ESG is about long-term performance, not arbitrary screening

These are often the gut reactions of the average UK pension fund when asked to incorporate ESG concerns into their investment strategy.

But pressure to respond from regulators, politicians, academics, civil society, scheme members and increasingly the business and investing community, continues to grow – and for good reason.

If ignored altogether there are significant long-term risks

Many people still think ESG equates to ethical screens, just as many still think of corporate responsibility as being about philanthropy – ie building playgrounds for local schools. This approach is outdated. 

Corporate sustainability today is much more likely to reside in the CEO’s office than with the PR team. Senior management has recognised that environmental impacts and resource efficiency are often key long-term issues that determine costs, competitiveness and exposure to volatility. 

Governance, ethics and the relationship with civil society will define the outlook for the banking sector for years to come, and as such issues come to dictate future profitability, so they naturally become increasingly relevant to investors who have a longer-term approach.

The real issue, however, is the impact of an ESG strategy on risk and return. Traditionally, pension funds have been concerned that an arbitrary negative screen on a portfolio will constrain a fund manager’s ability to perform, and applying such a screen will have an unwelcome cost attached. But that is really not what we are talking about. 

Future regulatory trends, risk control and management quality are the kinds of issues that should be considered under the heading of ESG. This kind of analysis generally lends itself towards managers that have a longer-term approach. 

The long view

Sadly, genuinely long-term investment strategies have become a relative rarity over the past decade, underlined by Mercer’s 2010 analysis, which found that more than 90 per cent of managers had an average holding period of less than three years. An emphasis on ESG tends to draw the focus back out to the longer term.

There is a broad and growing body of supportive evidence, both from academic research and practical experience. A Harvard Business School paper of 2012 found compelling “evidence that high-sustainability companies significantly outperform their counterparts over the long term, both in terms of stock market and accounting performance”.

Also in 2012 Deutsche Bank published a meta-study aggregating the research on sustainable investment and analysing cost of capital and stock market returns at a security and fund level. One of the key findings was that “89 per cent of studies we examined show that companies with high ratings for ESG factors exhibit market-based outperformance”.

ESG analysis is not straightforward and implementing a strategy adds complexity at a time when there is also relentless pressure to reduce the costs of delivering investment solutions. 

But there are also other factors to be considered in addition to the debate around the direct impact on the investment process.

Significant reputational risk is generated from an investment strategy at odds with the sponsor’s mission. The ability to recruit and retain staff is also sensitive to perception of value added to society by business. 

Institutions also find it very difficult to engage employees actively with their pension fund. A clearly articulated and integrated strategy towards ESG is seen by many as an opportunity to engage more actively with scheme members.

A number of those who have implemented such strategies have reported an improvement in manager selection and monitoring. 

Pension funds have found that asking open questions of fund managers around their approach to evaluating ESG issues in specific situations can be extremely enlightening in terms of their skills and approach. 

There are multiple ways a pension fund can consider ESG factors: from the implications for asset allocation, to appointing specialist managers or holding existing managers to account. 

If considered through the right lens there is value that merits the pension fund’s effort. If ignored altogether there are significant long-term risks. 

George Latham is managing partner and CIO at WHEB Listed Equity