The investment industry has seen some rapid shifts in embracing responsible investment (RI) as a new standard for investing. So much so that many funds now are embedding environmental, social and corporate governance (ESG) factors as part of their ‘mainstream’ investment activities. While this is good news, the uptake at the trustee level seems much slower, despite numerous best practice initiatives. Is lack of knowledge the key problem?
We believe that for pension funds to act in the long-term interests of their beneficiaries, they must ensure that sustainability risks and opportunities are systematically identified and addressed. The push for this should come from the very top of the organisation - at the trustee level - through learning and knowledge sharing.
There are growing regulatory and best practice provisions in the UK and beyond encouraging pension funds to articulate and formalise their RI policies and practices. There are also more pronounced societal expectations for companies and the financial system to behave responsibly and create a positive impact. In combination, this undoubtedly puts increased pressure on pension funds to take RI seriously. The question is; are trustees equipped to tackle this new development? And if not, what are the main obstacles and how can those obstacles be overcome?
While there are pockets of excellence within the pension fund industry, the majority still have a long way to go and need to act fast to address the gaps. We see three main obstacles to a wider uptake and understanding of RI at trustee level:
One: The myth that fiduciary duty is a legal impediment to trustees considering environmental, social and governance (ESG) factors in the investment strategy, asset allocation and investment decision making of a pension scheme still prevails.
Two: There is not enough knowledge among pension fund trustees of why RI, including ESG integration, is relevant to investments, and how to integrate that thinking into investment operations.
Three: There is a lot of jargon and confusing terminology, for instance the term “non-financial factors” as synonymous to ESG factors, that prevent the immediate recognition and uptake of best practice RI at trustee level.
How can these obstacles be tackled?
Clarity is emerging: We see clear evidence that the myth around fiduciary duty constraints is being busted and a more modern interpretation is taking hold. The Law Commission, in its 2014 report on the ‘Fiduciary Duties of Investment Intermediaries’, stated that “There is no impediment to trustees taking account of environmental, social or governance factors where they are, or may be, financially material.” Already in 2005, the landmark Freshfields report, legitimised the role of trustees to consider ESG issues in investment decision making. 10 years later, the Fiduciary Duty in the 21st Century publication concludes that “Failing to consider all long-term investment value drivers, including ESG issues, is a failure of fiduciary duty”.
At its core, RI encompasses all efforts to carry out the investment mandate in a way that aligns with the interests and values of the ultimate owners. As was evident in a recent study commissioned by the Norwegian Ministry of Finance into RI best practices among 18 pension funds across 13 markets, RI is seen by several prominent institutions simply as best practice asset management. As the definition of fiduciary duty broadens to allow trustees to consider ESG factors as materially relevant to beneficiaries’ interests, the next step must be to get clear and comfortable with what ESG issues are and how they work.
Knowledge is key: We believe that all pension fund trustees should have a minimum standard of knowledge on RI policy and ESG issues. A lack thereof could limit debate, hinder appropriate decision-making and potentially expose the fund to reputational or financial risks. It can also limit trustees’ ability to hold their immediate investment chain and intermediaries to account. As with any organisation, leaving key decisions on such long-term material issues to an individual or a siloed department is unlikely to be a lasting solution.
Language matters: Through targeted education, confusion caused by terminology can be diminished and clear distinctions can be made regarding different investment styles so that not all are associated with, for instance, exclusions and thus the fear of underperformance. We would caution against using a term like “non-financial factors” in describing ESG issues, because it risks implying that they are not material or relevant to the bottom line. What trustees need to be able to understand and address are complex and systemic economic issues such as the impact of climate change, food and water security, demographic changes, and how those trends will affect long-term investment performance. With that knowledge, trustees will be able to develop their policies and practices so that they are prepared, pro-active and continuously improving in their role of fiduciaries.
Training in RI needs to be continuous and up-to-date: We believe that pension fund boards should dedicate a sufficient portion of time every year towards professional training in responsible investment – not as a one-off, but as an integral part of ongoing development, ensuring that current and emerging topics are covered.