James Sparshott explores what the recent Supreme Court judgment on LGPS investing will mean for ESG integration
The Supreme Court ruling in April that the UK government cannot use statutory guidance on how the money of Local Government Pension Scheme (LGPS) members is managed is likely to add momentum to conversations around ESG investment.
From climate change to executive pay and zero-hour contracts, ESG issues touch on many important ethical questions. But focus on ethics has sometimes hindered discussions about financial implications.
Members' interests or interested members?
ESG is increasingly prevalent in discussions about risk - questions over highly-publicised governance failures and the viability of companies grounded in industries or processes that are harmful to the environment mean it is difficult to ignore such factors when considering long-term investments.
But how far should the LGPS go? ESG investment has been hindered by complexity, regarding both the ever-multiplying investment funds and vehicles, and what obligations LGPS funds are under in terms of incorporating ESG factors. However, requirements for administering authorities to set out their policies on how ESG is taken into account and on the exercise of voting rights demonstrates a shift beyond looking at purely financial metrics when considering investments. Together with prominent shareholder engagement activity and significant improvements in ESG data, this should help the LGPS to formulate clearer intentions and strategies by reducing some of the subjectivity clouding ESG investment, leading to potentially better investment decisions.
As academic research shows not all ESG factors are material. But many are, and are increasingly incorporated into the methodologies of investors, across asset classes and investment styles. Furthermore, companies are increasingly being expected to raise their standards on issues such as climate change and executive pay, particularly as the convergence of investors' ESG standards begins to affect companies' access to capital.
And it is not only trustees, but also their members who are becoming more aware of ESG factors. A Legal & General Investment Management survey found 60% of pension savers wanted their investments to have a positive social and climate impact,  while 55% of pension savers expect their pension by default to be invested less in companies scoring poorly on ESG issues.
However, reducing exposure need not equal complete avoidance - around half the UK's individual pension savers prefer engagement with ESG laggards, with divestment used only as a last resort, echoing our own view.
ESG and Covid-19
We are seeing increasing evidence that ESG investments have proven resilient amid current market turbulence. As the LGPS Scheme Advisory Board notes, responsible investment policy decisions "belong at the local level, reflecting the need to pay pensions both now and in the future; local democratic accountability and the views of scheme members".
We believe that the coronavirus crisis will add further impetus to this trend as better data, increased regulation and member demand mean that ESG investments are here to stay, with climate change in particular being a litmus test of balancing the needs of the present and the future.
Values and valuations
The global pandemic, disruption to daily lives and a global recession are helping to speed up and distinguish between different approaches to ESG. For the LGPS, when investing for their long-term investment horizons, it is becoming increasingly evident that using their large pools of capital to promote resilient companies and sustainable markets and through this, help to develop our societies in a more sustainable way, is becoming inextricable from the financial interests of scheme members.
While exclusions will remain one method for the LGPS to take account of ESG considerations, there are many other ways to integrate ESG factors into portfolios.
Yet if one trend is universal, it is that such factors will be an ever-higher priority. This has been accelerated not only by the recent Supreme Court ruling and this year's events, but also by more vocal shareholder actions, the ‘Fridays for Future' movement, and growing interest in the link between corporate governance practices and longer-term results. The increasing convergence and activity of investors on the financial materiality of ESG issues should encourage more LGPS funds to build sustainable portfolios for the future.
James Sparshott is head of local authorities at Legal & General Investment Management
 Khan, M., Serafeim, G., and Yoon, A. (2015) Corporate Sustainability: First Evidence on Materiality. Harvard Business School
 LGIM survey of c. 1,000 Mastertrust members and L&G staff
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