At the end of last year, I was surprised to find that half of all equity and fixed income fund launches I tracked in 2019 came with some level of ESG integration, and a quarter of all new hires were ESG related. ESG has, it seems, officially entered the mainstream, become an investible theme and a regulatory priority. 

Given these developments, what progress have pension funds made with ESG implementation? Has ESG found its place in trustee fiduciary duty? Has it graduated from a risk management factor into a return driver? Will divestment overtake engagement, and what role do regulators have to play? In attempting to answer these questions, mallowstreet Insights reviews the latest developments affecting investors and asset managers.  

Has ESG found its place in trustee fiduciary duty? 

The UN PRI claims that ESG considerations are an integral part of the fiduciary duties of any investor. UK pension funds, however, tend to consider ESG, and impact investing in particular, to be at odds with their fiduciary duties to scheme members, according to the mallowstreet ESG Report. 

This disagreement stems from the definition of trustee fiduciary duties in pension trust law as acting in the best interests of scheme beneficiaries and doing so impartially, prudently, responsibly and honestly. 

This begs the question: what does it mean to ‘act responsibly’, and is a lack of action on climate change in the best interest of scheme beneficiaries? ‘No’ may sound like the logical answer, but many pension schemes would argue that ESG considerations lead to lower returns. 

The mallowstreet ESG Report and reveals that pension fund trustees do not necessarily think ESG improves returns. On the contrary, some trustees believe ESG actually detracts from them, according to the mallowstreet Trustee Report. A survey by NNIP shows similar attitudes, with half of the respondents resigning themselves to lower returns for greater ESG impact. 

However, NNIP points out that 63% of 2,200 academic studies conducted between 1970 and 2014 show a positive relationship between ESG scores and financial performance. Only 10% of these studies imply ESG leads to worse corporate financial performance.  

When assessing academic or practitioner evidence on ESG returns, one important consideration should be the timing of the study and the time period it covers. The ESG return premium has grown with the focus on ESG over time. 

Amundi’s recent studies on the ESG risk premium in equities and fixed income support this. They have found a positive relationship between ESG and performance in the 2014-2019 period, which contrasts with a negative effect on returns in 2010-2013.

Amid the debate over ESG’s effect on returns, the UK pensions industry seems to be forgetting about the more intuitive path of integrating ESG into risk considerations. ESG seems to fit readily into risk management and due diligence across all asset classes covered in mallowstreet Insights’ projects so far. 

The mallowstreet ESG Report also finds that the main driver for ESG adoption is improved risk management. This is further substantiated by a report from Franklin Templeton, which finds broader consensus on the risk benefits of ESG than the return ones. 

Will divestment overtake engagement? 

The return argument makes UK pension schemes sceptical about divesting from fossil fuels. Several have claimed that they would have made a loss, but the figures cited amount to about 1.5% of assets. 

A new requirement on pension schemes to disclose their ESG policy in their statement of investment principles (SIPs), introduced last October, does not appear to have increased ESG integration. A report by the Society of Pension Professionals (SPP) shows that a majority of pension schemes have only made changes to their SIPs without adjusting their portfolios. The mallowstreet ESG Report also finds limited plans to reallocate assets. 

However, this does not mean that ESG adoption is superficial. Albeit recently pushed by regulators, it is steeped into risk management tradition. The mallowstreet report shows why UK schemes are not reallocating assets – they plan to first engage with their asset managers and only divest if they cannot get alignment. 

The mallowstreet report suggests there is currently a ‘chain of engagement’ – pension funds want to engage with asset managers, who in turn should engage with investee companies.

Engagement is one of the most widespread ESG approaches used by UK pension funds or their asset managers. Yet, InfluenceMap reports that just three of the 15 largest asset managers globally engage with investee companies “strongly and consistently” to meet the Paris Agreement goals, despite the “huge leverage” asset managers have to drive corporate action. 

Engagement offers more influence for owners and lenders than divestment. Where a pension fund divests, the ability to put pressure on management disappears. In the meantime there are plenty of investors who would be keen to snap up unloved companies and take advantage of their appealing valuations, as suggested by Psigma Investment Management and Orbis Investments. 

But divestment from fossil fuels has started. A survey by Octopus Renewables indicates that nearly 6% of global institutional investors’ assets might be divested from fossil fuels within the next year, and nearly 16% within the next 10 years. The question is whether this pace is sufficiently quick; the projected energy mix for 2040, based on International Energy Agency (IEA) data, basically looks the same as today. 

Change is slow but real. Take BlackRock, one of the biggest laggards in the InfluenceMap report, which also holds one of the worst track records in climate-related proxy voting according to ShareAction. The company has made headlines with its decision to embrace sustainability as a new standard for investing. It has vowed to remove from all active portfolios the stocks or bonds of companies that generate more than 25% of their revenues from thermal coal production by mid-2020. It also plans to launch sustainable versions of model portfolios and iShares funds. 

The Pensions Regulator (TPR) has outlined plans to improve the enforcement of ESG rules for pension funds, including the development of guidance to help trustees identify, assess and disclose exposure to climate risk. This follows on from pensions minister Guy Opperman’s query to 50 of the largest UK pension schemes on the ESG sections of their SIPs. 

The Department for Work and Pensions (DWP) has also suggested amendments to the pension schemes bill to make provisions for climate risk regulations. The DWP has since followed up saying it has no intention to direct investments. It has also published a letter outlining its approach following on from the Green Finance Strategy. 

Other areas where TPR is expected to publish new rules and guidance include: 

As an asset manager, are you facing greater pressure to align with pension schemes’ ESG views?