The times, they are a-changin’. And to paraphrase Bob Dylan’s anthem of revolution, public corporations better start swimmin’ or they’ll sink like a stone. Well, maybe not quite yet. But it is true that institutional investors who manage trillions of dollars in workers’ and retirees’ savings are in the vanguard of a movement that stands to fundamentally alter the rules of corporate finance. The catalyst is climate change. But other environmental, social and governance (ESG) factors are also being viewed in a new light, as indicators of long-term risk to investors’ portfolios on the one hand and corporate competitiveness on the other. Institutional investors’ failure to stay ahead of the curve on ESG-risk factors would thus not only be shortsighted, it would open them to charges that they failed their duties as fiduciaries.

A Sea Change in Analysis

The driving dynamic is the premium these investors are now putting on ESG, insisting that C-suites follow suit in identifying risks and providing investors with credible disclosure. The institutions’ clout, of course, turns on the magnitude of the assets they control. But it is also a product of their increasingly outspoken avowals to play hardball — to vote against management or to divest outright if enterprises fail to act sustainably.

According to the U.S. Forum for Sustainable and Responsible Investment, one in every four dollars under professional management in the United States in 2018 — a total of $12 trillion — was invested sustainably. If the top five global markets for sustainable investing — the U.S., Canada, Japan, the European Union and Australia/New Zealand — are considered, responsible investment grew by 34 percent from 2014 through 2018, to $31 trillion.

With deep-pocketed asset managers like BlackRock, CalPERS and CalSTRS in the United States, Japan’s gigantic Government Pension Investment Fund and public pension funds in Canada, western Europe, Australia and New Zealand in the lead, institutional investors have already pushed sustainable investing from the sidelines as a boutique investment strategy into the mainstream.

And they are collaborating with industry and nonprofit advocates to maximize their visibility and influence.

In some instances, funds are also divesting holdings — sometimes from entire sectors, such as oil and gas. In 2017, New Zealand Superannuation Fund, with nearly $6 billion in assets, announced a muscular climate change policy that began with the shift of $936 million away from companies with big stakes in fossil fuels. While this fund is tiny compared with the likes of CalPERS or GPIF, it has disproportionate symbolic impact as well as an outsized reach in one small but very visible country.

The path forward for funds leading the charge, however, has been rocky, in part because the initiative has unfolded against a backdrop of uneven regulatory requirements and guidelines worldwide. Meanwhile, the impact of regulatory ambivalence is aggravated by concerns that intergovernmental cooperation on ESG mandates would unravel in another global financial crisis. There is also the frustrating undertow of climate change denial to be reckoned with.

For example, in the United States, public companies are not required to disclose ESG risks (with a few specific exceptions). An effort was made in 2016 to add broad ESG disclosure requirements to the SEC’s Regulation S-K. But it became a nonstarter after the presidential election.

One consequence is that ESG-risk disclosure frameworks vary considerably by jurisdiction and circumstances. But lately, market demand (as opposed to government demand) has begun centering attention on a handful of alternatives. Institutional investors have been gravitating toward the use of three primary frameworks, all of which are anchored in disclosure of material risks that could affect the corporate bottom line.

This new reality has bolstered corporate executives and directors who wanted to communicate with investors about ESG risk in standardized terminology that wouldn’t keep their lawyers up at night. It also was helpful in focusing corporate management on the role of ESG in how they handle operations, production, supply chains and distribution — not to mention employee and customer relations.

Many see a similar dynamic unfolding in response to skeptics’ questions about the compatibility between the fund managers’ fiduciary duty to maximize the interest of their clients and efforts to persuade companies to adopt sustainable business practices. Sustainability- practicing funds now go to considerable lengths to couch their strategies in terms of the need to follow ESG practices to manage corporate risk. Risk mitigation is becoming part and parcel of sound investment practices.

Still, the fiduciary dilemma is keenly felt by many public funds and asset members, including funds in Asia, Europe and Canada (as well as the U.S.), where social-goal investing may be formally mandated as well as widely accepted by the public. There are degrees, of course, but as a group, these are also value investors who equate sustainability investing with successful risk strategies.

They operate apart from “social impact” and socially responsible investors such as Pierre Omidyar, the founder of E-Bay, whose Omidyar Network invests on behalf of explicit social values but with clearly defined parameters for measuring and monitoring investments to ensure profit-making in parallel with the Network’s social purpose.

There are subtle but important distinctions here. The pension funds are doing value-investing and applying risk strategies to account for ESG factors in their portfolios. The Omidyar group is investing for return as well as social impact; social impact, though, typically trumps concerns about financial returns. But the dilemmas created by the lack of a level playing field for disclosure as well as concerns about the application of fiduciary duty have proved problematic for both sorts of institutional investors.

Second-Guessing Milton Friedman

It happens that the fiduciary dilemma on the investment side mirrors the debate over corporate fiduciary responsibility, where the burner has been on low ever since Milton Friedman famously argued in a New York Times Magazine piece in 1970 that corporations have but a single social task: to make money for shareholders. Sentiment countering the so-called Friedman doctrine started to surface only recently within the corporate establishment — notably last August when the Business Roundtable published a manifesto on the subject signed by 170-plus CEOs. The headline-grabber declared the CEOs’ commitment to take into account the interests of all their stakeholders.

Now, shareholders are stakeholders. But the Business Roundtable defined stakeholders to include anyone whose interests have a bearing on what the company does and how well it achieves its ultimate goals of market competitiveness and enterprise value. These include workers, customers, suppliers and the communities in which the companies operate.

Some four months after the Business Roundtable initiative, another declaration pushed sustainability front and center in the worlds of both institutional investing and corporate management. Larry Fink, the founder and chief executive of BlackRock, the world’s largest asset manager (with some $7 trillion managed), announced a suite of sustainability mandates he planned to integrate across the BlackRock investment platform. And he described the effort as but a part of a larger movement to accelerate the reallocation of capital in a world threatened by climate change.

“Because capital markets pull future risk forward, we will see changes in capital allocation more quickly than we see changes to the climate itself,” Fink wrote to CEOs in whose companies BlackRock invests. “Our investment conviction,” he added, “is that sustainability and climate-integrated portfolios can provide better risk-adjusted returns to investors. And with the impact of sustainability on investment returns increasing, we believe that sustainable investing is the strongest foundation for client portfolios going forward.”

BlackRock’s plans include selling holdings in the fund’s actively managed portfolios that present high sustainability-related risk. The giant fund group also intends to work with providers to improve the quality of sustainability indices. Meanwhile, BlackRock will expand its range of active strategies focusing on sustainability. Managers will step up their engagement with companies, voting on proxy statements and shareholder resolutions. And they will demonstrate greater transparency within BlackRock, as well as publicly, when it comes to the fund’s own stewardship practices.

Fink said he would be joining forces with Climate Action 100+, a powerful institutional investor group started in 2017 to collectively lobby the world’s largest greenhouse gas emitters. When BlackRock is included, Climate Action 100+ represents investors with $41 trillion under management worldwide. Its leadership roster reads like a who’s who of institutional investment and the global sustainability movement. Successes to date include persuading Royal Dutch Shell and BP to set targets to reduce emissions and to be more forthcoming in disclosing relevant data.

Fink’s letter may also serve as a catalyst to increase clarity in the disclosure landscape.

His naming the work of the Sustainability Accounting Standards Board and the Task Force on Climate-related Financial Disclosure is likely to encourage their use across the corporate world — or, at the very least, by companies that must deal with BlackRock. “While no framework is perfect, BlackRock believes that [SASB] provides a clear set of standards for reporting sustainability information across a wide range of issues, from labor practices to data privacy to business ethics,” he wrote.

The SASB framework, it should be noted, also has the nod from the European Commission as a safe harbor for companies needing to comply with relevant EU requirements. And now, with the BlackRock stamp of approval, SASB should have momentum to become the “consensus industry-specific disclosure regime,” wrote David A. Katz of Wachtell, Lipton, Rosen & Katz. The TCFD framework, which was also touted in Fink’s letter, reflects the recommendations of a task force convened by the G20 after the 2007-8 global financial crisis to design guidelines for determining the material impact of global warming on corporate activities.

In bold type, Fink warned that noncompliance with either of these protocols could result in a decision by BlackRock to vote against, or withhold votes from, management and directors. BlackRock is an “enormously powerful force in corporate America,” Katz wrote — plainly an understatement.

To be sure, the reception to Larry Fink’s stance has not been uniformly positive, even among advocacy groups for action on climate change. BlackRock, it is argued, is late to the party. The fund group has been the target of criticism for investing in fossil fuels and in how it engages with those responsible. Ceres, a nonprofit that organizes investors on climate change, ranked BlackRock 43rd of 48 among asset managers in backing climate-related shareholder resolutions at companies. However you choose to judge BlackRock, though, there’s no doubt that its tilt toward sustainability is having a seismic impact.

It’s Not Just Blackrock

Another gigantic fund is worth a closer look. CalPERS, which topped $400 billion in assets in early January, can date its high-profile activist engagement with corporate governance at least as far back as 2009 and the arrival of Anne Simpson from the International Corporate Governance Network. Today, Simpson is the director of board governance and strategy in CalPERS executive offices, where she works closely with the chief executive, Marci Frost. Together, they are shepherding the fund’s active engagement with long-term ESG-risk mitigation as well as their advocacy via their leadership positions in core sustainability and investor programs worldwide.

Frost is the self-appointed keeper of the watch on CalPERS’s funding level, which she records daily on the blackboard side of a handheld wooden paddle. What’s the best way to build assets? Invest for the long term with an eye to sustainability, she says.

The pension fund’s Governance and Sustainability Principles, last revised in September 2019, lay out CalPERS’s case for activism in this arena. “This economic approach grounds our sustainable investment agenda in our fiduciary duty to generate risk-adjusted returns for our beneficiaries,” the document reads.

Yet, as determined as CalPERS’s management and its board of administration are to go this route, they have not been entirely successful in disarming the opposition. In 2018, Jason Perez, a sergeant in the Corona, Calif., police department (some public employees who do not work for the state are nonetheless covered by CalPERS) defeated a 15-year CalPERS veteran to win a seat on the CalPERS board of administration. He had campaigned in the statewide election on an anti-ESG platform, arguing that ESG-risk factor investing is contrary to CalPERS’s fiduciary responsibility.

Both CalPERS and CalSTRS, another giant California pension fund that manages public schoolteachers’ money, were early signatories to the UN-supported Principles for Responsible Investment, one of the original pacesetters in sustainability. An aim of PRI, explained its chief executive, Fiona Reynolds, is to witness a responsible investing move from niche to mainstream. “We want to be at a point where we just have investments — not responsible investments separate,” she said.

CalSTRS, the nation’s second largest public pension fund, with assets totaling $254.1 billion assets at the end of 2019, is also in the vanguard of the long-term value-seeking funds that fully integrate ESG in their risk management strategy. Last October, CalSTRS was heralded as one of a handful of U.S. institutions with a formal climate change policy after committing the fund to an 18-month low-carbon transition work plan. The initiative was also in line with a September 2019 executive order from Gov. Gavin Newsom that required California’s two huge public employee funds to come up with sustainability plans. It was likewise well ahead of California’s December 2019 deadline for providing public assessments of the climate risk in their respective funds’ holdings.

CalSTRS was one of 515 institutions that manage $35 trillion in assets in total to join in a statement to governments on climate change ahead of the 2019 United Nations Climate Action Summit in Madrid. The statement called on all countries to phase out thermal coal power, to tax or otherwise put a meaningful price on carbon pollution, to end government subsidies for fossil fuels (a very big problem in much of the world) and to strengthen nationally determined contributions to meet the emissions reduction goal of the Paris Agreement no later than 2020. The attendees, apparently, were not swayed; the summit failed to push the climate management agenda forward.

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It is early days in assessing the impact of investor coalitions in pressuring corporations to adopt ESG goals — climate change goals in particular. But it will almost certainly be substantial. Money talks, and as a result of the initiatives of BlackRock, CalPERS, CalSTRS and a horde of other public funds and asset managers worldwide, corporations are under the gun. ESG goals can no longer simply be dismissed as an eccentric enthusiasm of dogooders. The corporate bottom line is at stake.

And while it is bound to take some time, the signs are pointing to a long-term restructuring of corporate finance. “Your old road is rapidly agin’,” Dylan wrote. “Please get out of the new one if you can’t lend your hand, for the times they are a-changin’.”