Environmental, social and governance (ESG) and the amendments to Occupational Pension Schemes (Investment) Regulations.
George Graham discusses the business case for ESG investing by pension funds and looks at how to make investment portfolios more sustainable.
If there was ever any doubt about whether UK pension fund trustees could, or should, take environmental, social and governance (ESG) issues into account in setting their investment strategies, that doubt should now be lifted by the government’s amendments to the Occupational Pension Schemes (Investment) Regulations. Trustees will be required to state their approach to the “evaluation of financially material considerations”. This “includes but is not limited to environmental, social and governance considerations, including climate change, in the selection, retention and realisation of investments”.
How financially material, then, are ESG considerations? A utility dependent on coal-fired generation faces a risk of consumer or regulatory reaction that might damage its long-term financial health, but what is less obvious is the extent to which this risk is already priced into its shares or bonds. Although many environmental advocates would argue that financial markets are too short-sighted in their assessment of the long-term consequences of climate change – what Mark Carney, the Bank of England governor, termed “the tragedy of the horizon” – one of the easiest ways to come to grief as an investor is to think you know better than the market as a whole.
One line of argument is that companies with better ESG profiles also deliver better corporate financial performance (CFP). There is a vast and rapidly growing academic literature exploring this field; some would even suggest that the debate is over following the publication in 2015 of a meta-study aggregating the results of 2,200 other studies.
“The results show that the business case for ESG investing is empirically very well founded. Roughly 90 per cent of studies find a non-negative ESG–CFP relation. More importantly, the large majority of studies reports positive findings,” the authors concluded.
That sounds promising, but for the brave few who make it beyond the executive summary, there are caveats. Overall correlation averages could be considered rather “small”. In a field prone to data mining, that prompts caution for the investor; there is some evidence that all of the benefits of ESG investing can be explained by traditional Fama-French equity market factors such as size and volatility. Most problematic, however, is that the most positive results come from studies that exclude transaction costs. “Investors, on average, are unlikely to harvest the existing ESG alpha after
implementation costs,” the authors admit.
The direction of causality is not always clear: are companies with good ESG characteristics generally more profitable? Or might the most profitable companies have more resources to devote to ESG considerations? Even if the first is true, or if you conclude that a good ESG profile leads to higher valuations because such companies have a lower cost of capital, should you not then select companies with relatively poor current scores, but potential for improvement? Some studies have found an ESG momentum strategy – overweighting stocks whose ESG rating is improving and underweighting those that are being downgraded – performed better than excluding stocks with poor ESG ratings, or overweighting stocks with good ratings.
A cautious conclusion, then, might be that ESG investing need not lead to underperformance, but that building an effective investment strategy is fraught with practical difficulties.
Researchers at MSCI have provided a helpful base with their 2017 Foundations of ESG Investing, exploring how and why ESG scores might translate into valuations.2 This also looks at risk, an increasing focus for sustainability activists.
“Climate-related risks should be added to each scheme’s risk register, recognising that it poses a systemic risk that will impact beneficiaries’ investments and quality of life in retirement,” said the charity ShareAction in a recent report on pension funds’ policies. But, as with financial performance, the direction of risk causality is not always clear, although ESG analysis might intuitively be expected to play a useful role in stock and particularly credit selection.
“We have a chicken and egg problem,” concluded MSCI’s researchers, although they found some evidence that improving ESG ratings led to reductions in both idiosyncratic and systemic risk. Meanwhile, researchers at AQR Capital Management found that ESG exposures carry information about future risk that is not captured in traditional statistical risk models.
This area has, however, received much less academic attention than performance has. Academics Gunther Capelle-Blancard and Stéphanie Monjon noted with some perplexity that a third of newspaper articles and almost three-quarters of academic articles about socially responsible investment (SRI) focused on performance.4 “The rationale of SRI funds is to go beyond the financial aspects. Accordingly, it is surprising that the main question in the academic literature is whether it pays,” they commented.
But if there is little academic work on the role of ESG factors in risk, there is even less on a more fundamental conceptual question: setting aside the question of whether asset owners have the democratic legitimacy to drive public policy on these issues, would action by asset owners actually work – not in terms of improving financial returns, but in contributing to the creation of a more sustainable and equitable economy?
A company under pressure from investors to reduce its carbon footprint is likely not to close its carbon-intensive facilities but to sell them to an owner with a greater tolerance for reputational risk, or perhaps with a more cynical view of how long it will be before governments take effective regulatory action; this displacement certainly appears to be happening with French and German coal-fired power stations.
So what is an investor to do? Here are four steps trustees can take to make their investment portfolios more sustainable:
- Look to exert your ownership influence beyond equities, which are a diminishing proportion of many mature schemes’ portfolios. Credit owners may not have annual voting opportunities but their influence can arguably be greater: investee companies have to refinance periodically. Property and infrastructure, too, are asset classes where investors have leverage to demand improvements in energy efficiency through their fund managers. Hermes Investment Management, for example, claims to have achieved an 8 per cent annual reduction in carbon emissions from its property portfolio between 2006 and 2017.
- There will be room in many portfolios for investments with a positive impact on environmental or social objectives – most obviously in areas such as renewable energy infrastructure or sustainable forestry. Where there are opportunities whose central case risk-adjusted returns are at least equal to those available from less beneficial investments, why would a trustee not wish to consider them?
- Select managers whose approach to ESG and sustainability issues is in line with your own; particularly those who can demonstrate that they fully integrate ESG considerations into their investment process, rather than applying it as an overlay.
- If you really want to make your influence as an asset owner count, press governments and regulators, not just your investee companies. It is governments that have the legitimacy, the tools and the responsibility to tackle systemic problems such as climate change. Let us stop letting them shuffle that responsibility off onto asset owners.
George Graham was a Financial Times journalist for 20 years, including spells as banking editor and heading the Lex column. He is now a pension fund trustee and chairman of Fish Legal, a member cooperative using the law to protect fishing and the water environment.
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