The evolution of ESG

Written By: Matthew Craig LAPF Investments

ESG factors are becoming increasingly important to long-term investor thinking. Matthew Craig explains the effect it is having

Ethical, social and governance (ESG) issues have gradually moved from being a niche area of investment to an increasingly central position in institutional investment. It is no longer about giving a “green” or ethical tilt to an investment portfolio, but it is arguably an essential part of being a long-term investor, as pension funds are.

Ethical, or socially responsible, investing (SRI) as it was first called, originally grew out of the moral and religious views of groups such as the Quakers, or individuals wanting to avoid supporting certain regimes, industries or activities that they objected to. Alcohol, armaments, gambling, nuclear power or pornography could all be examples of businesses that some investors preferred to steer clear of. This led to negative screening, where some companies or industries are screened out of the investment universe. While effective in avoiding so-called “sin stocks”, this approach arguably can reduce returns and increase risk. The debate on the links between investment performance and ESG factors has rumbled on, but nowadays many think taking account of ESG factors can add to an investor’s knowledge of a company. Investing in companies which are badly run, or cause environmental or social harm, may lead to poor returns, aside from any possibly reputational damage for a high-profile investor such as a large pension fund.

Asked about whether incorporating ESG factors into investment can add to performance, West Midlands Pension Fund (WMPF) assistant director (investments), Mark Chaloner, said: “In broad terms, the fund believes that the integration of ESG into our investment process will aid in the protection of the fund’s returns over the long term. In practical terms, this means that the fund views ESG as a risk management tool to protect, rather than enhance, shareholder value.” The Environment Agency Pension Fund, has integrated responsible investment into its decision-making for 10 years, and in a statement on its website states: “We recognise that environmental, social and governance (ESG) issues can adversely impact on the fund’s financial performance and should be taken into account in the funding and investment strategies. Accordingly, the fund has integrated the consideration of ESG issues throughout the funding and investment decision-making process.”

Investing with a consideration for ESG factors is now about far more than avoiding certain stocks or business areas. Many investors now take a much wider view. They see acting responsibly, as long-term investors on behalf of a pension fund’s members and their dependents, as vital to their mission as an investor. This involves taking a responsible, long-term view as an integral part of the investment approach. Chaloner commented: “Our primary focus is creating a more formalised process for the integration of ESG into our active ownership and investment processes. Our responsible investment officer, Leanne Clements, leads this effort. We recognise that climate change is a key risk which could impact upon our returns over the long term, and thus is considered a priority as an ESG theme.” Chaloner added that the WMPF has recently published its Responsible Investment Framework which covers its guiding principles and beliefs, its expectations of itself, fund managers and companies, and how it implements its responsible investment approach.

The mention of climate change is arguably very significant here. Climate change was not on the agenda when ethical investing first emerged, but investors with long time horizons, such as pension funds, increasingly believe that the potential negative impact of climate change is something they must take into account when investing. For some time, pension funds have been part of collaborative efforts such as the Carbon Disclosure Project and the Institutional Investors Group on Climate Change. With the next round of the United Nations Climate Change Conference due to be held in Paris in December 2015, global attention is likely to be focused on this issue. If the conference produces a global agreement on limiting any future rise in global warming, this will imply widespread action on energy use, which could have profound investment implications. Already, some major pension funds, notably the French national reserve fund, FRR, and AP4, part of the Swedish state pension system, have committed €1 billion each to a low carbon index developed by index provider MSCI. By shifting equity assets into a low carbon index, investors hope to capture low-cost equity beta while avoiding the risk of companies with a reliance on carbon use. The Norwegian state pension fund is another major fund which has stated that it plans to reduce its exposure to fossil fuels in the future.

The Local Authority Pension Fund Forum (LAPFF) has been active on climate change issues through engagement with oil companies such as Shell, BP and others. It has been part of a £160 billion investment coalition engaging at company meetings and in January, Keiran Quinn, chair of the LAPFF and also the chair of the Greater Manchester Pension Fund, commented: “Active engagement by shareholders on climate change is becoming a permanent part of the governance landscape. Investors are interested in the longer-term strategic options for the oil and gas majors.”

As well as addressing the issues arising from climate change, pension funds are increasingly taking care to monitor the ESG performance of their fund managers. Again, this is an area where pension funds can work together in an effort to improve fund manager performance. At the WMPF, Chaloner said that he recognises the importance of industrywide engagement in order to support fund manager monitoring and reporting efforts. WMPF was one of 16 UK pension funds which supported and contributed to the a new report, A Guide to Responsible Investment Reporting in Public Equity, which was produced by the National Association of Pension Funds (NAPF). Chaloner said the report provides a consistent signal to the market as to what asset owner clients expect of listed equity fund managers regarding responsible investment performance. “Responsible investment reporting is a key focus area in our fund manager discussions, focusing on what the key ESG risks are in the portfolio and how they are being managed, as well as how managers are evolving in their approach over time to reflect market developments,” Chaloner said.

The Environment Agency Pension Fund has a strong track record in responsible investment, as shown by a number of awards it has won in recent times. It uses both quantitative and qualitative criteria in assessing the ESG performance of its fund managers. For the former, external managers help the fund measure its carbon footprint, while for the latter, the pension fund assesses its managers on a range of criteria.

Responsible investment is an evolving area and investors need to keep up to speed with the latest developments if they are to get the most out of it. As it puts it on its website, the Environment Agency Pension Fund stated: “We take an evidence- and research-based approach to investment: continually learning and reappraising from academic research, investment professionals, and our peers, and seek continual development in our understanding of investment.”

Over the last forty or so years, responsible investment has moved from a fringe activity to now being at the heart of how many long-term investors manage their assets. Arguably, not taking account of ESG factors is now bad practice and investors want better reporting and disclosure both by the fund manager they employ and at the companies they invest in. Eventually, responsible investing will no longer be seen as a separate subject, but will be considered to be part of acting as a long-term investor. That day has not yet arrived, but it is getting closer.