In part two of a special feature, Gareth Trainor, Head of Investment Solutions, looks at why environmental, social and governance (ESG) and sustainable investing are grabbing more headlines and what their growing prominence means for trustees and employers.
As the importance of environmental, social and governance (ESG) analysis and the choice of sustainable investments have increased, so too have the terms used. In part one, I explained the differences between the process of ESG assessment to help better manage risk and returns, and sustainable investing – funds that tend to target values-based outcomes.
Here I discuss what’s driving demand in these two different but often confused areas of investing. I also look at why these areas may be a topical and powerful way to engage employees in their pensions.
ESG is a mainstream approach attracting new regulation
The consideration of environmental, social and governance matters is a hot topic for two main reasons:
- recognition of its role in spotting investment opportunities and risks, and
- increasing regulation and directives.
1. Recognition of risk and return
There’s increasing recognition that assessing ESG factors can help determine risk and return. If companies take into account all the risks and impacts of their operations – including human rights, environmental issues and how they manage their employees – their businesses can be better managed. In turn, this can help support performance over the longer term.
On the other hand, companies that don’t consider these factors risk harming both their reputation and ability to generate long-term investor returns.
Though still in the early days of development, evidence seems to suggest that companies with high ESG scores can provide higher dividends and better manage their own business risks.
Your employees will usually be saving into their pension for many years, so they should be careful not to base all their decisions on performance, particularly over the short term. Remember, past performance is not a guide for future performance.
2. Regulation is responding
Key stakeholders – regulators, Independent Governance Committees (IGCs) and external agencies such as ShareAction – are pushing ESG into the mainstream.
Most recently, the DWP outlined trustees’ investment duties when it comes to ESG considerations. This follows the earlier IORP II pension requirements – for pension schemes to disclose the risk of their investments, including ESG. The DWP confirms that by 1 October 2019 trustees must produce, update or prepare a Statement of Investment Principles (SIP) that sets out:
- how they take account of financially material considerations, including those arising from ESG considerations such as climate change
- their policies around stewardship of investments, including engagement with investee firms and the exercise of voting rights associated with the investment
- how they take account of financially material considerations in relation to their default strategy, which includes those arising from ESG considerations
In addition, trustees will be expected – at the next review of the SIP after September 2019 – to include a statement on how members’ views on the SIP are taken into account. The DWP feels it’s reasonable for members to be told about the circumstances in which their views will or might be considered. This could give employers another hook to help employees engage with their pensions.
There have also been a number of high-profile announcements on ESG and values-based factors, such as the Law Commission’s view that socially responsible investments are acceptable in defined contribution (DC) investment portfolios.
From the investment industry, to regulators, to the media, there’s a shift in consciousness around these issues. This is good news for employers, as with greater clarity and increasing communication about ESG and sustainable investing, it will be easier to position these topics with employees. And, as we discuss later in the article, this could be an effective route to improving engagement.
What’s fuelling demand for sustainable investing?
More of us are choosing ethical and sustainable options in all areas of our lives; what some are calling the Blue Planet effect. In the UK, there’s significant growth in everything from green energy to ethical clothing, food and drink1.
This values-driven behaviour is also feeding into how we think about finances and investments. The Financial Conduct Authority (FCA) highlights rising demand from consumers for socially responsible and ethical investment options2.
Changes in society, and an increasing awareness that the companies we invest in have a direct impact on the environment and society, are driving this response. This is largely due to the ease of access to information online. Companies can’t operate in isolation – their businesses, the types of products they manufacture and how they operate are all under the public gaze.
Investment companies are responding to this growing awareness, introducing new types of funds that not only exclude negative investments but also invest in companies that actively tackle issues, such as social inequality and climate change. Globally more than $22.8 trillion is invested sustainably – that’s $1 in every $4 under professional management3.
And investors expect this to grow – 58% of them expect sustainable investing to become the standard approach to investing in 10 years, according to a 2018 report from UBS4.
Using these topics to engage employees
Climate change, human rights, corporate behaviour – these are all topical and emotive subjects; things that people can see and feel in their lives, communities and in the media. They’re easier to relate to than other investment concepts, so they could be used to better engage people in their pensions. Industry research shows that there’s genuine interest in responsible and sustainable investing.
- Aberdeen Standard Investments’ 360 ESG report5 found one in four women and one in five men surveyed like the idea that their investment choices could have a positive impact on the world. And 73% of pension respondents agreed that ESG issues could be a new way of engaging the next generation of members.
- Similarly, the DCIF report on navigating ESG6 (pages 22-24) highlights that responsible investment has the potential to build trust and engagement, especially among young members. And bringing members’ assets to life, using examples of responsible investment, is a powerful way to get their attention.
- In a report from Morgan Stanley’s Institute for Sustainable Investing7 75% of investors polled showed interest in sustainable investing – this rises to 86% in the millennials polled. That presents a huge opportunity.
Millennials are a core and growing customer group in new auto-enrollee membership. When asked, many are keen to invest responsibly8, but to do so they need to understand the terminology and what their different options are. For instance, they may not realise that they’re already invested in a fund that has ESG assessment applied to it. If employers can overcome the lack of awareness, then there’s real potential to build interest and trust. When you factor in the new requirement for pension trustees to produce a statement on members’ views, this could help employees feel they have an opportunity to influence.
There’s also recognition that genuine embedding of these sorts of considerations in investments (and communicating about them) is likely to become a hygiene factor for members in future. If providers and employers don’t do this, they may risk employees not engaging with their pensions or opting out altogether.
While there’s work to be done by all in the industry to help people understand the terminology – and to achieve some sort of consistency – the growth and innovation in responsible and sustainable investing does present an exciting opportunity to engage people in their pensions.
How ESG is applied to the Standard Life default pension options
Actively managed options
The Active Plus III Universal Strategic Lifestyle Profile is our flagship default investment option. The Active Plus fund range, which this default and other default options use, is managed by Aberdeen Standard Investments. Their investment processes include the integration and analysis of ESG-related risks and opportunities.
Find out more about Aberdeen Standard Investments’ ESG approach here.
Aberdeen Standard Investments is also a strong supporter of the principles of good stewardship set out in the UK Stewardship Code. They believe it’s mutually beneficial for companies and their investors ‘to have a relationship based on accountability, engagement and trust’. You can find out more here.
As the Active Plus funds, and the underlying funds they invest in, are mainly actively managed, ESG can be integrated at all stages. This is because active managers have the freedom and flexibility to fully integrate the outcomes of ESG analysis in their investment strategies.
Our default options also include the Passive Plus III Universal Strategic Lifestyle Profile. This mainly uses passive funds from Vanguard Asset Management. These funds track a market index, so ESG isn’t integrated into the investment process.
But Vanguard has an established investment stewardship programme and maintains a principles-based approach to governance. They believe that well-governed companies do better over the long term.
Vanguard’s approach has brought about robust dialogue with companies and improvements to board composition, executive pay and benefits, governance structures, and board oversight of strategy and risk.
Did you miss part one?
In ESG and sustainable investing – let’s clear up the confusion we explain the important differences between these approaches to investment.
We’ve also created a summary, jargon busting placemat.
The views expressed in this blog should not be regarded as financial advice. The value of investments can go down as well as up and may be worth less than was invested. Information is based on our understanding in September 2019.
3 Morgan Stanley Sustainable Signals: Asset Owners Embrace Sustainability, 06/2018
4 UBS Investor Watch, Global Insights: What’s on investors minds’ / 2018 Volume 2: Return on values
5 Aberdeen Standard Investments 360 ESG Report, November 2018
6 Defined Contribution Investment Forum: Navigating ESG, A Practical Guide, 04/2018
7 Morgan Stanley Institute for Sustainable Investing: Sustainable Signals: New Data from the Individual Investor, 2017
8 The Wisdom Council: Insights – Responsible Investing, October 2017