NEWS   |    August 2, 2016

ESG – on its way up?

By Anna Copestake, Senior Associate, Arc Pensions Law.

Now in the throes of Brexit, we are being reminded that pension schemes are in it for the long term. So are trustees taking account of long term risks when setting their scheme’s investment strategy?

The Law Commission’s report into the ‘fiduciary duties of investment intermediaries’ shone a spotlight on the role of ESG in setting investment strategies. The report concluded that trustees do not need to maximise short term returns at the expense of long term risks. The message being that pension schemes are long term investment vehicles. Two years on, and with the UK on its way out of the EU, that message is perhaps more pertinent than ever.
Below we ask, what is ESG? How can (and should) trustees take it into account as part of their investment strategy? And has the appetite for ESG started to wane or is there more to come?

Why now?

Focus on ESG considerations continues to grow and a large number of schemes now have an ESG policy in operation. More investment products with ESG selection mechanisms appear to be coming to market, alongside products aimed at helping trustees monitor ESG practices.

In Europe, the final text of the IORP II Directive requires the inclusion of environmental and social factors in scheme risk assessments. It also requires disclosures around the materiality of ESG in scheme investments. How far the Directive’s terms will be incorporated into UK law and when will, of course, now be subject to the terms of Brexit.

However, we only have to look at the current focus on the impact of climate change on sustainability, and the voluntary guidelines (e.g. the UN-backed Principles of Responsible Investment) already widely in use, to see that these considerations look set to stick around for the long-term.

What is ‘ESG’?

ESG is short-hand for the environmental, social and governance factors that pension schemes may take into account when selecting investments.
ESG analysis involves looking at the environmental stewardship (e.g. carbon emissions or energy consumption), corporate governance (e.g. structure or compensation packages) and social practices (e.g. relations with staff or suppliers, or health and safety) of a company into which scheme assets are invested. It is normally a risk assessment of long-term sustainability. The aim being to understand how business practices might affect investment return. The analysis can take place over a market sector, a particular company or a particular asset class.

It is important to distinguish ESG from investment decision making based on ethical beliefs. They are often confused but are, in fact, very different beasts. An ethical decision to invest (or abstain from certain investments) is based on a moral or political viewpoint. Yet trustees must ask themselves very different questions when considering whether to make an ethically driven investment decisions. As we see below, trustees may find it more useful to think of ‘financial’ and ‘non-financial’ factors when navigating the application of their investment powers.

Trustee investment powers – do they allow for ESG?

The starting point for any trustee investment decision is the scheme rules – they must permit the trustees to make the intended investment. Beyond the rules, it is a question of legislation and case law.

The Pensions Act 1995 and 2005 investment regulations place a range of investment duties on trustees. For example, trustees must secure appropriate asset diversification and invest in a manner ‘calculated to ensure the security, quality, liquidity and profitability of the portfolio’. Trustees are also required to include a statement in the scheme’s Statement of Investment Principles (SIP) regarding the extent they take ESG and ethical considerations into account.
Running alongside these legislative duties are those imposed by the Courts. The often-quoted overarching investment duty comes from the case of Cowan v Scargill, in which the judge held that trustees must act in members’ financial interests (i.e. with a focus on return). However, there are a range of other trustee duties that arise from case law. These include the duty to exercise the investment power for its intended purpose, act with due skill and care and to take into account all relevant considerations (and not irrelevant ones).

Within this legal framework the Law Commission considered that ESG analysis could properly inform investment decisions provided the legal duties were met, in particular the duty to act in the members’ financial interests.

In the Law Commission’s report also provided some useful guidance for trustees at a time when ESG was starting to gain more prominence on investor’s agendas.

In particular the Law Commission concluded that:

  • The purpose of trustees’ investment powers is usually to provide a pension and the primary aim of an investment strategy is to secure the best realistic return over the long term.
  • The key distinction is between financial and non-financial factors. Financial factors are those relevant to the trustees’ duty to balance returns against risks, and include risks to the long-term sustainability of a company’s performance. Non-financial factors are motivated by non-financial concerns e.g. improving members’ quality of life or showing disapproval of certain industries.
  • Trustees may take into account any factor relevant to the long-term performance of an investment. These include risks to a company’s long-term sustainability and are often referred to as ‘ESG factors’. It is worth noting, however, that ‘ESG’ can be used to refer to a wide range of factors some of which may, depending on the circumstances, not necessarily be financial factors. A key question to ask is whether the factor is relevant to the returns or risks associated with the investment.
  • Trustees should take into account financially material risks. It is a matter of trustee discretion, having taken proper advice, to determine what these risks are.

What about ethical investments?

Ethically-driven investment is likely to be a non-financial factor. An example would be excluding a sector of the market because of a disapproval of those industries.

It had previously been thought that the Cowan v Scargill case prevented trustees from making ethical investments if they were not financially advantageous to members. However, the Law Commission considers that trustees may take into account non-financial factors provided they ask themselves the following:

  1. Do you have good reason to think that scheme members share your concern?

Trustees cannot impose their ethical views on the membership and should be comfortable they are acting in line with members’ views. This raises interesting practical questions of what degree of member agreement and what form of evidence gathering (if any) would the trustees want to see before proceeding. The answer will be scheme-specific and based on the circumstances of the investment. Members may include survivors, children or ex-partners of former members and trustees may want to think specifically about how they consider the views of these beneficiaries.

  1. Does the decision risk significant financial detriment?

Trustees will want investment advice on the financial impact of the investment. It is worth noting that the Law Commission thinks there are two instances where significant financial detriment would be allowed – (i) where the investment is expressly permitted by the scheme rules; and (ii) in a DC scheme, where the member has specifically chosen the fund.

Trustee questions when considering approach to ESG

Questions that trustees might find it useful to ask themselves include:

  • Do they understand their duties in relation to ESG and ethical investing?
  • Have the trustees discussed their approach to ESG and/or have a policy?
  • Do they understand their investment adviser’s approach to ESG and the impact of any incentives received by asset managers on investment approaches?
  • Are the trustees getting the right information at the right intervals? It can be harder to have direct oversight when investing in pooled vehicles, for instance.
  • What would an ESG assessment look like?
  • How would they monitor ESG changes in the companies in which they are invested?
  • How would they respond to member questions about ESG investments?

Are there specific considerations for DC schemes?

As with most things DC, integration of ESG remains a developing area. In past years some DC schemes have sought to address ESG considerations by simply adding an ethical fund to the self-select options. However, this may not always be the answer. As mentioned above there is a difference between ethical and ESG. In addition, trustee investment duties apply across the portfolio as a whole, so the inclusion of an additional ethical fund option may have proved a distraction from a wider ESG analysis, particularly in relation to a scheme’s default fund(s). DC trustees may want to check the extent to which they want (or should) take into account long-term sustainability in the scheme’s default fund and other investment options.
DC trustees may also have different approaches to DB trustees when it comes to the weight placed on certain factors. For example a DC trustee may have greater overall liquidity demands where the scheme operates daily dealing.
DC trustees may also receive more member questions than their DB counterparts. With an industry-wide push to increase engagement with DC pension provision they could receive more frequent enquiries about the ESG and ethical offerings in the scheme.
As discussed above there is also no need to avoid risks of significant financial detriment in relation to ethical self-select funds.

The views in this article are intended for general information purposes only and should not be used as a substitute for professional advice. Arc Pensions Law and the author(s) are not responsible for any direct or indirect result arising from any reliance placed on content, including any loss, and exclude liability to the full extent. Always seek appropriate legal advice from a suitably qualified lawyer before taking, or avoiding taking, any action. If you have any questions on the points raised in the above, please do not hesitate to get in touch.

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