A question often asked by individuals new to sustainable and responsible investing is: "My priority is a secure pension pot for retirement, so why should I care about sustainability and climate change?"
And while the answer is nuanced, fundamentally it is: because you will have a bigger retirement pot by doing so.
Mounting evidence shows this to be the case and it is a key reason why the Department for Work and Pensions recently laid new regulations that will require pension schemes to publish their approach to sustainability.
Specifically, the DWP’s proposals, outlined in its consultation on Clarifying and Strengthening Trustees’ Investment Duties, make clear that pension scheme trustees are to consider all financially material factors – including environmental, social and governance concerns – and clarifies that even non-financial or ethical factors may be considered in certain circumstances.
ESG can create opportunities
ESG factors are often overlooked as being purely ethical, conflicting with our duty to maximise returns. However, investors that properly understand ESG issues and the impact they have on value can, and very often do, find their investments outperform.
Will Oulton, global head of responsible investment at First State Investments, says: “Across all our asset classes globally, 83 per cent of our funds on an asset weighted basis have outperformed their respective benchmarks over the past five years. We believe ESG issues are sources of risk and return and therefore contribute to such compelling performance.”
Key Points
- The DWP recently issued new rules requiring pension schemes to publish their approach to sustainability
- The government has been taken to court over its failure to act on air pollution
- The new regulations offer an opportunity to innovate
Our approach to investment includes increasing our understanding of how emerging risks and opportunities can stem from ESG issues. Pension scheme trustees should already be considering such factors when they are material to their investments, and we welcome the government’s announcement that it will clarify this in law.
Some individuals often labour under the related misconception that considering ESG means trustees will be forced to invest in line with members’ ethical views.
However, the government’s new rules are helpful in clarifying that financially material factors should always be considered while non-financial factors only need be considered in limited circumstances.
Caroline Escott, the policy lead for investment and defined benefit at trade body the Pensions and Lifetime Savings Association says that: “Pension funds increasingly recognise that they need to take account of ESG risk factors in their investment approach.
“Indeed, the PLSA’s steward-ship survey found three-quarters of pension fund respondents agreed ESG factors, such as climate change and human capital, can be material to investment performance.
“However, there is still some confusion around how and when schemes should take ESG risks into account in their investments. The government’s work to clarify investment duties should help tackle this issue and ensure trustees are clear on the distinction between when an ESG issue is a financial consideration or an ethical one.
“This should remove a key obstacle for trustees when considering ESG factors in their investment plans.”
The confusion about what factors can, should or must be considered has been a major obstacle for trustees in meeting their fiduciary duty to date.
Climate change must be considered
One factor that has often been dismissed as a purely ethical issue is climate change. In 2016, the Pensions Regulator published new guidance on pension scheme investment that stated clearly that climate change is likely to be financially material to funds, especially over the long term.
Yet the guidance failed to change behaviours, and a survey conducted later that year by Pensions Buzz showed that 53 per cent of pension professionals still did not consider climate risk as financially material to their investments.
This lack of understanding is a key motivation for the government to specifically refer to climate risk in the new investment regulations. Trust-based pension schemes are now required to develop policies on how they consider financially material factors, defined by the government as material “[ESG] considerations, including but not limited to climate change.”
The government drawing out climate change as a specific issue is welcome. It is cross cutting, systemic and wholly under appreciated by asset owners. Research for the UK Sustainable Investment and Finance Association’s event, Ownership Day 2018, found that 90 per cent of fund managers expect climate risk to significantly impact oil company valuations within two years. Oil and gas represent the third most heavily weighted industry in a typical default fund, yet 41 per cent of managers say they have no engagement strategy to mitigate climate risks.
Litigation risk is something schemes will need to consider in relation to climate change.
ClientEarth is a not-for-profit firm of environmental lawyers that has taken the government to court – and won – on its failure to meet its legal obligation on air pollution. More recently, it has put 14 of the biggest UK pension schemes ‘on notice’, meaning that they are at risk of being sued if they do not consider climate-related financial risks during the investment process.
ClientEarth pensions lawyer Joanne Etherton said: “The law requires pension trustees to consider all financially material factors when determining investment policy – for many schemes, this will include climate change.
“There remains confusion among some of those who manage pension schemes who think that ESG risks and financially material risks are mutually exclusive – they are not, and proposed clarifications to the law are set to bust this myth for good. The impacts of climate change pose a serious risk to pension investments and this needs to be reflected in investment decisions.”
Members want SRI
The new regulations also represent an opportunity for the sector to innovate and meet demand for sustainable products. Polling for UKSIF’s Good Money Week 2017 showed that 47 per cent of the public wanted to both make money and make a positive difference to the world.
The same research showed that 57 per cent of pension scheme members believed their investment managers should have a responsibility to manage funds in a way that is positive for society and the environment.
Jennifer Anderson, investment manager at TPT Retirement Solutions, argues that managers’ ESG credentials will become an important consideration for funds: “In situations where pension funds are allocating to new managers I expect that a fund manager’s approach to ESG will become a more important component of the overall criteria on which they are being assessed.
“In fact I suspect ESG will increasingly become the deal maker or deal breaker in many manager selection exercises.
“Again, it should be noted that these rules will not force schemes to invest ethically or in a particular sector. The pensions minister, Guy Opperman, was at pains to stress that the government would ‘never exhort or direct private sector schemes to invest in a particular way. Trustees have absolute primacy in this area.”
The new regulations are about clarity. Clarity for trustees to give them the confidence to invest for the long term, to mitigate risk and seize on emerging investment opportunities. The government’s decision to introduce these rules represents good news for savers, investors and the planet.
Fergus Moffatt is programme director and head of public policy at the UK Sustainable Investment and Finance Association
