ESG: Focus efforts from a risk perspective

Responsible investment means better managing risk and seeking out more sustainable long-term returns by incorporating a greater number of risk factors, such as environmental, social and governance issues, into investment decisions.

This is fundamentally sensible; ignoring potentially material risks should not be a serious option and may negatively impact performance over the long term as ESG factors become priced by market participants, such as credit rating agencies.

It is no surprise that many leading pension schemes with long-term obligations – such as the Brunel Pension Partnership and the BT Pension Scheme – are prominent advocates.

A growing number of schemes already pay out more than they receive from investment income or sponsor contributions, and this is driving many to seek out sources of more reliable income to help meet their cash flow requirements.

Long-term fixed income strategies, which aim to hold high-quality assets that generate contractually defined cash flows until they mature, are one common method.

Managing long-term default risk is a key objective of such strategies. ESG factors can influence long-term default risk, and investors building such portfolios must integrate ESG analysis to mitigate downside risks.

Regulators are also turning up the heat on investors. The UK government has proposed to clarify trustees’ duty to consider financially material risks and opportunities, and has specifically identified ESG factors among them.

ESG focus will sharpen

This is just one example of an increasing number of regulatory initiatives both in the UK and globally that are focused on responsible investment.

Longer-term, it seems likely the focus on ESG issues will sharpen. Politicians are regularly challenging poor accountability or governance, often driven by popular demand.

They are also seeking improvements in transparency. Of course, for many investors, focusing on ESG issues retains a moral or ethical purpose.

Many institutions – especially in Europe – are explicitly pushing for their investments to have a direct positive impact on society and the environment. Investors in the UK bifurcate their financial and risk responsibilities from their moral responsibilities more than their peers in Europe.

Though responsible investment may fill up more trustee time it can easily be confused.

Correctly, focusing efforts from a risk perspective is the approach taken by the largest pension schemes and should be a priority for every investor with a commitment to manage risks over the long-term.

Joshua Kendall is senior ESG analyst, fixed income group, at Insight Investment