How to adjust your ESG strategy following the Law Commission report

This narrow view is in the process of changing in the light of this year’s report from the Law Commission examining the fiduciary duties of investment intermediaries.

The commission was quite clear that trustees may consider any financial factor relevant to the performance of an investment, including risks to a company’s long-term sustainability.

In its words: “There is no impediment to trustees taking account of environmental, social or governance factors where they are, or may be, financially material.”

Trustees therefore need to consider carefully their exposure to ESG issues and what, if any, decisions they need to make to manage these exposures. Doing nothing is no longer a reasonable position to adopt.

Before making any decisions, trustees can benefit from creating a simple framework to help guide their thoughts and actions.

Revisit your SIP

Trustees should review their existing investment governance principles to ensure that appropriate reference is made to ESG issues.

Wording in these documents is often outdated, having been created after Sip regulations changed in 1999 to require specific wording on a scheme’s position on these issues.

It does not often reference more recent guidance such as the UK Stewardship Code or the 2014 Law Commission report. Other relevant scheme documents should also include references to the position taken on ESG issues.

Set your expectations

Trustees can establish a simple framework for implementing ESG integration by defining a set of beliefs and expectations. This is often best achieved through a group discussion that includes trustees, investment staff and sponsor representatives.

Such beliefs should reflect long-term views of how investment markets work and how to create value. Having clearly articulated beliefs regarding ESG and sustainability provides a broader perspective on risks and opportunities, which strengthens the investment governance process.

From these principles, expectations for third-party investment managers and advisers regarding ESG issues can be established.

Smaller schemes in particular should focus on understanding the ESG integration activities of their managers – for example, do they have an ESG policy? Are resources applied internally to understanding the relevance of ESG issues?

Over time a more sophisticated approach will evolve as trustee knowledge improves, for example reviewing managers’ ESG integration activities in more detail.

Going further, these beliefs can be drawn upon when reviewing new investment opportunities, including sustainability themes such as water, clean energy, timber, or agriculture.

Monitor your managers

Manager monitoring is an important aspect of the role most trustees. With a clearer view of ESG expectations, broader conversations can take place both with existing managers and during the selection process for new managers.

ESG considerations and expectations should apply to both active and passive mandates, although in the latter the ability to adjust portfolios based on ESG factors is clearly limited. However, taking listed equities as an example, passive management of equity portfolios is not an excuse for ignoring ESG risks.

If anything, the lack of flexibility in portfolio construction for passive managers should be an incentive to understand how ESG, and in particular corporate governance factors, contribute to market risk over time.

Ask for ESG detail

A useful means of monitoring managers on ESG integration is to use some form of assessment.

Managers are increasingly able to provide information on their ESG activities. The critical question for trustees to ask is what evidence managers can provide to demonstrate that engagement is happening.

Ideally, trustees should try to determine if these resources are being applied where they are needed most, ie to the greatest areas of risk or where the manager is most likely to have an impact.

Aled Jones is European head of responsible investment for Mercer