ESG: Coming soon to a pension scheme near you

27 Feb 2019

The world is changing, and approaches to investment are changing alongside it. The potential economic consequences of global trends, such as climate change, social movements and increased regulation, are becoming clearer to many investors. However, there is a lack of consensus regarding the financial implications of these factors for investors. Currently environmental, social and governance (ESG) factors are often ignored or alluded to rather than being part of the decision making process.

This will change. The government has laid down regulations which strengthen the obligation on pension scheme trustees to consider ESG in investment decisions. By 1st October trust-based defined contribution pension schemes with more than 100 members will need to disclose the risks of their investments, which include risks arising from ESG considerations.

Pension schemes who do not start to integrate ESG into their investment strategy could therefore face legal difficulties, higher admin and legal costs, and potentially reduced returns in the future as a result of not taking financially material risks into account.

There are a number of acknowledged barriers to ESG integration, as set out in the recent Pensions Policy Institute report on this topic. There is a lack of consensus regarding how to define and implement ESG considerations. Smaller schemes in particular may not have the resources to bring control of their detailed investment strategy in-house and are generally dependent on third party investment managers who may not believe that ESG factors are important to consider. In response, some investment managers have developed, or are developing, off-the-shelf products which could be used by small schemes.

However, not all asset managers offer investment funds which integrate ESG factors. Given the change in regulations, this may well change. Further, if consideration of ESG factors was built into asset manager benchmarking, there may be more motivation to consider them.

The evolution of the ESG asset management market is important. If more products that involve ESG were available to small schemes, they would find it easier to invest in companies with better ESG credentials. But, as ever with pensions, there is a trade-off involved. Funds which engage with companies about ESG may cost more than funds which passively track indices without engagement.

There is, not surprisingly in such a complex and fast changing area, confusion among trustees and investment governance committees as to the definition of ESG, and the assessment and integration of ESG factors in investing is not straightforward. Trustees and investment governance committees would benefit from more concrete guidance and support. Smaller schemes may also need more support around consolidation of assets and/or investment administration, in order to make consideration of ESG factors easier. Only time will tell if this will be forthcoming as the regulations come in to force.

Chris Curry is the director of the Pensions Policy Institute

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