Shifting trustee mindsets: ESG integration just means risk management

Defined contribution trustees must also update their default investment strategies to take account of financially material considerations. Crucially, these risks now include financially material environmental, social and governance risks, notably climate change. 

Not that this should come as any great surprise. Policymakers, financial regulators, non-governmental organisations and professional bodies all have this firmly in their sights, as evidenced by the recent plethora of recommendations, directives and guidance issued to strengthen ESG integration in the investment processes of almost all asset owners. And for good reason.

Trustees should keep asking questions of their investment consultant and asset managers until they are satisfied that financially material ESG risks are being properly managed

Well-governed companies with strong ESG risk management credentials should deliver more sustainable returns by not being so materially exposed to operational, regulatory and reputational risk. 

However, the perception that responsible investment means compromising on financial return and diversification still prevails, despite a considerable number of meta studies that provide evidence of companies with best-in-class ESG credentials exhibiting strong financial performance.

ESG risks could hamper portfolios

Supporting best practice is obviously an important consideration, but the need to start viewing ESG through a risk management lens is of greater importance – and this will require a change of mindset.

Indeed, a failure to incorporate ESG into investment strategies could be materially detrimental to investment outcomes, and therefore a failure of fiduciary duty to the scheme’s beneficiaries. ESG analytics need to become an integral component of the trustee risk management toolbox. 

Of course, this is easier said than done, given that there is no universally accepted definition of ESG.

Indeed, the term comprises a myriad of factors from resource depletion to diversity, employee relations to executive pay.

It can be hard for trustees to assess the extent to which their portfolios have ESG-related vulnerabilities, which factors are financially relevant and material, and how ESG risk affects different asset classes.

Additionally, totally excluding higher carbon emitters from pension portfolios, for example, is not a sustainable strategy. Exclusion precludes engagement, which is instrumental in effecting positive change.

Good advisers should be clear on ESG

Forming a view as to what constitutes a coherent responsible investment framework suddenly becomes a daunting task. This is where the scheme’s investment consultants and asset managers come in.

With their detailed knowledge and proprietary ESG rating systems, both groups are in principle well positioned to help trustees make an informed decision about what constitutes a coherent, evidence-based ESG policy. However, while most investment consultants and asset managers are very close to the topic, understand the issues and largely present the suggested policy in a risk management frame, not all do. 

Acknowledging that ESG and risk management are inextricably linked, trustees must keep asking questions until they have total clarity. This process can be aided a great deal if it is led by an independent trustee with an investment and risk management background.

This is not a set-and-forget exercise. A revised UK Stewardship Code is imminent, and by October 1 2020 DC trustees will be required to publish an implementation statement setting out how they have acted on their policies.

Together with their consultants and asset managers, they must monitor and continue to develop their schemes’ ESG policies as the materiality of different risks becomes more apparent.

Regulators need to help

Ultimately, trustees want to be able to confidently state investment beliefs such as, “markets efficiently price in long-term ESG risks, especially climate risks” and “ESG is a collection of identifiable risk factors that prospectively attract a positive return in the long run”.

However, the proof points are contingent on regulatory intervention, such as measures requiring companies to make the necessary disclosures. 

In the meantime, trustees should keep asking questions of their investment consultant and asset managers until they are satisfied that financially material ESG risks are being properly managed. In short, ESG analytics need to become an integral component of the trustee risk management toolbox.

Chris Wagstaff is head of pensions and investment education at Columbia Threadneedle