Environmental, social and governance factors, commonly known as ESG factors, have sparked debate in the pensions world for many years and given rise to much confusion.
For a long time following the 1984 case of Cowan v Scargill, in which the High Court ruled that trustees should invest based on financial criteria rather than moral and ethical principles, the prevailing view was that ESG factors are irrelevant because trustees need to focus on financial returns rather than invest for ethical reasons.
Failing to engage with this topic because of the difficulties of doing so is no defence against a claim
We can no longer say that ESG factors are irrelevant, but what has changed over that period is not the trustees’ investment duties, but our understanding of the long-term nature of pension scheme investment and the importance of sustainability.
The Law Commission’s 2014 review of the fiduciary duties of investment intermediaries has helped to clarify the position.
Identify financial risk factors
That review draws an important distinction between financial and non-financial factors – financial factors being those that have the potential to impact on investment performance.
Non-financial factors are those motivated by different concerns, such as disapproval of certain industries.
The Law Commission concluded that there is no specific requirement for trustees to take account of ESG factors as such – indeed, this would be too broad a requirement because the ESG label covers a wide range of risks and approaches.
However, trustees should take account of risks to investment performance that are financially material. The duty of trustees is not simply to maximise returns but to balance returns against risk, recognising that trustees invest for the long term.
In this context, ESG factors are potentially relevant because of their risk to the long-term sustainability of investments.
Political will is clear
In practice, this means that trustees should be actively considering whether their own portfolios are susceptible to ESG risk, otherwise they cannot be in a position to assess whether that risk is financially material and, therefore, whether they have a duty to take account of that risk. This is just basic good governance.
Of course, the reality of taking account of ESG factors is not always that easy. Climate change is particularly topical at the moment – not least because of the action taken by the cross–party Environmental Audit Committee in writing to the UK’s top 25 pension funds to ask them what they are doing about climate risk.
This is consistent with the Pensions Regulator’s guide to defined benefit investment, which states expressly that trustees are expected to assess the financial materiality of risks around long-term sustainability, including climate change risks.
Ask the experts
But even so, many trustees are unclear whether and how to take account of climate risk. A good starting point for trustees is to engage with their investment advisors on this topic.
Although there are no industry standard methods of measuring climate risk, there are techniques that trustees can use to help them assess this risk – climate risk can be managed through investment strategy, strategic asset allocation, the selection and monitoring of fund managers and active stewardship.
Failing to engage with this topic because of the difficulties of doing so is no defence against a claim if, as a result, trustees have been in breach of their duty to consider financially material risks.
Ethical investments can be included
Finally, a word about ESG factors that are motivated by non-financial concerns – for example around the ethics of certain industries.
Trustees can take account of these factors when investing, but only if they have good reason to believe that members share their ethical concerns and provided that there is no risk of significant financial detriment to the fund.
So the message to trustees is that they risk being in breach of duty unless they, at least, consider whether ESG factors could pose a financially material risk to investment performance.
In its 2014 review, the Law Commission recommended some legislation in this area to clarify the position for trustees and we are expecting the government to follow these recommendations.
Carolyn Saunders is head of pensions and long-term savings at law firm Pinsent Masons
