De-risking schemes must rethink fiduciary duty over ESG risks

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Winch: A passive allocation to a carbon-tilted index can deliver a reduced exposure to carbon emissions with little impact to cost, risk or return
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Winch: A passive allocation to a carbon-tilted index can deliver a reduced exposure to carbon emissions with little impact to cost, risk or return

Helene Winch says in light of regulatory guidance, schemes focused on de-risking need to re-consider their fiduciary duty to also manage ESG risk

The Pensions Regulator (TPR) has surprised the market by publishing new defined benefit (DB) investment guidance on ethical, social and governance (ESG) factors that significantly opposes the currently held, conservative views of current trustees, their consultants and many pension lawyers. These views are based on the now outdated Cowan v Scargill case, which many in the market interpreted to mean fiduciary duty was synonymous with return maximisation.  

The guidance details the regulator's expectations for trustees responsible for DB schemes and in particular clarifies whether or not they should consider ESG factors when making investment decisions. This comes as part of a wider push to improve scheme governance. The paper, published on 30 March, clearly states that investors "should take ESG factors into account where financially material". 

This new guidance mirrors defined contribution (DC) scheme guidance, published in 2016, that incorporated the Law Commission's guidance. This has already led to many DC schemes' chief investment officers and trustees reconsidering their responsibilities on ESG and committing to new investment strategies that explicitly incorporate ESG factors (for example the HSBC Pension Scheme and NEST).

This guidance increases the pressure on trustees to respond on responsible investment. First in 2015 we had the high level policy commitment at COP21 where 192 countries globally committed to transition to zero net-carbon emissions by 2050 with many institutional investors committing to act.  In 2016 the Financial Stability Board Task Force recommended that all parts of the investment chain from asset owners to investment managers - through to companies - needed to actively manage climate-related financial disclosures and report on climate-related strategy, risks and targets.

TPR's signalling is due to be further reinforced by the Institutions for Occupational Retirement Provision (IORP) II Directive which includes requirements for European schemes to "take into account the potential long-term impact of investment decisions on [ESG] factors". This directive has to be adopted by the UK before Jan 2019, prior to Brexit.

In parallel with this significant modification on the treatment of ESG factors, the academic research on financial materiality has become more convincing. ESG data has improved in quality and quantification as well as length of historical series (for example MSCI ESG data now has 10 years of data).  Tools, like the Sustainability Accounting Standards Board Materiality Map, guide investors to focus on specific ESG factors for each sector and are backed up with performance data highlighting the financial benefits. Strategies that provide exposure to pure ESG factors give additional uncorrelated financial returns to investors focused on market cap index.

For investors focused on carbon reduction, a passive allocation to a carbon-tilted index can deliver a reduced exposure to carbon emissions with little impact to cost, risk or return (although historical returns can't be used to predict the energy transition we are about to face). However, some of these solutions have expensive license fees, un-transparent processes, backward-looking factors and unintended consequences such as tilting away from renewable energy ownership or over-exposure to the financial sector.

Beneficiaries of many schemes are asking their trustees to deliver headline carbon reduction to lower the financial impact of the revaluation of companies that are unable or unprepared to embrace the rapidly changing energy system. DC schemes with large equity allocations and long-time horizons are already responding, aware of their responsibilities of managing long-term climate-related risks for their future beneficiaries.

The universe of DB schemes focused on de-risking need to re-consider their fiduciary duty to also manage ESG risk across the portfolio in the remaining equity allocation and corporate bond issuers' carbon risk. They also need to look at the government risk associated with carbon reduction targets, as articulated by nationally determined contributions that could impact on government credit ratings if not met.

Helene Winch is senior responsible investment specialist at HSBC Global Asset Management

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