How should trustees be incorporating ESG into their investment strategy?

Often individuals fulfilling different roles with different responsibilities focus on different time horizons. The Ops Manager of any given business might think about the month ahead; the MD about the year ahead; the CEO about the next 3-5 years. Pension Trustees are compelled to think 5, 10, 15, 20 years and more ahead due to the long-term nature of our obligations to act in the best interests of scheme beneficiaries.

When these obligations are considered in combination with the influential volume of the combined assets of UK pension schemes and in light of the weight of emerging evidence, the declaration of climate emergencies, the Paris Agreement, as well as the increase in public awareness and engagement with the issue, we believe it is entirely right that the pension industry should lead the charge on the promotion of sustainable practices for the long-term benefit of our scheme members.

It is essential to consider environmental, social and governance (ESG) factors in our investment decisions, including in relation to buy-ins and buy-outs. The increasing requirement to document the consideration of these factors is useful as it undoubtedly improves the rigour applied during the investment process.

Low carbon economy

An obvious example of these medium to long-term risks is associated with the transition to a low carbon economy. There will be stranded assets associated with organisations that fail to adapt appropriately. Many common investments will be faced with transition risk which will need to be managed and, where it becomes apparent that organisations have failed to adapt, appropriate action will need to be taken.

There is a continuing stream of innovation in this space which warrants continued attention: carbon credits, offsetting, carbon capture and energy storage, the list continues and will grow ever longer over time. It is important that we continue to evolve our understanding along with the scientific community and regulators. The scope of emissions, for example, represents a rapidly evolving picture. Currently, in the UK, firms are required to publicly report their scope 1 and 2 emissions (footnote [1]), covering essentially the direct contribution of an organisation to climate change. This ignores entirely both the up and down-stream activities of a firm, which still represent risk.

TCFD

The Taskforce for Climate Related Disclosures (https://www.fsb-tcfd.org/) is becoming increasingly influential as a vehicle to standardise reporting in this space and we welcome this. Until now disclosure has largely been on a voluntary basis, with draft guidance being developed for pension schemes by the Pensions Climate Risk Industry Group. This is likely to change in the near future to become mandatory for large pension schemes under measures being introduced in the Pension Schemes Bill, and over time we expect there to be a move for disclosures to cover scope 3 emissions.

The TCFD is an excellent example of a united, high-profile, international effort working with governments, businesses, scientists and regulators to make real progress towards mandatory, practical, standardised reporting enabling asset owners, such as pension funds, to make educated investment decisions relating to ESG factors.

Not forgetting S&G

It is of course easy to focus on the ‘E’ in ESG: serious consideration should also be paid to social issues, such as employment standards, and governance issues, including fighting corruption and ensuring sound decision-making. Additionally, companies with higher governance standards should be expected to perform better over the long-term. These three elements also need to be well balanced.

The UN Principles for Responsible Investment (UN PRI) continue to provide a useful framework to guide decisions in the space.

Making sense of data

Getting a grip of the absolute and relative ESG performance of underlying assets remains extremely challenging. We have seen significant improvement in recent years, but there is more to do, particularly around standardisation of metrics.

The reality is that, while for a long time ESG data has been extremely patchy, we are all regularly inundated with large volumes of information. However, much of it is difficult to understand and often contradictory. We must endeavour to see through the noise and focus on building our understanding of scientifically and objectively important measures such as greenhouse gas emissions, water usage, staff remuneration, conflicts of interest and so on. To this end the Sustainability Accounting Standards Board provide useful guidance by industry (https://www.sasb.org/).

Passive strategies

One further area of consideration for trustees is the use of active or passive investment strategies. Over recent years there has been a strong move towards passive funds as they carry lower costs and active managers have on the whole struggled to outperform net of fees. There is an argument being made to return to active funds with the idea being that managers cannot take a proactive approach on ESG if they are matching an index. However, ESG strategies can be employed in passive space and there is a growing range of passive trackers where the index has an ESG tilt. For example, MSCI have a world equity index which incorporates ESG ratings and trends (MSCI ACWI ESG Universal Index). Active management should be a separate decision and not an accidental consequence of moving to an ESG strategy.

Practical next steps for trustees

ESG considerations represent a rapidly evolving and important area of increasing focus. With most schemes having updated their SIP to reflect ESG policies, a practical next step is for trustees is to engage with their investment consultant and asset managers to make sure they understand what is being done currently on ESG. For each part of the portfolio, trustees should establish three key aspects:

To what extent have managers incorporated ESG into their investment process?
Are managers engaging with companies in which there are investing?
Are shares being voted on and the policy being followed?
Doing this enables trustees to establish the current position and identify where there may be gaps and areas to focus on in the future. It also gives trustees a solid starting point to build in for further discussion with advisors and managers.

[1] Greenhouse gas emissions are categorised into three groups or 'Scopes' by the Greenhouse Gas (GHG) Protocol. See https://ghgprotocol.org