A More Measured Approach as States Navigate ‘Environmental, Social, and Governance’ Mandates

State policymakers across the political spectrum have increasingly created rules and mandates targeting environmental, social, and governance (ESG) investment strategies in recent years. In 2024 alone, more than two dozen ESG bills have been introduced—some favorable to the concept but most oppositional—and six so far are now law.

ESG investment strategies have traditionally focused on the long-term impacts of investing in industries that could be economically, environmentally, or politically undesirable—with the bottom-line goal of limiting financial exposure to potential risks. In contrast, some state policymaker efforts around ESG have conflated this traditional use with what is known as impact investing, a strategy that aims to achieve certain social or environmental outcomes.

This year, for example, Idaho lawmakers joined those in more than a dozen other states, including Texas and Florida, in prohibiting government entities from doing business with certain companies that use ESG considerations in their investing approach. On the other end of the spectrum, Oregon’s pension fund is planning to divest from coal after lawmakers enacted legislation as part of an effort to have a net-zero pension portfolio by 2050.

But 2024 has seen an evolution toward a more measured approach—on both sides of the issue—with a great recognition that strict pro- and anti-ESG investing mandates can lead to unintended costs and administrative challenges. Oregon’s divestment bill, for example, is a narrower version of previously proposed legislation that called for unwinding from all investments in fossil fuels.

The legislation also says that divestment or reinvestment must be accomplished without monetary loss to the system. In Maine, meanwhile, the state retirement system is pushing back against a looming deadline to divest from all fossil fuels by January 2026 because an analysis by the pension fund found that the expedited timeline could result in losses for plan beneficiaries.

Florida last year enacted one of the most far-reaching mandates reining in ESG considerations with a law that, among other things, banned state and local entities from using credit rating agencies that issue ESG scores for governments. And this year, a state transportation bill deemed ESG-related factors, such as goals focused on social justice or federal carbon emission reductions, financially irrelevant to the transportation planning process—and prohibited them from being considered. But that language was removed in subsequent versions before the bill was signed in April by Governor Ron DeSantis (R).

In New Hampshire, meanwhile, a bill that would make it a criminal offense for the state retirement system to use ESG investing strategies was swiftly rejected by lawmakers in February.

These developments come as more information emerges about the potentially higher costs associated with aggressive legislative policies for or against ESG investing, primarily because of the unintended administrative and financial challenges that follow. For example, boycotts that forbid business ties with banks that embrace ESG investing practices could limit governments’ underwriting options, leading to less competition and higher borrowing costs for states. At the same time, policies that call for swift divestments of state assets from certain businesses and industries, such as fossil fuels, can also come with significant upfront costs and fees for such transactions.

More broadly, ESG mandates can potentially hinder the ability of government finance officers to act in the best interest of their constituents. This then could increase the fiscal risk around states’ two largest liabilities: their retirement obligations and debt.

Mandating pension investments

Separate from directly guiding investment, assessing ESG factors can illuminate material risks and opportunities—such as a company’s record on employee relations or compliance with environmental regulations—that should be considered as part of any financial decision-making process. Public pensions, which have a much longer investment horizon than funds for individuals, tend to approach ESG considerations from this standpoint, using them to inform overall investment and risk management strategies. For example, experts largely agree that changing environmental conditions pose a systemic risk to the broader financial system and, in turn, to the more than $5 trillion in assets invested by public pension funds.

State policymakers, however, have largely viewed ESG through a “social impact” lens, which has prompted policies either prohibiting or requiring certain ESG-related investments. Not only is this view potentially out of alignment with pension systems’ fiduciary role to act in the best interest of its beneficiaries, it also risks leaving money on the table. For example, a 2022 report from Wilshire Advisors noted that transaction costs and impact on investment returns from the 2001 divestment by California Public Employees’ Retirement System (CalPERS) from tobacco would be roughly equivalent to $4 billion in lost profits two decades later. However, according to CalMatters, the system’s divestments from thermal coal and Iran “have translated to small gains” for the system.

For his part, Oregon Treasurer Tobias Read (D) has called climate change “an urgent risk to investment returns” but he also has opposed state legislation that created divestment mandates, the Oregon Capital Insider reported. When lawmakers put in place such requirements, “the investment environment gets more complicated,” Read said. “Our sole responsibility at the treasury is to achieve strong returns for the Public Employees Retirement Fund.”

Increased costs in the bond market

When it comes to the cost of issuing debt, municipal market investors tend to view climate change as a potential risk to a government’s ability to meet bond obligations. And that can then lead to lower bond values for investors and increase interest rates for government issuers going forward.

Other research shows that ESG-related legislation prohibiting certain investments can also drive up costs as municipalities and other governmental entities seek alternative underwriters for municipal bond issuances, and in some cases, take on increased borrowing costs.

In Texas, a 2024 study estimated that government entities have paid an extra $270 million per year in bond interest and transactional costs since the state passed a pair of laws in 2021 that limited government entities from working with financial firms seen as unfriendly to the firearms and fossil fuel industries. The study, commissioned by the Texas Association of Business and Chambers of Commerce Foundation, values the total lost economic activity linked to the higher costs for taxpayers at nearly $670 million annually.

“These findings illustrate that when government attempts to mandate values (no matter what kind) to business, the market loses, and taxpayers bear the consequences,” the study’s authors wrote.

The study builds upon previous work that found cutting ties with banks can limit governments’ underwriting options, leading to less competition and higher borrowing costs. A 2022 study estimated Texas local governments paid between $260 and nearly $500 million in higher borrowing costs in the first eight months the laws were in effect. Florida, Kentucky, Louisiana, Missouri, Oklahoma, and West Virginia also now have laws prohibiting ESG considerations that extend to governmental borrowing. A separate analysis for a coalition of nonprofits in 2023 estimated that governments in those states may have paid between $264 million and $708 million in higher borrowing costs over a 12-month period.

A similar study released by the Oklahoma Rural Association in April finds that implementation of the state’s Energy Discrimination Elimination Act has meant an estimated $185 million in additional expenses to the state and local governments in the law’s first 17 months. This year, lawmakers have proposed legislation that would clarify that the requirements do not apply to municipalities.

Final thoughts

Lawmakers’ and financial practitioners’ differing interpretations of ESG can lead to confusion and politicization. Recent laws governing ESG investing, whether with a favorable or unfavorable view, may intend to mitigate exposure to financial risks for pension funds and other critical state investments, but in practice, some laws are having the opposite effect. These conflicting outcomes make it even more challenging to implement ESG mandates, as evidenced by a recent ruling in Oklahoma that halted the state’s energy law. In her ruling, Judge Sheila Stinson wrote that it was very likely the law’s “stated purpose of countering a ‘political agenda’ is contrary to the retirement system’s constitutionally stated purpose” to act in the best interests of its beneficiaries.

These latest developments underscore the fact that policies restricting investment options often force officials to make immediate and unanticipated changes to investment and borrowing strategies and approaches. The resulting upfront transaction costs and administrative challenges could ultimately mean greater costs to taxpayers to meet states’ retirement obligations or finance needed public investments through bonds. The rising difficulties associated with implementing these rigid mandates are prompting at least some officials to moderate their policy approaches to ESG in the public finance space.

Fatima Yousofi is a senior officer, Liz Farmer is an officer, and Stephanie Connolly is a principal associate with The Pew Charitable Trusts’ state fiscal policy project.