Following the COP26 summit in 2021 and the Paris Agreement, most governments made a net zero pledge, with the UK setting a date of 2050. To reach this, various activities and targets were put in place meaning many businesses and consumers are making more informed choices about services and investments based on their green credentials and sustainability.
Whilst on the whole, most businesses are on board, there are some investors who follow the Milton Friedman philosophy, that states a corporation’s sole responsibility is to maximise stakeholders’ profits, meaning that individuals rather than corporations should pioneer social causes and environmentally sound investments.
But in the current climate this idea is shifting, and more investors are becoming socially conscious and take more of an interest in the investments being made and actively look for corporations who are socially and environmentally responsible. This is demonstrated by the 2022 Global Perspectives on Responsible Investing survey which found that 68% of respondents claimed the most concerning issue with investments was in regard to climate change.
This therefore means, that any changes that pension funds can make in their sustainability will go one step towards helping clients meet their own environmental and climate goals and will make the organisations more attractive to them. The key between the two attitudes is finding the sweet spot between social responsibility and future investment returns.
This shift in government targets and consumers’ priorities have led to a number of changes being instigated – namely in the way that investments are made.
Whilst sustainable investment in itself is a very broad term and can be open to interpretation, a measurable subset of this is Environmental, Social and Governance (ESG) which the government has legislated.
For many years before COP26 the urgency surrounding environmental and climatic factors had increased and was a driving factor in the improvement and evolution of ESG regulations. This has resulted in a lot of change in legislation and regulations in a very short space of time including:
- Updates to the Stewardship Code
- Guidance from The Pensions Regulator
- Guidance from the Financial Conduct Authority
- Regulations with the Pension Schemes Act
- Updates to the PRI code
- Updates and advice from the Institutional Investors Group on Climate Change (IIGCC).
In the past year alone pension funds have had 70 to 100 consultations on different aspects of running the funds from admin and investments to member communication. This in itself can be overwhelming, especially for the smaller funds.
The UK was the first government to legislate that pension schemes should report on their climate-related financial risks and in March 2022 this was expanded further as the Pensions Minister asked pension schemes to manage the risk of deforestation issues, carbon footprint and biodiversity.
As part of the framework to ensure all businesses play their role in the fight against climate change, global ESG regulations were put in place for private businesses. These regulations meant they had to report on and prevent adverse impact on the environment and climate.
Whilst the ESG integration can be seen as just another set of regulations and reporting on top of all these other changes, the majority of organisations are keen to make their contributions to a better world. For this reason the approach to ESG integration is not so much about regulating certain investments, but about understanding the risk profile of the investments as well as the opportunities from an environmental, social and governance perspective.
But of course this comes with reporting.
The first reports produced in line with the Climate Change Governance and Reporting Regulations were published in December 2021 and stated that the largest UK pension schemes were subject to certain obligations from 1 October 2022. These include:
- Occupational pension schemes with more than £5bn of net assets, along with authorised master trusts and authorised collective money purchase schemes.
- Schemes with more than £1bn of net assets.
- Schemes with more than 100 members are required to have a clear ESG, climate change and stewardship policy in place.
- All occupational funds will need to complete the TCFD report by 2023.
- Application to smaller schemes will be reviewed in 2023.
The key aspect of the reporting for pension schemes will need to be transparent about how they are investing their members’ money, especially if it is detrimental to the environment. The overwhelm however, has set in for many organisations as their personal drive for sustainability can get lost in time-consuming reporting, implementation statements, and regulations.
The Climate-related Financial Disclosures (TCFD)
As part of the ESG regulations the Climate-related Financial Disclosures (TCFD) is a mandatory requirement for the largest of schemes.
Regulations state that trustees must publish a TCFD report within seven months of the scheme’s first year-end, and then for each year thereafter where their scheme continues to meet the asset size threshold. This report which is signed by the Chair of Trustees is to be made publicly available free of charge.
The TCFD reports are reviewed by The Pensions Regulator (TPR) who then provides high-level observations and feedback to in-scope schemes and advises smaller scheme trustees who aren’t currently in scope but who wish to improve climate-related risks and opportunities management.
However, failure to complete a TCFD carries penalties issued by the TPR:
- If the report has not been published there is a penalty of at least £2,500.
- If the trustees have not made a genuine effort to comply with the regulations there is a discretionary penalty of up to £50,000.
For many trustees there is significant work to be carried out in order to comply with the Climate Change Governance and Reporting Regulations and as these start to apply to smaller schemes this workload will increase, and some of the small to medium schemes could struggle.
How have pension schemes prepared?
When new regulations are introduced there is often little choice but to get on board, but with ESG according to Aon’s 2022 Global Perspectives on Responsible Investing Survey more than 84% of pension firms claim to engage already with responsible investment through ESG integration and 48% have an ESG or investment policy in place.
Those who do have a policy in place feel they are making suitable changes to their investment habits and a fifth of UK asset owners aim to get in line with the 2050 net zero pledge although more than half claim they will do something “soon”.
Such vagueness in regard to targets could be down to overwhelm for in order for a pension scheme to achieve net zero it means all the aggregate emissions across every portfolio would need to achieve this. This is a massive undertaking.
But like anything on such a large scale as climate change and the environment it can only be achieved by taking small steps. Many schemes are therefore starting with being compliant with the ESG legislation and there are a number of things they are already doing which include:
Asking the right questions – To aim for net zero trustees need to ensure that all their providers can demonstrate ‘climate competency’, so carrying out due diligence is key.
There are three key questions:
- What are the emissions of the portfolio?
- Is there a net zero target across the portfolio, now or in the future?
- How realistic is this target?
Questions can also include asking asset managers about voting policies and practices and finding out what drives these. Others can include change and how it is implemented, as well as what guidance, training and support they offer.
Trustees are at the top of the pyramid and what they ask, and the precedent they set is important. The more information they can gather the better decisions they can make.
Starting such discussions with providers is the only way to instigate positive changes to products, practice and policy. Processing the answers can then lead to setting of clear, achievable goals and realistic expectations.
Investment today has a lot more riding on the way a company runs and the policies they have in place than they did in the past where returns were more important.
Knowledge and expertise – Trustees need to be confident their providers have the knowledge and expertise to manage climate-related risks and opportunities.
Investment-led fiduciary management approach – The fiduciary manager is directly responsible for the engagement with providers and their emissions targets which ties in with asking the right questions.
Having an efficient governance structure in place is vital and offers a number of key benefits:
- Effecting real and measurable change
- Gathering and understanding data regarding risks and opportunities
- Understanding application of net zero across different asset classes
It’s important that pension schemes are aware that reaching net zero is a long journey, and it needs to be achieved through a series of small incremental steps. Identifying these steps and knowing what can be done today, and what is a target for the next year and beyond is fundamental in achieving it.
However, there is a continuing debate about what investments are sustainable or responsible, and the definitions will always depend on perspective. For example gas is better than coal environmentally speaking and could be viewed as an ESG initiative, even though gas is non-renewable. So, even the small steps could end up being a little more complex than initially thought.
While many organisations want to embrace ESG, implementing it can be extremely challenging. This is even more so for organisations with weak infrastructure or weak employer covenant.
According to a survey by MallowStreet and Janus Henderson Investors, 17% of those with weak employer covenants find it much harder to keep abreast of ESG demands. Many of the weaker organisations may have a single pensions manager who is expected to complete all the extra reporting and they may not have the time or the skills to do this effectively resulting in overwhelm and not knowing where to start.
That doesn’t mean that all those organisations with strong employer covenant find ESG integration easy. The survey showed only 45% have an ESG policy in place which means both weak and strong infrastructures need to put work in.
The MallowStreet survey also showed that high funding schemes are more likely (approximately four out of five) to include responsible investing in their statement of principles (SIP). However, this is not down to lack of interest on behalf of the underfunded schemes; they are as keen to discuss and consider ESG risk but may not have the means to actually act on it. Trustees may simply not have the finances, time or capacity to manage a weak employer covenant as well as implementing ESG integration. It’s about immediate priority, and in some incidents climate change can slip behind the possibility of bankruptcy.
However, there are some steps that weaker schemes can consider when addressing ESG integration:
Trustees and employers should work together to implement ESG objectives so the ESG priorities are aligned with company objectives.
If the integration is treated as a box-ticking exercise, then there is little intrinsic value for the organisation but if trustees and employers agree on the strategy going forward with things they believe in it will prove to be invaluable to them.
Weak schemes should use independent external advisors and fund managers to create a responsible and sustainable investment strategy.
Weaker organisations may have fewer resources available to them in general to put together ESG integration. An independent third party will have experience to draw on and will be viewing the processes with fresh eyes. A credible advisor can be an invaluable asset during this process.
Regardless of the weak status of a company as more legislation comes in, it will be regulation for all companies to have an ESG policy in place. It is better to understand the processes now and start on the journey to net zero sooner rather than later.
As ESG is relatively new, as are the concepts it embodies, so companies need to be willing to adapt to a new way of doing things, and therefore there is little room for trustees who are stuck in their ways and are not able or prepared to evolve.
It is very easy to fall into the comparison game, especially when larger schemes may be making big pledges to reach net zero such as the M&S Pension Scheme, or Aviva who plan to be net zero by 2040. Such targets may not be a possibility for a smaller, weaker fund.
Trustees should focus purely on their own funds and what would be beneficial and possible for their members. For some DC schemes this could be a long-term investment programme but for others it could be more in the here and now depending on circumstances. Whatever steps are taken will have an impact and will contribute towards the goals of net zero. Making a net zero plan which is not credible is just as irrelevant as not making one at all.
Pension schemes have a great deal more influence over the flow of investments in the economy than initially believed and are therefore in a position to choose better investments which will lead towards a lower-carbon economy and better working conditions. They are able to see the value and influence that responsible investing and improved working conditions have on the wider market.
A key target for pension schemes going forward is to ensure the portfolios are focused on both risks and opportunities whilst also adhering to the underlying regulations. ESG is an important aspect of modern pension schemes and is only going to become more integral to the debate going forward. This is in the form not only of trustees’ regulatory obligations, but also in acting upon the desires of the members to do better when it comes to the environment and climate change. Investor engagement is having a real-time effect on companies and will eventually lead to a change in culture and working practices.
According to Aon’s recent Global Perspectives on Responsible Investing Survey the majority of investors are happy with the returns they are seeing on ESG investments which bodes well for the future. When investments are producing returns for the members but also for the environment it is seen generally as a win-win situation.
In some instances ESG funds can even outperform non-ESG equivalents and have a long- investment horizon. Therefore they could generate higher excess returns, reducing a pension’s deficit which would be invaluable for weaker schemes who are unable to focus on ESG strategy. Research from MSCI in 2020 shows that over a period of 13 years, those companies with high E, S and G pillars outperformed bottom scoring companies by as much as 27%.
It’s important for corporations to take ESG seriously as it is not going anywhere. By keeping abreast of changing opinions and aspirations of the members, the more socially and environmentally friendly investments will be seen as more attractive.
But this in itself needs to be balanced with the business in hand which is making long-term financial returns. Evidence shows that companies with high ESG ratings do actually have higher market valuations than businesses with lower ESG ratings, so the investments are also financially attractive. This could, however, be because, as mentioned companies with high ESG ratings are generally stronger organisations with a robust infrastructure in place meaning they are more likely to be better at managing the risks of their business models.
Although we have been tackling issues of climate change for some time now, this is a long-term project and is one that will be in development for decades to come. Essentially we are at the start of what will be a long, frustrating but ultimately important journey to making the world a better place.