Estimated reading time: 4 minutes
ESG, or environmental, social and governance, is a hot topic at present for those who manage defined contribution (DC) pension schemes. Regulatory requirements from the Department for Work and Pensions (DWP) and The Pensions Regulator (TPR) means trustees now have to consider how ESG affects the investment strategy for their members. What are the implications of this change?
The DWP requires that the DC default strategy should reflect how the trustees take account of financially material considerations, including ESG matters, and that pension fund trustees should produce environmental, social and governance statements. One of the difficulties with this is that there is no common acceptance of what ESG actually is.
This means trustees will need to define what ESG means before they can say whether and how they will take ESG factors into account. They will then have to communicate this to their members. Another difficulty is that many companies already have strong views on ESG issues and have policies in place. So, should trustees follow the company lead on those issues? Or should they come up with their own approach? It would certainly look odd if the company had one view and their pension scheme another.
A further complication is that many people confuse ESG with ethical investments, such as choosing not to invest in areas like arms manufacture or tobacco. There are many other categories too including socially responsible investing (SRI), sustainable investments, green investments and so on that add to the confusion. Trustees can fall into the trap of thinking that by offering ethical investments as an option outside of the default strategy, they are covering their ESG responsibilities.
Although there hasn't yet been a great deal of ESG activity, DC scheme trustees all need to consider this now – action needs to be taken by October 2019. Some trustees have started to integrate ESG risk factors into the default strategy, as they have come to the conclusion that these factors are financially material.
Generally speaking, scheme members are happy to include ESG considerations, but without negatively impacting the returns they are receiving. This is why companies need to be clear about their ESG policies.
Some of the biggest contributors to returns are companies that you perhaps wouldn't consider suitable for ESG. For example, there is a recognition that we still need oil and gas for the foreseeable future, but there are obviously some environmental concerns. However, if your ESG outlook is to say you invest only in companies that are the best in their sector, then you're on firmer ground. If these companies are governed as well as any in the sector and are trying to positively drive innovation in that sector (for example, investing in new technologies such as renewables) then this is a positive message.
In addition, companies with good ESG characteristics are likely to pose less risk and therefore are better able to mitigate financial risks related to ESG factors, whether environmental disasters, employment issues, regulations, corruption or security - all of which could reduce returns to pension funds.
Even investment on a passive basis can contribute from an ESG perspective if the manager attends AGMs as a shareholder and votes on topics such as remuneration and environmental issues in line with their ESG beliefs. In this way they put pressure on the companies as a shareholder, rather than not investing in them. This shows that there are different ways to implement your ESG beliefs.
Trustees generally debate the need to have some pure ethical funds within the suite available for members who want to make specific choices. In an Australian Master Trust there is a 'cruelty-free vegan' investment option, for example. However, this would be more difficult in the UK, where the pensions choice is driven by the employer / trustee, rather than the employee and therefore it is difficult to cater for each member’s views.
These types of options may help to engage people about pensions. It will be easier to engage them by communicating the positive things their fund is doing in relation to issues like the environment.
The future of ESG
Regarding wider ESG factors, even if they are unlikely to engage the masses you could disengage a significant proportion of people if you don't take them into account. ESG is becoming more and more a core part of investment management and if trustees do believe that these factors are financially material then you have to ask – why aren’t you doing it? The result is that members will still reap the benefits of positive returns on their investment, without necessarily engaging deeply with ESG.