, links to those episodes will be available in the transcript of this episode, so you can find them there: Overview of New California Law Requiring Disclosure on Diversity in VC Investments by “Venture Capital Companies” (December 5, 2023) and New California Climate Disclosure Requirements and Their Relevance to Asset Managers and Their Portfolio Companies (December 19, 2023). But, if you didn’t catch them, here’s a quick refresh:
• SB 54, titled the Fair Investment Practices by Investment Advisers, seeks to provide transparency with respect to certain investments by venture capital companies (a term that you may recall is defined broadly enough to seemingly capture a wide range of private investment funds, including: traditional venture capital funds, private equity funds, as well as other investment vehicles).
• We also spoke about AB 1305, the Voluntary Carbon Market Disclosures Act, which requires entities that (i) operate within California and (ii) market or sell carbon offsets, purchase or use carbon offsets, or make certain claims regarding, for example, progress toward carbon reduction goals, to disclose on their websites how such claims have been determined to be accurate or actually accomplished.
• Similarly, SB 261, titled the Climate‐Related Financial Risk Act, which will take effect in January 2026, requires a company doing business in California with annual revenues in excess of $500 million to make publicly available on its website a climate-related financial risk report.
• And, finally, SB 253, titled the Climate Corporate Data Accountability Act, which requires annual public disclosure of Scope 1, 2, 3 greenhouse gas (“GHG”) emissions by U.S. entities doing business in California with annual revenues of greater than $1 billion.
Each one of these laws has a direct and significant impact on the asset management industry by imposing reporting or other requirements on asset managers, investors and/or portfolio companies.
Josh, with that background, let’s move into today’s discussion. As you know, there is a pending bill in California’s legislature, SB 252, which prohibits investment by state pension plans in the 200 largest publicly traded fossil fuel companies as determined by the carbon content of the companies’ reserves and requires divestment from those companies by July 1, 2031. How does SB 252 compare to some of the other ESG-related initiatives you and your team have been tracking at the state level, and what impact do these bills have on asset managers, their investors and their business?
Josh Lichtenstein: Thank you for the context, Catherine. It’s great to be speaking with you today, and I’m excited to be part of this series. I’d actually like to put SB 252 aside for a minute. As you were explaining, California’s ESG rulemaking to date has generally been very disclosure-focused and disclosure-heavy for companies that do business in the state, and there hasn’t really been much that has been pension-specific. This is different from what we’ve been seeing in the majority of states we’re tracking, where the focus is on the role that ESG considerations will play in the investment decision-making and proxy voting activities for various public sector pension plans—these are state plans, municipal plans, and the like. This has had a huge impact because for the first time in the history of these plans, we are seeing the laws that govern these types of actions diverge from the federal standards under ERISA—which apply to private pension plans—and these are the rules which all the state laws are originally based on. And we’re also seeing differences among the various states, which is also a very new development in the market.
This growing divergence can be attributed, at least in part, to what’s been happening at the federal level with the Department of Labor (“DOL”). The Department of Labor has had an ongoing rulemaking process for decades now over how ESG or similar considerations can be factored into retirement plan investment decisions for private sector pension and 401(k) plans. We’re currently operating under a rule that came into effect in 2022, which clarified that climate change and other ESG factors may be relevant to the risk and return analysis for a fiduciary in evaluating a potential investment—and when they are relevant, they can be weighted and factored into those investment decisions alongside any other relevant factors as the fiduciaries deem appropriate.
Now, over the last couple of years, we’ve seen various red states respond to this current federal policy by proposing—and in some instances, enacting—legislation to require all investment and proxy-related decisions by these public pension boards to be based solely on material financial factors. The phrase or term that you’ll see often used is “pecuniary factors,” which is a term that comes from the Trump administration’s Department of Labor’s rule on this same topic—and the term “pecuniary factors” is generally understood to take a very narrow view of when environmental, social, and other related factors would qualify as “financially material.”
Catherine Skulan: Thank you. So, you just described a couple examples of how red states have been legislating in this space, but can you also speak to some of the pro-ESG initiatives that other states have been pursuing?
Josh Lichtenstein: Definitely—there’s less of it, but the activity is out there. On the flipside, you have states like Illinois, which currently stands alone as, in my view, the most pro-ESG state. They enacted a law in 2020 that directs state and local government entities that manage public funds to consider materially relevant sustainability factors, including corporate governance and leadership, environmental, social capital, human capital, and business model and innovation factors when they’re making their investment decisions.
You also have states like Maine that have been more focused on one or more specific ESG issues, such as discouraging investments in energy or in certain segments of the energy industry (i.e., fossil fuels), or in the firearms industry. Maine was actually the first state in the U.S. to enact any legislation of this type, and their law requires the board overseeing the state public retirement system to divest the plan’s holdings of the 200 largest publicly traded fossil fuel companies in the world, and they have a deadline of completing that divestment by January 1, 2026. This type of divestment law is what we’re talking about when we talk about SB 252 in California.
One thing that is clear, though, is that for asset managers who are used to ERISA’s requirements, when it comes to investing money on behalf of state pension plans, this new labyrinth of state laws and guidance is adding increasing layers of complexity and confusion.
Catherine Skulan: Let’s go back to California with that confusion then, Josh. You mentioned that California has more of a disclosure-based regime for ESG as opposed to what we have seen from other states. Can you elaborate a little bit on that point?
Josh Lichtenstein: Of course. Even though California has been one of the most active states in terms of legislating in the area of ESG more broadly—as evidenced by the laws that you summarized earlier and that were discussed earlier in this series—it has not been aggressive in mandating ESG undertakings for its public pension plans. Unlike Maine and certain other blue states, California has not embraced this divestment issue statewide. Instead, California’s approach has been more disclosure-based, aiming to increase information available to investors and the public. While a disclosure regime has its own set of compliance costs and complexities, in some ways, this approach is preferable for asset managers because it provides greater flexibility around implementing actual investment programs and—while you need to be cognizant of disclosure obligations—it makes it easier to invest the state assets in accordance with standard practices, alongside other accounts.
Another notable difference is that California’s current ESG requirements do not apply just to managers and other entities that invest or oversee state pension assets. Rather, it imposes significant reporting requirements on any company doing business in California. As you mentioned, SB 253 requires disclosure of Scope 3 greenhouse gas emissions, which are emissions of companies in the reporting company’s supply chain. Asset managers may be required to make disclosures to their portfolio companies or investors in respect of those emissions—and this actually goes further than the SEC’s new rule on greenhouse gas disclosures.
Catherine Skulan: How have the California state pension plans reacted to the evolving ESG landscape as it hits their particular investment programs?
Josh Lichtenstein: That’s a great question, Catherine—it’s actually been very interesting. As we’ve noted, SB 252, which has not yet passed in California’s legislature, focuses on divestment of fossil fuel companies. Last year, the board of CalPERS voted to formally oppose SB 252, noting that mandatory fossil fuel divestment would not be an effective solution to reduction of greenhouse gases. That position is consistent with a public statement made by CalPERS in 2017, in which CalPERS explained that it believes the divestment is not aligned with its fiduciary duties to its investors. CalPERS explained that divestment can result in decreasing diversification, cause CalPERS to give up a “seat at the table” to have influence over companies, and cause CalPERS to incur financial losses as a result of forgone performance and transaction fees.
The public statement goes on to discuss certain “wins” by CalPERS relating to ESG that it was able to achieve by having a “seat at the table,” including:
• spearheading shareholder initiatives on climate risk reporting,
• adding climate-competent members to boards of companies through proxy access provisions in company bylaws,
• forming a coalition to develop a guide for investors to engage companies to improve worker safety, and
• forming a coalition with other investors at like-minded institutions representing in the aggregate over $20 trillion to engage on these topics.
Catherine Skulan: That is interesting. It’s interesting this is something that CalPERS has been putting serious thought into for quite some time. So, how do you wrap that all up—how do you think about this holistically?
Josh Lichtenstein: It’s definitely a nuanced area and it’s a nuanced conversation. My takeaway is that CalPERS has been actively pursuing certain ESG goals despite its opposition to divestment, but I don’t think that is necessarily contradictory. Also, unlike CalPERS, CalSTRS’s investment committee has actually embraced the divestment issue in part, and has pledged to achieve net zero greenhouse gases in the fund’s portfolio by the year 2050. But in making this announcement, CalSTRS also emphasized that divestment is a last resort option and noted that it can have a negative financial impact on the fund. Similar to CalPERS, CalSTRS has noted that divestment would also limit its ability to shape corporate behavior because they would no longer have a “seat at the table,” and it also has highlighted diversification concerns. So, CalSTRS’s investment committee emphasized the importance of taking a holistic approach to addressing climate change, not just focused on the fossil fuel industry, which it says accounts for approximately 25% of all greenhouse gas emissions, but also other industries, like agriculture, forestry, and land uses, which represent about 24% of greenhouse gas emissions.
At this point, I think it’s important to note that SB 252 also contains a fiduciary carveout, which would exempt CalPERS’s and CalSTRS’s boards from having to divest “unless the board determines in good faith the action is consistent with [its] fiduciary responsibilities.” And when I think about that, it feels actually very consistent with what we’ve seen from CalPERS in CalSTRS, where there’s a nuanced discussion about what’s really best for the plan—what’s the best way to actually achieve climate goals and plan returns—in order to be able to pay participants. On the other side of the table, we’ve seen states, like Oklahoma, that have similar carveouts for fiduciary exceptions—we’ve seen them use those to refuse to divest from managers the state has deemed to be boycotting industries, like fossil fuels.
That said, I think it’s important for asset managers to ensure that they understand the investment policies and goals of CalPERS and CalSTRS, because these are two of the largest state retirement plans in the entire country. And when making any claims about investment goals and whether they align with those of CalPERS and/or CalSTRS, I think a manager should make sure their disclosure is appropriate and set up to comply with the current disclosure regime in California. I wouldn’t underestimate the importance of crafting messages in a way that considers the needs of plans like these, even though we may see fewer formal rules on this topic than we see from most red states—we know these are topics that CalPERS and CalSTRS care about, they’re major investors in a lot of funds, and it’s important to make sure that you’re attentive to their needs and requirements, even if those don’t have the exact same formal force that we’re seeing in some red states.
Catherine Skulan: Thanks, that is a very good overview. And I’m probably stating the obvious that these are topics that people feel very passionate about on both sides of the political spectrum, and there are a number of ways that people have been reacting to them. Legal challenge is a good example. Have there been any legal challenges to California’s ESG laws that we’ve been discussing today?
Josh Lichtenstein: Yes, there have, which is expected in the current environment where we see legal challenges to new regulations and laws very often. The U.S. Chamber of Commerce and various industry associations have brought a lawsuit alleging that SB 253 and SB 261 violate the First Amendment by compelling businesses to engage in subjective speech. They further argue that the federal Clean Air Act preempts California’s ability to regulate emissions in other states because it would create reporting requirements for companies in other states that might be in the supply chain of companies required to report under California’s laws. But we should note that California’s enforcement of these disclosure laws will begin in 2026, and so, we have plaintiffs in the case requesting that the federal court declare these laws to be without effect before compliance or enforcement actually occurs.
Catherine Skulan: You’ve given some great examples of why California’s ESG regime is relevant to asset managers. Let’s wrap it up: What considerations should asset managers take into account in respect of California’s ESG regime when designing their investment program?
Josh Lichtenstein: When we think about California, it’s important for asset managers to understand the significant new portfolio disclosure requirements relating to climate, and also, to proactively make sure that their portfolio companies are taking appropriate steps to meet these new requirements. The additional disclosure may also result in potential litigation, as lawsuits challenging companies’ representations relating to ESG or “greenwashing” are on the rise—and these can come from all different directions, so it’s important to be attuned to that.
But, I think, stepping back, it’s important to remember that California’s ESG legislation and other policies are just one piece of a rapidly evolving ESG landscape in this country and in the world, and asset managers not only need to navigate it, but they also need to be prepared to holistically evaluate and manage their messaging and risk in this diverse environment. On the regulatory side, we have regulations at the federal level, such as the DOL rules, we have regulation in Europe at the EU level, such as SFDR, and we have similar rules in some other jurisdictions. But it’s not just legislation—we’re also seeing regulators increasing their focus on climate risk, so it remains to be seen how that ultimately will influence ESG, but with everything going on nationally, internationally, and among the various states, there’s definitely a lot to pay attention to.
Catherine Skulan: With that, Josh, I would like to thank you for joining me today and sharing many valuable insights about the ESG landscape in California and the relevance it has for asset managers. For more information on the topics that we have discussed, please visit our website at www.ropesgray.com. And, of course, if we can help you navigate any of the topics we covered, please don’t hesitate to get in touch. You can subscribe and listen to this series wherever you regularly listen to podcasts, including on Apple and Spotify. Thanks, everyone, again for listening.