What happened to the 'E' part of ESG?

As awareness of environmental issues has risen over the decades, some investors have demanded their ethical preferences be reflected in their investment decisions.

Green investment funds have posted disappointing performances in the past few years

The asset management community duly responded with socially responsible investing and green investment funds.

Typically, these kinds of funds applied exclusions or filters to companies that did not meet certain environmental criteria, thereby lessening their attraction to schemes.

An alternative approach, which has been coming to the fore in the past two years, has been for fund managers to apply environmental, social and governance principles across their entire investment process.

“This is the new trend being presented to pension funds,” explains Steve Butler of investment analysis company Camradata. “Rather than saying we won’t buy certain stocks because of ESG, if we need to buy, for example, an oil and gas stock, we will choose the best one from an ESG perspective.”

But Tim Currell, partner at Aon Hewitt, describes exclusionary fund management strategies as “old fashioned”, saying the new approach to ESG is one of “sustainable investment”.

According to Jane Goodland, senior investment consultant at Towers Watson, corporate pension funds have shown limited interest in capital allocation along environmental themes, noting some funds have shown interest in renewable energy infrastructure, but that a wider ESG approach has garnered far more attention.

“How investors measure the impact of ESG risk on their existing portfolios is where we’re seeing a lot of interest, and that level of interest is increasing year on year,” she says.

How the crisis hit green investment

The global economic crisis has inevitably led in some cases to the shelving of green concerns in favour of keeping economic ships afloat.

Before the crisis, there was a pan-European policy of issuing carbon credits to companies, whereby high energy-using companies would have to buy more credits than they were allocated by governments. Once the recession bit, however, governments became more relaxed about carbon-credit issuance.

“Investors... thinking carbon credits would have a short-term impact were disappointed,” says Currell. “In the longer term you would expect more energy-hungry companies to face some sort of costs and pricing pressure against carbon, but that has been deferred. Before the recession, analysts thought solar renewable energy would take off and that high-energy companies would be penalised – but neither has happened.”

Green investment funds have posted disappointing performances in the past few years compared with the global equity average, which has put UK pension schemes off investing in them, he adds.

The tension between environmental objectives and generating returns is echoed by the Universities Superannuation Scheme, which says it will continue to support the investment case for pension funds to commit to the low carbon economy, despite a lack of opportunities in the asset class.

“There is currently a shortage of investment-grade opportunities and global energy demands which cannot be fulfilled by alternative energy sources at the present time,” a spokesperson warns.

The picture of the recession hampering green investment by pension schemes is supported by the observation that the governance part of the ESG acronym has made the most progress.

John Clements, investment partner at LCP, agrees, adding: “Fitting environmental investment into the wider bucket of ESG, there has been a lot less progress with the environment compared with governance.”

Broader political concerns seem to determine which pension schemes demonstrate a more enthusiastic approach to environmental investment.

“We find that clients like charities tend to invest in specifically environmental funds, though not all of them do,” Clements says.

Towards an industry standard

Of course, a number of schemes have signed up to the UN-supported Principles for Responsible Investment.

Taking the PRI as a thermometer of environmental investing, Butler points out a mismatch between the far higher number of asset management signatories compared with those from pension funds.

“The challenge the pensions industry faces is that ESG is a very subjective thing which means different things to different people,” he says. “It needs an agreed framework and agreed standards for reporting. At the moment that is missing from the industry.

There are lots of positive stories in this space from fund managers, but pension funds are still a bit cautious. It’s the beginning of a long-term trend: the big pension schemes will act first and then the others will follow.”

Notwithstanding the bumpy ride environmental investing has had in recent years, consultants agree that green concerns are not going away. Currell says: “UK pension schemes have become a lot more aware of environmental issues as general awareness has risen.

Although they don’t particularly like green investing as a narrow idea they are amenable to the broader approach of sustainable investment.”

In one key respect, pension schemes’ approaches dovetail with the environmental agenda: both look to the long term. But the partnership between environmental action and pension fund investment still has a long way to go.

Catherine Lafferty is a freelance journalist