Written By: Ian Maybury
Ian Maybury of City Noble examines the potential conflicts investors face when considering the opportunities in ESG
The increasing impact of the fossil fuel divestment movement is giving new impetus to the application of ESG in the investment portfolios of institutional investors. The somewhat “tick box” approach applied to its predecessor, Socially Responsible Investment (SRI), is being superseded by an approach which is seeing Environmental, Social and Governance (ESG) emerge as a more integrated part of investment policy and strategy.
When deciding whether to incorporate ESG into an investment policy there are a number of potentially conflicting areas that need to be considered.
There is the potential conflict between maximising future investment returns and that of investing in a manner consistent with the wider common good or in line with the ethics and values of the investor and/or those on behalf of whom the investment is being made.
The legal position is relatively straightforward for those investing institutional monies on behalf of companies, charities, universities and endowments. There will be a natural and logical desire to align investment policy with the values of the organisation. The challenge here, as elsewhere, lies in the practical decision-making around its design and implementation, the criteria for exclusion and the extent to which engagement is preferable (and practical!).
The legal position for pension trustees is less clear cut. They have a responsibility to demonstrate that they are acting in the best interests of beneficiaries, which usually means the best “financial” interests. It is not surprising then that proponents of ESG increasingly focus on the correlation between an effective ESG policy and “better” investment performance. “Better” in this context can be defined as either investment outperformance or through better risk assessment and management.
As the Law Commission’s report has alluded to, it seems logical that ESG factors, particularly those focusing on sustainability, including risk and reputational management, will generate better long-term returns. This would seem to justify ESG on “financial” grounds for most pension schemes. However, not all members in a given Defined Contribution (DC) plan will be investing for the longer term and arguably many mature Defined Benefit (DB) schemes with their emphasis on de-risking and flight-path driven investment strategy, will not be doing so either!
The recent Law Commission report set out the distinction between financial and non-financial factors that can be taken into account by trustees. The gist is that many factors, which may appear to be predominantly ESG concerns, are actually financial concerns to the extent that practices such as poor governance, environmental degradation, and lax health and safety standards, among others, all represent a reputational risk to the company, which may well convert to a financial risk in the longer term. As such, trustees are not only entitled to take ESG considerations into account but have a fiduciary responsibility to do so.
However, the most accomplished sophist will not be able to align all the moral and ethical concerns a trustee might have with certain companies or sectors without potential financial detriment. Certain industries will be anathema as investment opportunities to some trustees, but will be difficult to exclude on purely financial considerations. Here, the Law Commission identifies two tests when “non-financial” factors can be taken into account to exclude such investments: that members share the trustees’ concern and that there should be no risk of financial detriment to the fund.
When considering financial factors, should trustees encourage companies in which they invest to operate more responsibly with regard to ESG matters with a view to improving standards of governance and long-term financial security and performance? In short, is engagement a more effective policy than exclusion? There is no straight answer. If a sufficiently large number of investors divest rather than engage this will drive corporate behaviours. On the other hand, there is evidence that some stocks, most egregiously tobacco companies, have provided investment opportunities, particularly high dividend yields, for those willing to invest because the share price is depressed and precisely because of disinvestment by organisations operating robust ESG policies. In other instances, particularly where “non-financial” issues are being considered, exclusion will often be the only logical course of action. This will be the case where a specific sector or a company’s primary purpose is contrary to the values of the investors.
However, the application of “non-financial” factors by trustees requires care. Trustees will need to consider how they can evidence that they know the views of their members and whether there is a significant voice of dissent within the membership. Perhaps more challenging, they will also need to demonstrate that the decision will not risk financial detriment. Despite the welcoming of the Law Commission’s “clarification” on the extent to which trustees can allow ESG factors to drive investment policy, it will still be difficult for some boards of trustees to allow “non-financial” concerns to prevail.
There are further challenges for smaller investors in the execution of an ESG programme given that their governance budgets do not extend to the time, capacity and expertise required to engage directly with the companies in whom they are invested. Given that engagement is likely to form a part of any ESG policy, then for all but the largest investors there is a need to rely on others, particularly the appointed fund managers, to implement the policy.
Passive investment, often the most cost-effective approach for smaller investors, would not by definition be expected to sit comfortably with an active approach to ESG. A number of indices, such as FTSE4Good, have been created to address this. However, care needs to be taken when using these indices. In particular, trustees need a clear understanding of the rules applied to generate the index to avoid results that are difficult to comprehend and interpret.
Further, adherence to principles and practices enshrined in international agreements such as the FRC Stewardship Code and the UN Principles for Responsible Investment (UNPRI) make it easier for trustees with a limited governance budget to implement an effective ESG framework.
The majority of fund managers will operate their own ESG or Responsible Investment programme and investment advisors or consultants will assess them as part of their manager research. However, recent comments in the financial press and even from trade bodies has suggested that a significant proportion of the ESG policies of fund managers are doing little more than paying lip service to some of the international agreements to which they have signed up.
However, we are seeing improvements. A number of organisations, such as Hermes EOS, are addressing this by providing investors with the ability to separate their voting at meetings from their fund manager’s engagement by undertaking voting on behalf of the members.
Another recent initiative that is worthy of mention is Red Line Voting from the Association of Member Nominated Trustees (AMNT) in conjunction with the UKSIF. This allows investors to take back some of the delegation, providing smaller pension schemes with the ability to instruct their managers on how to vote via the use of standard templates.
ESG has been in wide use for a number of years now and there is a body of evidence available to assess its effectiveness. Unfortunately the various studies are, at best, inconclusive, if not contradictory. Our own view is that the process of working through policies on ESG risks, determining and applying screening criteria for companies with a view to either product-based or behaviour-based exclusion and how to engage effectively with companies where there may be concerns, will provide a rigour, discipline and transparency to the governance of all investors and can only lead to improved decision-making.