There is ‘huge interest’ among pension scheme members in the green agenda

The IORP II Directive is an EU directive requiring pension schemes to take additional steps to improve governance, risk management, investment strategy and communications to members.

Long-delayed, it has not been transposed into law here in Ireland yet but that has not meant a reluctance to take environmental, social and governance (ESG) factors into account when making investment decisions.

In fact, most pensions trustees are ahead of the curve when it comes to investing with their conscience, while being acutely conscious of the long-term risks of climate change to the planet and pensions returns.

Investing in ESG is big business. The market was worth over $30 trillion in 2018, but is estimated to surpass $50 trillion over the next two decades as companies with impeccable green credentials steal the financial thunder of fossil fuel and carbon-heavy industries.

According to Richard Kelly, head of client business, Ireland, Legal & General Investment Management (LGIM), to reach the goals of the Paris Agreement the world needs to redirect around $1 trillion dollars a year to the energy system of the future away from the fossil fuel dominant sector that exists today.

“For this capital to move regulatory pressure on investors, including asset managers and pensions schemes, is needed. Investors need to develop robust, transparent, and flexible risk management frameworks to assess the financial materiality of this climate risk. IORP II is requiring scheme trustees to start considering the impact that climate change, governance and societal issues will have on their investments,” says Kelly.

LGIM surveyed approximately 1,000 pension scheme members last year, and we found out that members overall are eager for their pension to have a social impact. “Trustees are therefore listening to their members and are actively looking for ways to integrate ESG into their portfolios,” he says.

Social responsibility

Alistair Byrne, head of EMEA pensions and retirement strategy with State Street, says regulatory pressure is just one of the drivers for the steady march towards ESG investment and he notes there is “huge interest” among pension scheme members in the green agenda.

Byrne also highlights corporate social responsibility (CSR) as one of the reasons companies are viewing the pensions they sponsor through a sustainable prism.

“It’s important for their positioning and their market to be a responsible company and a sustainable company. If the corporate sponsor has marked that out for the business overall, then it makes sense that they reflect that in how the pension scheme is run as well.”

He says these three factors have come together in “quite a powerful way”, meaning what was once a trend is now a common ethos. But it doesn’t mean pensions scheme members have to lose out financially.

“People describe the debate as being about ‘value vs values’ because there are ethical issues at stake. But when you think about pensions funds and investments the more important aspect is value and how taking account of ESG factors can help mitigate risks,” says Byrne. “This is consistent with their judiciary duty to their members rather than thinking about it purely through an ethically or socially responsible perspective

Indeed he warns that if companies are engaged in unsustainable practices at some point that will “come home to roost”. Consequences include the risk of “stranded assets”.

“If you are a company that mines coal, at some point that will not be allowed and at some point those assets will become stranded and potentially worthless.”

According to Kelly, it is “essential” that markets are able to generate sustainable value.

“We believe that climate change is one of the biggest risks that pension schemes are facing today. For instance, there is approximately $10 trillion of capital invested worldwide in globally-listed energy sectors. Energy is amongst the most vulnerable sectors in investor portfolios when it comes to the energy transition required to meeting the Paris climate agreement by 2050.”

Asset stewardship

Asset stewardship is just one tool pensions advisers have at their disposal as they seek to drive improved ESG practices and greater sustainability. This is the voting and engagement they undertake on behalf of their clients with the companies that they are investing in, says Byrne.

“The starting point is engagement, asking them about their plans and about how they are going to deal with climate change and any gaps in their business model,” he says.

“The lever behind that is the voting; if we feel a company isn’t making progress and improving its environmental profile or its social profile then we have the option of voting against management and can seek to drive change.”

This is more dramatic, but even at a basic level trustees can exercise an “exclusionary approach” where the worst offenders from an ESG or climate point of view are simply not held in the portfolio, says Byrne.

Typically there is a “best in class” approach, where the portfolio is tilted towards companies that are leaders in ESG and at the forefront of new technologies with energy, as well as having high standards of governance. “Your expectation is that those companies would have a better risk-return profile,” Byrne says.

Kelly says LGIM engages “directly and collaboratively” with companies to highlight key challenges and opportunities, and to support strategies that can seek to deliver long-term success.

Risk-reduction

Ultimately, an ESG approach to investment is one of risk-reduction for pension scheme members. While in the past there was a perception that an ethically-themed portfolio meant potentially giving up returns, now the prevailing wisdom is that such a strategy helps avoid negative risks while also finding positive opportunities.

Kelly agrees, saying IORP II will inevitably lead to greater adoption of ESG strategies within Irish pension schemes.

“We believe that ESG factors are financially material. As a result, responsible investing is in our view essential for mitigating risks, unearthing investment opportunities, and strengthening long-term returns.”