Should regulators take the lead on ESG in pensions?

In a recent twitter poll, Pensions Expert asked its readers whether or not regulators should take the lead on ESG within asset management. The result reflected how divisive the issue is in the industry.

The poll revealed 53.6 per cent of respondents felt regulators should intervene to meet demand for standardisation across ESG, while 42.9 per cent were opposed, claiming regulatory presence limits investor freedoms. Just 3.6 per cent responded that regulators should intervene because it helps investors.

A key issue is the lack of standardisation in the industry, with ESG issues still being a relatively new concept for many pension funds to engage with. Lars Hagenbuch, consultant at RisCura, argues this is evidenced by the lack of a data standard for funds to follow.

Given such a multitude of definitions and actions that one can take to integrate ESG, we are often found comparing apples to oranges without even realising it

Maria Nazarova-Doyle, Scottish Widows

“Exactly how [ESG] will impact funds is not certain,” he says. “We are seeing considerable attention being placed on the statistics of ESG, where managers and underlying companies are coming under increasing pressure to show numerically what their carbon footprint or other environmental impact is and how it compares with various indices or peers.

“[ESG] statistics are not uniform. In some cases, depending on the data provider, a company may be ranked great by one, but poor by another. From this perspective, having a regulatory standard would be helpful.”

Clampdown from regulators

Over the past few years, regulators and lawmakers globally have increasingly intervened on how sustainable finance is administered in the pensions industry. However, Maria Nazarova-Doyle, head of pension investments and responsible investment at Scottish Widows, is wary of too many officials attempting to have their say.

“Regulatory intervention would help a lot with standardisation of investment approaches and vocabulary,” says Nazarova-Doyle. “Given such a multitude of definitions and actions that one can take to integrate ESG, we are often found comparing apples to oranges without even realising it.”

ESG change is sweeping pension markets around the world. In the UK, last year saw the Financial Conduct Authority propose draft measures to ensure pension fund alignment with Task Force on Climate-Related Financial Disclosures requirements, mirroring government efforts on the matter. Under the Pension Schemes Act 2021, large occupational pension schemes are required to set climate-related targets from October 2021.

In June, the US Department of Labor submitted a new regulation proposal titled ‘Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights,’ expected to revise some ESG regulatory measures the Trump administration had attempted to introduce.

With so much activity, Nazarova-Doyle wants a more measured approach between different authorities. She recognises the benefits of structure for the industry, but this can still make room for innovation from pension funds: “Regulated areas shouldn’t be seen as where innovation goes to die.

“With some of the world’s brightest and most passionate people drawn into the field of sustainability, I can’t for a second imagine that standardising reporting or definitions will have a detrimental effect on creativity.”

Balance and harmony needed

The challenge then, for regulators, is how to put frameworks in place that still allow for creativity. This requires a nuanced approach, according to Callum Stewart, head of defined contribution investment at Hymans Robertson.

“Overregulation has the risk of stifling innovation,” he notes, adding that “balance of regulation and innovation is probably the right answer”.

He adds: “The pensions industry needed regulation in the form of TCFD governance and reporting requirements because it wasn’t doing enough to tackle climate change. We now have a golden opportunity as an industry to develop innovative solutions and enhance long-term outcomes.”

Overly prescriptive regulations often invite criticisms, but if done right a positive ESG culture could be fostered, argues Hagenbuch.

He says: “The industry must be encouraged to engage with underlying companies as that is by far the most effective and important way of bringing about on-the-ground change.

“It would be very unhelpful if, due to regulation, an ‘avoidance of poor companies to improve ESG scores’ culture is created, which would leave the most polluting or poorly governed companies in the hands of unscrupulous owners, which will not bring about any change — quite the opposite in fact.”

Limiting investor freedom was the primary concern for 42.9 per cent of poll respondents who objected to a heavier regulatory presence.

Lorant Porkolab, director at Law Debenture, is not surprised so many respondents were fearful of restrictive approaches being adopted by regulators. He argues flexibility could still feature in these new regulations, but he points out investors must remember why these are being drafted in the first place.

He says: “This can result in restrictions, exclusions and implied limitations on certain types of investments, but there should remain plenty of flexibility for pension schemes and institutional investors, and the changes will no doubt unearth new opportunities too.

“Regulation and industry self-innovation are not exclusive. But self-innovation and self-regulation are unlikely to be sufficient here to trigger change and do that at a pace climate risk requires and justifies now.”