ESG: A missed opportunity to engage

New governance structures have the potential to push ethical investment issues further up the agenda. So why, asks Emma Wall, is the industry struggling to connect end investors with the idea?

When Kermit the Frog sang “It’s not easy being green”, he may as well have been talking about fund management. At the risk of confusing the animal analogies, it seems the fat cats in the City aren’t willing to put the planet before profits.

With the advent of governance committees you might have thought there would be the potential for engaging with pension scheme members on environmental and social governance (ESG) issues and on corporate social responsibility (CSR).  

Newly appointed independent governance committees (IGCs) are to act as the champions for pension scheme members, ensuring that members of their schemes receive value for money in the long term. It seems that the priority for the ICGs is to enforce the 0.75 per cent annual charge cap on default funds introduced last month – but the scope is there for their role to extend to upholding best practise governance across the social and environmental scale.

ESG and CSR doesn’t just seem to be a low priority for pension providers.  We approached a number of consultants and asset managers and despite having governance departments, they were unable to comment for this article.

ShareAction director of communications and public engagement Matt Davis admits that quite often “the rhetoric around pension funds engaging with their members on these issues is stronger than the action in reality”.

The Government-provided default pension provider Nest was among the few we spoke to who recognised the importance of responsible investment in all its guises.

Nest assistant director of investment Paul Todd said that the pension provider was committed to responsible investment for all of its members, which means they consider the environmental, social and governance issues across all the asset classes they invest in where feasible.

“We believe that this approach protects and enhances the value of investments over the long term. The main goal is to enhance returns by managing the risks that ESG factors can bring to our investments. We do this is by selecting fund managers that integrate the management of ESG risks within their investment processes and engaging with companies to discuss their approach to managing ESG risks,” he says.

“Where we have voting rights we’ll use these votes to look to encourage sound corporate governance to help improve long term performance and sustainability of companies.”

Can Green Be Profitable?

Part of the challenge is that being green and obtaining the best possible returns for pension savers are not always compatible aims. Prior to the global recession, ethical investing was a hot topic. A slew of ethical funds were launched – competing for the status of “darkest green”. But then the credit crisis happened, and the search for yield and capital safety became of greater concern.

These days National Ethical Investing week – which runs in October every year – gets coverage in only a handful of financial publications and money sections.

Traditional ethical funds – referred to as “dark green”, do take a very restrictive approach to investing, screening out stocks that are involved in unethical industries such as alcohol, animal testing, tobacco, oil miners and armament firms. They can also include companies that are involved in human rights issues, nuclear energy development, intensive farming and even in some cases the use of fur. Companies that responsible for large carbon emissions are also on the sin list. 

While these “sin stocks” may not be the equities you would be most proud of holding, they have also been responsible for delivering big profits for investors – star fund manager Neil Woodford has long held tobacco stocks in his portfolio.

According to a report by specialist bank Triodos half of the companies listed on the FTSE 100 would fail to make the ethical criteria, including 12 mining companies and seven oil and gas stocks.  Looking at the mid-cap index, the FTSE 250, there are six arms and defence companies and seven companies involved in fracking. The insurance arm of Aviva has been reportedly involved in arms dealing, as has insurer Legal & General. National Grid has involvement in nuclear energy development, and Unilever uses animal testing in product development. But one person’s sin is another person’s staple – with ethics being such a personal thing, finding an investment strategy that matches the moral compass of everyone is difficult.

Todd says that ethical investment is different in that all the investment decisions are made within a moral framework with a consideration of both values and value. Nest has created an Ethical Fund for members who want to make sure that ethical considerations are a key factor in deciding how their money is invested.

For those investors who think these limitations are too restrictive, “light green funds” – or socially responsible investment (SRI) ones – invest in companies across all industries which are deemed to be more ethically responsible than their peers. At the time of the Gulf of Mexico oil spill disaster, seven funds in the ethical sector held BP, as the company was considered ‘best in show’ among oil companies when it came to adopting good environmental and social practices.

But pension funds are starting to take a more active role, even if the fact of their doing so is not being channelled down to the end investor. Major Dutch pension fund manager APG, French giants Amundi and BNP Paribas, the Pensions Trust and Kames Capital in the UK, Wespath in the US, and large German fund manager Union Investment declared their support for the shareholder resolution on climate change resilience put before the BP Annual General Meeting in April – as did Aviva Investors, Jupiter Fund Management and Schroders.

Towers Watson head of defined contribution Nico Aspinall believes that SRI investing is actually the more profitable option over the long term.

Aspinall, who is also on the Resource and Environment Board of the Institute and Faculty of Actuaries says that the investment industry has become too focused on short-term performance and that we should be basing long-term investment decisions on more sustainable factors. The possibility of future regulation – with significant global carbon emissions talks taking place in Paris later this year – pose real economic risks to the erstwhile lucrative energy sector.

“I think that the companies that do best in the future will be the ones who are prepared for it. Companies that cut their carbon emissions now for example will not have to spend millions in the future on carbon capture storage,” he said.

Aspinall says that these governance considerations come to the fore in a tie-break situation – where two portfolios offer the same returns, but one has an SRI slant.

“I have never spoken to an investor who doesn’t recognise the importance of reducing carbon emissions and conserving water for future generations. The difficulty is an SRI strategy will never have enough impact as a self-selection option for DC savers. We need to get trustees on board with holistic portfolio management and get it in the default.”

He recognises that the challenge – as with so many alternative investment strategies – is the cost.

“Taking an active decision in investment, be it a fund manager that does stock selecting or even a smart beta ETF costs more than an ETF that simply tracks the FTSE 100,” he concedes.

“In a fee-constrained world I am concerned not enough money will go into ethical strategies that recognise that the future looks different – call it urbanisation, call it demographics; we need to consider the impact of global trends. Certain companies such as Shell may offer a short term gain but it is not sustainable.”

Even Bank of England Governor Mark Carney has recognised the potential dangers of carbon giants – saying at a World Bank meeting that vast majority of fossil fuel reserves may be “unburnable” if global temperatures are limited by the world’s governments.

Davis said that people need to see their savings have the potential to impact the world in a positive way – and that pension providers need to see that is their responsibility.

“Fossil Free indices in the US has outperformed fossil fuel companies over the past year – sustainability is simply a good investment strategy,” he argues.

Do Young Savers Mean New Strategies?

Figures from the Office of National Statistics recently found that the number of young workers saving for retirement is at a 17 year high. Thanks to auto-enrolment there are more young people than ever before in DC schemes, and these young savers have different priorities to the baby boomers.

Head of the London Corporate Governance Team at JP Morgan Asset Management Robert Hardy says that the new generation of savers entering workplace schemes is looking for more than just financial returns.

“The problem with the old ‘dark green’ SRI exclusion strategies was relatively low take-up. When it comes to making the actual election, you tend to go for the financial returns first and foremost,” he said.

“As we start to move to more inclusive ESG strategies, which aim to bring about improvements on these important issues, without detracting from performance, we are seeing ESG considerations becoming ever more important and ever more closely-integrated into investment processes, which can only be for the good”.

Nest’s Paul Rudd says that addressing ESG considerations may be particularly important for young people not just because this may speak to their moral conscience, but also because of the negative impact these factors could have on young savers’ pensions pots.

“Many ESG risks play out over long-term horizons, for example, climate change. This means younger savers may be more impacted if such issues are not addressed,” he said.

But while Aspinall agrees ESG risks are a long term consideration, is he concerned that that the nature of auto-enrolment – which capitalises on scheme members’ inertia – means that young people in DC schemes are actually harder to reach with the issues. He reiterated that the change must come from funds’ trustees, and likens SRI investment to an “empty restaurant”.

“No one wants to eat in an empty restaurant, we need to get money flowing into these strategies for people to recognise their benefits,” he said.