ESG: vital risk management but application challenges remain

Written By: Emma Powell LAPF Investments

Emma Powell discusses how trustees are approaching the requirement to integrate ESG principles into their investment strategies and the importance of consistent reporting standards from managers and the companies they invest in, to help them do so

Changing regulation and increasing awareness of the risks posed by climate change and social inequality to investments has pushed environmental, social and governance (ESG) issues from the sidelines to the fore.

By integrating ESG principles into their strategies, investors hope not only to stave off risks, but also identify opportunities. Those range from climate-related challenges such as cutting carbon intensity, to addressing the UN Sustainable Development Goals, which cover areas including health provision, social housing and equal pay.

Changing government policy and regulatory guidance is a major driver. In February 2020, amendments to the Pensions Schemes Bill were proposed, which would require pension trustees to review the impact of climate change on their investment strategy, manage exposure to those risks and set targets for exposure to these pitfalls.

Building on this, the government has also consulted on mandating larger schemes and master trusts to disclose climate risk in line with the Task Force on Climate-Related Financial Disclosures’ (TCFD) recommendations by the end of 2022. The outcome of that consultation is yet to be announced.

Trustees must already produce a statement of investment principles setting out their policies on financially-material ESG considerations and their policies on stewardship, including when and how they plan to engage with investment issuers or managers on matters such as risks and social and environmental impact. This statement must also be published online.

Since October trustees have been required to go further, disclosing their policies with asset managers including remuneration, performance, costs and how they incentivise managers to align investment strategy and decisions with their own policies.

With the UK government among several major economies targeting net zero carbon emissions by 2050, it is unsurprising that climate change has captured greater investor attention than social issues, according to Majedie head of responsible capitalism, Cindy Rose. “There isn’t a sharp and sudden disruption over that,” she says.

That urgency is also apparent among investors. “There is that sense that you need to do something,” says Rose. “People want to be more connected with what they’re investing in.” However, the core motivation behind ESG investing is risk management, she adds. “My consideration looks entirely at what the key material risks and opportunities are in a business we invest in,” she says.

For example, the government’s net zero target and growing consumer awareness of climate change issues could result in fossil fuel companies being left with stranded assets. “And that’s become part of the investment rationale, [so] then increasingly we’ll take that more seriously,” says Rose.

Growing impetus for action
However, the outbreak of Covid-19 has also provided added urgency for investors to act, says Charlotte Tyrwhitt-Drake, director at Pensions for Purpose. “The pandemic itself has highlighted some specific issues – that we are not just looking at long-term effects,” says Tyrwhitt-Drake, referencing the impact of biodiversity loss in transmitting disease to humans. Member engagement on ESG issues is also growing, she says, with consumers asking more questions of how their investments fit with the transition towards a more sustainable world.

Global inflows into sustainable funds hit a record £930 billion during the third quarter, according to data provider Morningstar. The proliferation of investment products being launched has contributed to the rise in ESG integration into investment strategies. One of the more recent launches came from Schroders, the UK’s largest asset manager, which unveiled an impact investment fund designed to support emerging and frontier market companies damaged by the pandemic. The fund, which will be managed by boutique BlueOrchard, has a funding target of $350 million.

In fact, PwC forecasts that ESG funds will outnumber conventional funds in Europe by 2025, reaching $7.6 trillion, up from 15% last year. In a survey carried out by the accountancy group, 77% of institutional investors said they planned to stop buying non-ESG products within the next two years.

Beyond private markets, in a landmark announcement the chancellor last month confirmed that the UK would issue its first ever green bond in 2021. The issue would “help fund projects to tackle climate change, finance much-needed infrastructure investment, and create green jobs across this country,” the chancellor said. It followed a letter earlier this year from the Impact Investing Institute to the prime minister, making the case for the issuance of green Gilts. Signatories included Brunel Pensions Partnership and represented more than £10 trillion in assets.

For local government schemes, the advent of investment pools has helped schemes with gaining access to a broader range of ESG investment products, with the enhanced scale also helping lower costs. At the start of this year the London Collective Investment Vehicle (CIV) and Local Pensions Partnership announced that they would be joining with the London Pensions Fund Authority in launching a London-focused fund aimed at improving “the quality of life for London communities”, targeting housing and infrastructure assets. Those include residential property – specifically build-to-rent – and affordable housing, community regeneration projects and infrastructure, including digital infrastructure and clean energy.

However, earlier and more frequent communication between schemes is needed to develop solutions that better fit their requirements around ESG, says Tyrwhitt-Drake. “There is collaboration going on but we’re still working with pension schemes on an individual basis before they then go to the pool to see what they can put in place,” she says.

Challenges persist
Yet while there is growing drive among schemes to integrate ESG into their investment strategies, practical difficulties remain. The first is companies’ willingness to engage with investors and disclose ESG-related factors that may impact their operations. That can be a mixed bag, according to Majedie’s Rose. Some companies will complete materiality assessment and know the specific risks and opportunities within their individual business environment, which they can demonstrate they are seeking to address, she says. One of the asset manager’s holdings, UK-listed Hotel Chocolat, is such an example, Rose says, as it has a close tie to its cocoa suppliers and good adherence to certification programmes. “It really pleased us when they took that exposure so seriously because it’s unbelievably fundamental to their business,” she adds.

If a company cannot or will not address ESG risks within their business, divestment is the ultimate sanction. In November, Scottish Widows revealed that it would ditch at least £440 million in investments that were not compatible with their new ESG policy, including companies that derived more than 10% of their revenue from thermal coal and tar sands, manufacturers of controversial weapons, and those that violated the UN Global Compact on human rights, labour, environment and corruption. Yet it could soon become easier for investors to gain the information needed to decipher whether companies meet their ESG standards because of fresh proposals from the government to make TCFD-aligned disclosures fully mandatory across the economy by 2025, and by 2023 for all UK-authorised asset managers.

For trustees, inconsistent reporting standards within the asset management industry itself can make it tricky to determine the progress being made against sustainability targets, says Tyrwhitt-Drake. “I think they’re still struggling to work out the interim measures in order to get to that end goal,” she says.

However, some, including the world’s largest asset manager BlackRock, have called for a globally recognised framework for companies to disclose their progress towards sustainability goals. In September, the International Financial Reporting Standards Foundation issued a consultation proposing that it set up a sustainability standards board and collaborate with the existing initiatives. Meanwhile five organisations, including the Global Reporting Initiative and the CDP, said they planned to work together to create a single reporting standard.

Establishing a global framework for reporting ESG-related risks would make it easier for trustees to scrutinise asset managers and help avoid so-called “greenwashing”. Indeed, it can be difficult for trustees – who sometimes feel the burden to decipher ESG risk lies too heavily on them – to determine the exact benchmark an asset manager is using to measure progress against ESG goals, says Tyrwhitt-Drake. She asks: “Is it against your own standards? Is it against a peer group that’s trying to achieve the same thing as you?”

Trustees may also want to apply greater scrutiny to the extent that managers have aligned their fees with the scheme’s ESG goals, she argues. If they are based solely upon the level of assets under management then high growth could be the main objective, she says. “We’re not saying you can’t get that with ESG but you wonder if the focus is in the right area,” says Tyrwhitt-Drake.

With the regulatory glare focusing increasingly on tackling climate change, and member awareness of broader sustainability issues heightening, the move by trustees towards genuine integration of ESG principles looks set to accelerate further. However, how fast this shift occurs – and how much impact it will have – will depend upon the adoption not only of consistent reporting standards by managers and the companies they invest in, but also benchmarks against which to measure progress.