Big changes are on the horizon for pension schemes this year. From 1 October 2019, pension schemes will have to report how they take account of financially material matters, including Environmental, Social and Governance (ESG) considerations in their Statement of Investment Principles.
Some schemes will have been doing this already to varying extent, but for some ESG may be a new topic and one that merits further exploration and consideration.
What is ESG?
Once a niche area, ESG has grown in prominence in recent years. According to data from the Global Sustainable Investment Alliance[1] $22.89 trillion of assets globally are now managed in responsible investment strategies. This way of investing grew out of a desire by likeminded investors wanting to avoid investing in companies that they believed to cause harm. The industry has developed over the years and there are now many different funds and investment approaches available to investors.
Many funds and strategies set out to invest in different ways and the different terminology and jargon can be confusing at times. Here we attempt to explain some the different approaches to help you make an informed choice in this area.
Ethical Investment
This was the first area to develop and investing ethically, at least in the earlier days, tended to be exercised by exclusion of certain investments in areas that don’t align with the investor’s values. Investments on the exclusion list may include tobacco, weapons production and alcohol. Excluding an area of the market can cause investment returns to be potentially more volatile, particularly since some of the tobacco stocks have historically been dividend-paying stocks which tended to reduce overall volatility. However, proponents of ethical investment often state that the industries excluded – such as tobacco – are declining anyway due to the adverse nature of their products.
Best in Class
The best in class approach is an attempt to counter the problem that ethical investment can exclude entire sectors of the market. Doing so could make funds more volatile than those without such restrictions. The fund manager will attempt to invest in the company in a particular sector that they perceive to be operating in the most sustainable manner. This does have the problem that you are relying on the manager to make a judgement which may be different to the investors. In addition, in some sectors, such as tobacco there is no getting away from the fact that all the companies have a product that is seriously harmful to consumers.
Sustainable Investment
Sustainable investment is an attempt to move away from investing on an exclusions basis to a more positive outlook. Exclusions may still be used, but the fund manager will also aim to invest in companies that make a positive contribution to the community and society they operate in. Firms are often scored by the manager in various areas such as corporate governance, social and environmental impact. Many fund managers of sustainable funds will invest in long term themes that they believe will benefit society. Themes might include areas such as climate change, health and wellbeing and urban regeneration.
Impact Investment
Impact investment shares some similarities with philanthropy in that the investment is designed to cause an improvement in communities. It has been growing rapidly in recent years with the Global Impact Investors Network (GIIN) estimating in a recent survey[2] that there is now US$228 billion in assets invested under the ‘impact investing’ category. Impact investments could include companies trying to improve communities in developing countries, or companies helping climate change adaption.
Engagement and Stewardship
As responsible owners of assets, investment managers have an opportunity to influence company behaviour through engagement and voting. Large institutional asset owners often have privileged access to senior company management where they have the opportunity to make their views known. Some investment managers will encourage the companies they own to behave in a more responsible way. In addition, voting rights that come with share ownership can be used to influence company behaviour in areas such as executive pay and governance policies.
ESG is not just one approach
ESG is often used as a catch all term and can encompass all of the approaches above. Many asset managers now recognise the value that integrating ESG considerations into their investment processes brings. By fully integrating ESG into the decision making process alongside more traditional financial metrics, managers can often reduce investment risk and produce more sustainable long term returns.
What should Trustees be doing?
Trustees need to have thought about their approach to this area. The Regulator has been clear that a ‘standard template’ approach is not appropriate for the Statement of Investment Principles and that it should reflect the views of the trustees and other stakeholders. We are currently working with many clients to help them devise their approach, if you’d like to find out more about how we can help please do get in touch.
This article is aimed at Professional Investors only and is not aimed at Retail Clients. It should not be regarded as providing specific advice or a recommendation of suitability.