One of the more controversial and contentious legislative issues addressed by various state legislatures in 2023 concerned ESG-related legislation. But what actually is ESG? It stands for environmental, social and governmental. It is a concept used by investors in capital markets to measure the sustainability and ethical impact of an investment in a company. According to Kyle Peterdy, vice president at CFI, “ESG is a framework that helps stakeholders understand how an organization is managing risks and opportunities related to environmental, social and governance criteria. ESG takes the holistic view that sustainability extends beyond just environmental issues. While the term ESG is often used in the context of investing, stakeholders include not just the investment community but also customers, suppliers and employees, all of which are increasingly interested in how sustainable an organization’s operations are.”

Environmental criteria examines how a business performs as a steward of the natural environment, focusing on:

• Waste and pollution.
• Resource depletion.
• Greenhouse gas emission.
• Deforestation.
• Climate change.

Social criteria looks at how the company treats people and concentrates on:

• Employee relations and diversity.
• Working conditions.
• Local communities — seeks explicitly to fund projects or institutions that will serve poor and underserved communities globally.
• Health and safety.
• Conflict.

Governance criteria examines how the company is governed and focuses on:

• Tax strategy.
• Executive renumeration.
• Donations and political lobbying.
• Corruption and bribery.
• Board diversity and structure.

The Federal government has been active in the ESG space recently. The August 2022 passage of the Inflation Reduction Act infused significant investment into ESG-related initiatives, with a particular focus on clean energy. Earlier in 2023, the Department of Labor also passed a final rule permitting the use of ESG factors in corporate retirement plans.

The SEC has worked through new ESG-related disclosure rules. The Commission finalized cybersecurity risk management disclosure rules, requiring companies to make timely disclosure of cybersecurity incidents and to offer more robust information about risk oversight and management. While the SEC has not yet finalized the significant climate disclosure rules proposed last March, they remain on the Commission’s agenda, and indications are that they will reach finalization. The SEC’s agenda also includes finalization of proposed rules requiring additional information from investment funds regarding their ESG investment practices, and changes to the “Names” Rule to ensure that ESG investing strategies are appropriately disclosed. Proposals for new rules relating to corporate board diversity and human capital management also remain on the SEC’s short-term agenda. Other agency activity includes the Federal Trade Commission’s current undertaking to update its “Green Guides” on the use of environmental claims.

As noted by Leah Malone, an attorney with Simpson, Thacher & Bartlett LLP, “The backlash against ESG in the United States has been unmistakable in 2023. More than one-third of states have passed anti-ESG laws in 2023, most ESG-related shareholder proposals failed to garner majority support, new lawsuits have been filed challenging companies’ ESG-related activities and decisions, and some companies seem to be distancing themselves from the term ‘ESG’ itself.”

New state laws vary in their approach to limiting ESG considerations in decision-making. Most requirements focus on state pension plans or other investments, proxy voting and state contracts. Some laws, as in Montana, require that investment decisions only be made based on financial factors. Laws in Utah penalize companies deemed to boycott certain industries based on ESG factors. States with new laws include Alabama, Arkansas, Florida, Idaho, Indiana, Kansas, Kentucky, Montana, New Hampshire, North Carolina, North Dakota, Texas, Utah and West Virginia. Legislation in Kansas and Kentucky limits the use of ESG in public retirement system investments. An Indiana law prohibits the public retirement system from contracting with service providers that make ESG commitments. Idaho law prohibits banks and credit unions that hold state funds from boycotting certain industries, including fossil fuels and guns. The law denies a boycott as penalizing or limiting services in some sectors without a reasonable business purpose.

Florida and Texas have been particularly involved with anti-ESG legislation. In Florida, public or state-controlled funds can no longer be invested based on environmental, social or governance factors. The law (HB 3) directs all Florida pension funds to prioritize returns without considering ESG factors in investment decisions. The law also prohibits Florida municipalities from selling bonds that are tied to ESG projects or impose restrictions tied to ESG ratings. The law creates new unsafe and unsound practice standards for financial institutions, prohibiting the denial or cancellation of services to current or prospective customers, or otherwise discriminating against customers, on the basis of any rating, scoring, analysis, tabulation or action that considers a social credit score based on (a) engagement in the lawful manufacture, distribution, sale, purchase or use of firearms or ammunition or (b) engagement in the exploration, production, utilization, transportation, sale or manufacture of fossil-based energy, timber, mining or agriculture.

HB 3 requires financial institutions to attest their compliance with the new “unsafe and unsound practice” standards under penalty of perjury. A financial institution’s failure to comply with the bill’s “unsafe and unsound practice” standards or attestation requirement will constitute a violation of the relevant Florida statute and subject the financial institution to sanctions and penalties under Florida’s financial institutions codes. Under HB 3, a violation of an “unsafe and unsound practice” by a Florida-licensed financial institution will also constitute a violation of the Florida Deceptive and Unfair Trade Practices Act.

In Texas in 2021, legislation was approved that prevented Texas from investing in environmental, social and governance financial products that boycott Texas energy companies. The law affected the state’s six pension funds, including the Employees Retirement System and the Teacher Retirement System of Texas, which, at the time, managed over $200 billion. Under the law, Texas’ public pension funds would be required to “sell, redeem, divest or withdraw all publicly traded securities of any financial company” that “boycotts energy companies.” The bill defines “boycotts energy companies” as “refusing to deal with, terminating business activities with, or otherwise taking any action that is, solely or primarily, intended to penalize, inflict economic harm on, or limit commercial relations with a company because the company: engages in the exploration, production, utilization, transportation, sale or manufacturing of fossil fuel-based energy and does not commit or pledge to meet environmental standards beyond applicable federal and state law; or does business with a company described above.”

The law tasks the Texas Comptroller with keeping track of the financial institutions and companies that are banned from doing business in Texas. The 2021, the Texas Legislature also enacted a similar boycott bill on firearms. Multiple states, including Oregon, Connecticut, Illinois, Maryland and Maine, have enacted legislation allowing consideration of ESG factors in the investment decision-making process. These states also promote the implementation of sustainable investment policies, and Maine’s law is designed to divest from industries like fossil fuels. State pension funds in California, New Jersey, New York and Oregon follow similar policies. For example, New Jersey’s policy requires that fund managers engage in an ESG analysis of factors that present material business risks and opportunities, including carbon gas emissions, climate change, workforce diversity, human rights and fair wages.

There is a widening division between states regarding ESG investing. Many states absolutely oppose ESG, citing the need to consider only what monetary gain may come out of the investment, whereas other states see ESG-like investments as an opportunity to promote societal and environmental goals in combination with future financial considerations. It seems an absolute certainty that the 2024 state legislative session will witness a widening of that divide.