Is ESG Investing Illegal? And Other Sustainable-Investing Questions in the Trump Era

For sustainable investors, these are confusing times. The Trump administration’s antagonism toward sustainable investing, combined with other setbacks, have raised a number of questions about whether people can still invest sustainably.

The White House declared an “energy emergency,” pledging to end policies that “impose undue burdens on energy production and use” and withdrawing from the Paris Agreement, in which nations pledged to reduce the greenhouse gas emissions that cause global warming. It has also halted tens of billions of dollars in energy and environmental spending. Meanwhile, it has targeted diversity, equity, and inclusion, or DEI, programs in the federal government.

At the same time, a US District Court in Texas found that American Airlines AAL violated the law by including funds from investment companies that consider environmental, social, and governance factors. Among other things, the judge wrote, “The belief that ESG considerations confer a license to ignore pecuniary benefits is mistaken. Erisa does not permit a fiduciary to pursue a nonpecuniary interest no matter how noble it might view the aim.” (The term “ESG investing” is frequently, but not always, interchangeable with “sustainable investing” because it’s used by investors who are aware of climate and other risks that are not necessarily accounted for by traditional financial metrics. For a look at the different kinds of sustainable investing, read this.)

Already, a number of states have also taken steps to limit sustainable investing including in-state pensions. (Pleiades Strategy tracks state actions here.) Trump is also likely to erect new barriers to ESG investing in retirement plans governed by law. (For a briefing on the backlash against ESG, read this Bloomberg story.)

Following are answers to a few simple questions that may arise for current and would-be sustainable investors.

Is ESG Investing Illegal Now?

No. But it will be more difficult in retirement plans. Nonretirement investors will be free to invest how they want.

- The American Airlines decision affects the 401(k) retirement plan for the carrier’s employees and is likely to be appealed. “The investments of 401(k) plans will be at a higher level of scrutiny because of the Erisa standard of fiduciary duty,” says Lia Mitchell, senior policy analyst at Morningstar. Under the Employee Retirement Security Act of 1974, a fiduciary must act solely in the best interests of the plan participants and beneficiaries. Also, the Trump administration’s new secretary of labor is likely to overturn guidance that plans can consider sustainability factors in addition to pecuniary factors. That flip-flopping is one reason that plan sponsors have been reluctant to put sustainable funds in their plans in the first place. Fewer than 15% of 401(k) plans offer an ESG fund in their investment lineup, according to research by Jane Danyu Zhang, assistant professor of finance at the University of Oregon Lundquist College of Business.

- For public pension plans, some conservative states also restrict aspects of sustainable investing in their public pension plans, but this is on a state-by-state basis. For example, Florida restricts State Board of Administration fund managers from considering ESG factors. Ohio also bars state pension funds and university endowments from prioritizing ESG in investing. Some attempts to ban sustainable investing outright have failed, including an effort by New Hampshire to make ESG investing a crime.

- The so-called brokerage window, which allows one to open a self-directed brokerage account that lives within their retirement plan and own a wider range of investments including ESG funds, if one so chooses, will likely remain untouched. “If you made your investments through the brokerage window, or that’s where they’re available, I would not expect that to change,” says Morningstar’s Mitchell. “In general, most experts believe that plan fiduciaries aren’t obligated to monitor brokerage window investments. However, if an ESG fund is offered in the plan itself, that could change.” Plan sponsors will give you plenty of time for the change and suggest equivalents, Mitchell says.

- Outside of retirement plans, you are free to invest how you want, and financial advisors aren’t proscribed from making sustainable investments available. Still, a retirement account is often the sole financial investment for many people. “If you have enough money it will be no trouble to invest this way, but for the little-guy investor, it’s more difficult,” says Jennifer Coombs, head of content and development for US SIF, a trade group for sustainable investing. “The average small do-it-yourself investors are the ones that get hurt.”

Will Investment Managers Pull Back on Using ESG Factors Because of the Backlash?

Possibly, but unlikely, not least because Europeans are enthusiastic about ESG investing. And active investment managers consider that ESG analysis is part of their due diligence. “It’s so easily shown that certain ESG factors do affect investments,” says Chris Fidler, head of industry codes and standards at the CFA Institute. “If I were investing in a piece of real estate that’s in a flood zone, that’s an environmental factor, and if I didn’t take that into account I’d be breaching my fiduciary duty.”

To be sure, Fidler says, investment managers will need to exercise care and justify the logic of the investment. “People are saying generally that they’ll carry on, but not be as public about” their activity, he adds.

Indeed, asset managers think demand for sustainable investing will increase. Some 78% of asset managers and 80% of asset owners expect sustainable assets under management and allocations to rise in the next two years, according to an August 2024 survey of more than 900 institutional investors globally by the Morgan Stanley Institute for Sustainable Investing.

Will Sustainable Investments Underperform Because of the New Policies?

They may keep lagging, although the long-term thesis for electric vehicles and renewable energy remains intact. In 2024, US sustainable open-end funds and exchange-traded funds suffered a second year of outflows, partly because of performance—only 42% of sustainable funds landed in the top half of their respective Morningstar categories, says Hortense Bioy, head of sustainable-investing research at Morningstar Sustainalytics. Since 2021, green investments, including wind, solar, battery, and electrical vehicles, struggled to generate good returns for investors, mainly owing to high interest rates.

Still, the consensus is that the global energy transition will continue, albeit at a slower pace. That means transition themes will play out, with investment performance dependent on the skill of the manager or the costs of the fund.

- Near term, renewables sentiment may stay weak if Trump cuts green credits, and if, as the Fed suggests, it will slow its pace of easing. Brett Castelli, a Morningstar equity analyst, thinks a partial repeal of the Inflation Reduction Act, which provided tax credits for renewables and electric vehicles, is possible. Castelli notes that renewables, excluding hydroelectricity, accounted for almost 90% of new generation capacity in third-quarter 2024. They benefit from their zero-emission profile, cost competitiveness, and current tax incentives. Despite “meaningful roles for legacy fuels,” Castelli adds, “we expect renewables to continue to comprise the bulk of near-term capacity additions, with select natural gas additions to help meet rising electricity demand.”

- The EV tax credit of $7,500 will be hard to eliminate “without new legislation because the credits (as well as battery manufacturing credits) are part” of the IRA, writes David Whiston, a Morningstar strategist who follows autos. Still, Whiston expects current EPA rules calling for a steep decline in auto emissions “to be reduced or eliminated.”

- How about Tesla TSLA? Seth Goldstein, a Morningstar strategist, observes that even if the $7,500 EV tax credit is lost, “Tesla is better positioned to withstand the change as it is already profitable. Additionally, we think Trump would continue to enact tariffs to effectively keep lower-priced Chinese EVs out of the US market. This positions Tesla to maintain its market leadership position in the US.”

Does Sustainable Investing Even Work?

This depends on what you’re looking for. Sustainable investors run the gamut—some are looking to avoid risk, and some are looking for impact. Likewise, funds are available in an array of flavors.

- For investors (usually institutional) who practice integrating ESG analysis into their active management or proxy voting, it’s part of the way they anticipate all kinds of risks they believe will be material to the bottom line.

- For values-based investors, who typically filter out certain investments, the resulting portfolio meets their needs. These can include climate-aware investors seeking to avoid fossil fuel stocks.

- See above for a discussion of the outlook for big themes like renewables and EVs.

- For investors seeking impact, it’s difficult to measure the effectiveness of general ESG funds. Best to use thematic funds, which focus on opportunities or seek to address particular problems.

- For those seeking outperformance from general ESG funds, there is some debate. In theory, sustainable investing predisposes you to lower returns because higher-quality stocks will already carry higher valuations. Larry Swedroe, head of financial and economic research at Buckingham Wealth Partners, provides a clear description of this phenomenon here. In addition, Swedroe points out, investors with screened-out assets clearly have a less-diversified portfolio, and by definition, less-diversified portfolios are also less efficient. On the other hand, companies with low sustainability scores are more at risk for things like pollution or government interventions that could increase their costs. “If you’re subject to less risk, you should have a higher valuation,” Swedroe says. The process of acquiring that higher valuation should produce strong returns for the company’s investors.

- On the other hand, some argue that ESG principles can benefit single-stock returns as well as portfolio risk management, and that better-quality companies can perform better than their peers. That is what Abrdn Investments, an institutional asset manager that runs mutual funds and ETFs, found when it reviewed a wide array of research papers about sustainable investing. You can read about it here.