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PPI on pensions and ESG: “Still work in progress”

17 Dec 2020

Lauren Wilkinson, a senior policy researcher at the Pensions Policy Institute (PPI), comments on the uptake for ESG strategies among UK pension schemes.

Following changes in regulation and an increasing recognition of the financially-material nature of environmental, social and governance (ESG) risks, we are seeing more schemes engaging with such strategies than ever before and to a greater extent. However, there is still work to be done before we reach a point where all schemes are engaging in a meaningful way. For some, this may mean more support and guidance. But there may be a need for stronger intervention for those who are finding it difficult to recognise the financially-material nature of ESG risks.

In the early years of ESG and responsible investing, funds predominantly focused on ethical, rather than financial, considerations. This perceived conflation of ESG and ethics led to confusion and a belief among some that ESG investment was in opposition to schemes’ fiduciary duties. This confusion can be traced back to the often-cited case of Cowan vs Scargill in 1984, which found that investment in line with union policy was not considered a legitimate basis to discharge the fiduciary duty to act in members’ best financial interests.

This led to fiduciaries favouring a narrower definition of members’ interests, that often excluded the consideration of ESG. The legacy of this case has continued to be a challenge for ESG investment, although investors increasingly recognise the financially-material risks associated with such issues, following efforts to disentangle the ethical from the financial in recent decades.

From the 1990s onwards, especially following 2008’s financial crisis, there has been an increased focus on the long-term impacts of investments. This arose from concerns that not all schemes were investing in a way that prioritised the long-term sustainability of returns or accounted for all the potential long-term risks, where possible. During this period, we also saw an increase in ESG-focused research, the introduction of voluntary codes and targets and a broader range of ESG investment approaches emerging.

In 2012, the Kay Review recommended that the government do more to address disincentives and perceived regulatory barriers for trustees and providers to engage with companies. This included establishing an investors’ forum and making it easier for schemes to engage collectively and share information. It was followed by Law Commission reports in 2014 and 2017 that called for greater clarity in regulation to provide guidance to schemes that were struggling to understand their obligations in relation to ESG.

Over the past two years, evolution in the ESG investment landscape has accelerated. In 2018, the House of Commons Environmental Audit Committee published two reports which called for a greater focus on sustainability in investing. 2018 also saw many developments at an EU level, with the European Commission publishing regulations which aim to integrate ESG into the investment and advisory process in a consistent manner across sectors, the introduction of the Shareholder Rights Directive II and a Sustainable Finance report establishing recommendations to make ESG investment easier across Europe.

And, of course, we have seen increased SIP regulation relating to ESG considerations, with schemes now required to not only illustrate how they have considered ESG factors when designing their investment strategy but produce an implementation statement explaining how they have followed and acted upon the stated investment policies set out in their SIP.

We are now in a position where regulation is strongly encouraging pension schemes to increase their engagement with ESG issues and the rapid change we have observed in recent years in the ESG investment landscape does not look set to slow down, making it important that schemes are supported to appropriately integrate these material risks into their investment portfolio. Many schemes recognise that their ESG investment strategy is a work in progress, as supported by responses to our Engaging with ESG survey (the findings of which will be published in 2021). This suggests that the landscape is still developing and more schemes are moving towards a greater consideration of ESG risk factors.

However, it will take time for this process to work through, particularly for schemes that were not engaging on ESG prior to the regulatory changes, and the specific support that schemes might need for further development is less clear. Some of this evolution will happen organically, with more engaged schemes who have greater levels of resource and expertise pushing development forward and creating more opportunities and insight for schemes that might be lagging behind. Other schemes may need greater support or guidance from government and industry to fully integrate an appropriate ESG strategy. And those schemes that are still struggling to recognise the financial importance of integrating ESG risks into their investment strategy may need stronger intervention.

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