The ESG evolution

Written By: Matthew Craig LAPF Investments

Matthew Craig examines how ESG trends are informing the investment decisions at local authority pension funds

For the members of Local Government Pension Scheme (LPGS), investing with regard to environmental, social and governance (ESG) issues has gone from an optional extra to a key part of their investment mission in the last 20 or so years.

Human rights, the use of plastic, the health of the world’s oceans, gender diversity on company boards, executive pay, and myriad other issues are now seen as being part of the investment decision-making process. Accompanying a greater awareness of these issues is a belief that taking account of them does not necessarily harm investment performance, but can enhance returns and also help manage risk, as well as meeting the aspirations of the pension fund members.

In particular, environmental issues have been given a new impetus since the Paris climate change conference in 2015 led to global agreements to limit global warming. This has led to a general attitude that companies and financial institutions, as well as individuals, need to act more sustainably and reduce carbon emissions. While awareness of ESG issues is probably higher than it has ever been, some think that LGPS funds could be doing more. Bob Holloway, pension secretary at the Scheme Advisory Board, said: “A recent paper commissioned from ShareAction by UNISON examined the ESG policies of all 88 administering authorities in England and Wales and concluded, amongst other things, that a significant number were falling short in bringing forward effective ESG policies, in particular, climate change risk.”

And the trend to what is also called sustainable, or responsible, investing, raises a number of questions related to the changing structure of the LGPS. One such question is whether asset pooling will help or hinder ESG investing? On the positive side, larger asset pools should command more resources, enabling them to hire ESG specialists, for example. And with larger sums under management, the asset pools should be in a better position to negotiate with asset managers on how ESG factors are applied in funds.

On the other hand, because asset pools are made up of a number of different LGPS funds, there could be an issue when the underlying funds have differing views on ESG issues. Karen Shackleton, senior adviser at MJ Hudson Allenbridge and founder of Pensions for Purpose, pointed out that it is common for one fund within an asset pool to be at a different stage in their ESG journey to another fund in the same pool.

One example of this could be at the London CIV, the asset pool for 30 or so London borough pension funds. While some London boroughs, such as Islington, are strong advocates of applying ESG factors to their investments, others, such as boroughs that usually have Conservative-run councils, may have shunned ESG investing in the past. “Where you have two very different approaches to ESG within the same pool, that makes a real challenge for the pool. If you have a policy to keep everyone happy, then the danger is that the pool’s ESG policy goes for the lowest common denominator,” Shackleton commented.

Holloway said he is seeing a growing awareness of the need for sustainable investment, particularly in the area of climate change risk. He commented: “Climate change risk has to be top of the list with many funds taking positive steps to measure the carbon footprint of the companies in which they invest. Many funds are also questioning their divestment policies regarding investments involving fossil fuel.” However, Holloway agreed that the approach to ESG varies between different funds. “LGPS administering authorities are required to publish their policy on ESG considerations as part of their Investment Strategy Statements and the overwhelming majority do approach this positively but the degree to which ESG considerations are taken into account in strategic asset allocation decisions does vary from fund to fund.”

Some asset pools have made a virtue of having like-minded pension funds as members, with a greater degree of agreement on issues such as ESG investing. In this situation, the asset pool may be better placed to continue on the ESG journey that the individual LGPS funds have already started. Here, Shackleton points out that the asset pools, due to their greater size, do have an opportunity to use impact investing, where investments are undertaken to produce positive social or environmental outcomes, as well as to produce financial returns. “A problem for a lot of impact investing in the LGPS sector is that a local authority might want to invest locally, but for investment advisers, that brings specific risks. However, if an impact investing policy is applied through the asset pool, it could produce a diversified return but with a local impact. There are some really exciting opportunities for the pools.”

Impact investing is still a new area for many within the ESG universe. Most investors adopting ESG practices start with negative screening to exclude companies, such as those involved in particularly unacceptable activities, before integrating a wider set of ESG considerations into their investment process. Impact investing then adds a positive twist, as investors actively seek out assets that will produce positive environmental or social benefits. Holloway commented: “There is a growing awareness of social impact investments within the LGPS but there is no available evidence to demonstrate the extent to which this is happening in practice.”

A perennial ESG investing debate is its impact on investment performance. The conventional investment view is that if following an ESG approach reduces the potential investment universe, by excluding certain sectors or stocks, then this could limit investment performance. But this view should now be reversed, according to some experts. By taking account of ESG issues, investors can gain a better picture of the potential risk factors in their investment portfolio. Looking at governance issues, for instance, could give an early warning that helps investors avoid failing companies such as BHS and Carillion. And many large institutional investors have switched to low-carbon global equity indices, which aim to generate the same returns as the standard global index, but without exposure to fossil fuel companies.

On ESG and investment performance, Holloway commented for the Scheme Advisory Board: “We shouldn’t lose sight of the fact that the primary aim of a funded pension scheme is to achieve sufficient long-term returns to ensure that future pension liabilities can be paid. On that basis, it is as important to measure the performance of investments made under ESG policies as it is for any other type of investment. It is equally important for those making strategic allocation decisions to be able to assure themselves that allocation decisions taken on non-financial considerations are not inconsistent with their fiduciary duty and policies set out in their Investment Strategy Statement and Funding Strategy Statements.”

While there is debate over whether implementing ESG policies helps or hinders investment returns, there is a growing view that pension funds, have to invest responsibly and sustainably, if they are to serve their members over the long-term. The Brunel Pension Partnership, the asset pool for LGPS funds in the south-west of England, sums up this viewpoint on its website: “Brunel aims to deliver stronger investment returns over the long term, protecting our clients’ interests through contributing to a more sustainable and resilient financial system, which supports sustainable economic growth and a thriving society.”

While Brunel’s responsible investment is clearly stated, there is an ongoing debate about how fiduciary duty interacts with ESG policies, and also how these decisions are taken when LGPS funds collaborate to form larger asset pools. LGPS funds are responsible for strategic asset allocation decisions, while the asset pools select fund managers on behalf of the LGPS funds. For the Scheme Advisory Board, Holloway commented: “The work currently being undertaken by the LGPS’ Scheme Advisory Board on Responsible Investment guidance will assist all parties involved in investment decisions to establish, implement, manage and monitor ESG policies as part of the overall investment portfolio.”

In conclusion, LGPS pension funds, like many other stakeholders in our economy, now face urgent pressures to “do their bit” in tackling climate change risks and other ESG concerns. Undoubtedly this adds greatly to the workload for LGPS funds. But many LGPS funds are taking this responsibility seriously. Collaboration is an important element for investors tackling the ESG agenda and a range of bodies and forums can help here, including the Local Authority Pension Fund Forum. Over time, the LGPS funds, through the asset pools, will become very significant forces within the UK institutional investment world. It must be hoped that their approach to ESG investing will be seen as a test case of how long-term investors are able to play a positive role in creating a more sustainable economy and avoiding climate change catastrophe.