Pensions - Articles - Trustees to consider ESG factors

ESG, SRI, ethical investing… these terms are rarely out of the news in any discussion of investment strategies or policies. The terms are often used interchangeably; but actually they are different and these differences affect how client portfolios should be designed and which investments are appropriate for meeting a client’s objectives.

 By Paul Maguire, Investment Consultant, Barnett Waddingham

 So, what is ethical investing?

 Socially Responsible Investing (SRI):
 focusses on principles - investments are chosen based on ethical values
 employs negative screening - investors exclude investment in certain companies or sectors based on specific criteria, e.g. health-related charities may exclude investment in tobacco companies, or religious charities may screen out so-called “sin” stocks in the alcohol or gambling industries
 tends to be narrowly defined - e.g. excluding from a portfolio the top 200 fossil fuel companies, ranked by the potential carbon emissions content of their reported reserves
 SRI is big business – a 2016 survey by the US Forum for Sustainable & Responsible Investment estimated that it accounted for over 20% of assets under management in the US, or more than US$ 8 trillion, an increase of one third from just two years earlier.
 By contrast, Environmental, Social and Governance (ESG) factors:
 represent a relatively newer concept - having first gained widespread attention with the launch of the United Nations Principles for Responsible Investment in 2006
 focus primarily on investment returns - the theory underpinning ESG investing is that by including these long-term sustainability factors in research, it should be possible to identify investments with the potential to generate higher investment returns
 usually preclude negative screening - specific investments are not banned, rather rankings are assigned to ESG factors for companies (these rankings are then integrated into the overall research process, so that a low ESG score per se does not necessarily exclude a stock from investment but will provoke further evaluation)
 are broader in scope - a wide set of factors can guide stock selection, e.g. which mining companies are less likely to suffer catastrophic events because of their environmental and safety practices?
 promote a more holistic approach to investing - certain factors are broadly applicable to any investment scenario, e.g. good governance, strong shareholder rights, transparency – these might be seen as positives for investors in any company or sector
 These issues are relevant to trustees of charities and pension schemes alike, and therefore of particular interest to trustees of charities with defined benefit pension schemes.

 The question of financial materiality
 A fundamental question for trustees is whether these approaches to investment need imply a sacrifice in financial return (some, of course, might see that as a risk worth taking). There is some evidence that strong ESG scores are reflected in companies recording stronger financial performance and beating their benchmarks.

 As yet, though, there is little or no long-term data available on the extent to which an ESG tilt can improve portfolio returns. Intuitively, one might expect companies with better ESG credentials to outperform lower-ranked competitors, based on the tenet that issues such as bad governance or environmental problems damage corporate profitability.

 A Boston Consulting Group report in 2017 on over 300 of the world’s biggest pharmaceutical, consumer goods, oil and gas, banking and technology companies also suggested that those with more “ethical” operations are more profitable. There remains though a concern among large investors in particular that too great an emphasis on responsible investment can limit returns, for example by restricting investment in profitable sectors such as oil, which have traditionally paid out large dividends.

 DWP consultation
 In June this year, the Department for Work & Pensions (DWP) caused a stir when it released a consultation paper on changes to the investment regulations for occupational pension schemes. We covered this event in an earlier briefing note; ESG in focus. The final paper, published in September, states that it remains government policy not to direct the investment decisions or strategies of trustees of pension schemes and includes what the government referred to as an “optional policy” on non-financial factors – these include members’ ethical concerns and their views on social and environmental impact matters and quality of life considerations. Trustees will be required to outline their policy on the extent - “if at all” – to which they take such matters into account.

 “Perhaps more noteworthy for many trustees, the regulatory changes on the back of the consultation will put more pressure on trustees to have given proper consideration to the extent to which ESG factors are financially material.”
 In particular, trustees will need to have updated their statement of investment principles (SIP) by October 2019 with a policy on how they take account of financially material considerations “over the appropriate time horizon of the investments”. Crucially, “financially material considerations” will include ESG considerations (specifically including climate change), which the trustees consider financially material.

 Note that, where concerns are not financially material (e.g. concerns which are primarily ethical), trustees may only take the concerns into account where there is broad consensus. Where there are differing views on an investment issue, such as in relation to fossil fuels, trustees should focus exclusively on financially material risks and opportunities.

 Whilst the regulations described above are of primary concern to occupational pension scheme trustees, charity trustees will wish to be aware of them, given the increasing importance of ESG topics in the charity sector. This is a complex and developing area, which can easily tie up trustees in lengthy and time consuming debate. We would of course be delighted to assist charities which are facing such a challenge.

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