With so many institutional investors pressing ahead with plans to pioneer sustainable investment strategies, are UK pension funds already a step ahead of regulators?

Earlier this month, Lindsay Tomlinson, the chairman of the UK's National Association of Pension Funds (NAPF) and a director of the Financial Reporting Council (FRC), told the NAPF's Investment Conference in Edinburgh that a bit of short-term inconvenience for funds would benefit them in the long run.

Tomlinson was referring to the seven-point Stewardship Code for institutional investors, launched in 2010 by the FRC, aimed at "tightening the ratchet on corporate governance".

The code's main objective is to engage funds with the companies they invest in and make them more responsible investors, for example by monitoring the behaviour of firms, taking a lead in shareholder democracy and avoiding conflicts of interest.

"Good corporate governance is consistent with the long-term investment objectives of pension funds. It also pushes back on those that are currently calling a review on fiduciary duties that would consume a lot of time and energy," said Tomlinson.

He added that greater responsibility on behalf of pension funds would support UK equity investment in the long-term and help the Government's growth agenda. Foreign investors, he claimed, strongly admired UK corporate governance and some overseas regulators are said to be looking to launch copies of the code in their own countries. 147 institutional investors have now signed up to the code.

While there is little argument against its principles, trustees have raised concerns that corporate law discourages investor engagement regardless of their intentions. Commenting on the code, Dennis Buckley, Chairman of the SAUL Trustee Company that governs the University of London scheme has said that there is "still something fundamentally wrong with the system when shareholders can vote down a remuneration report and the company can totally ignore it."

Nevertheless, a strong argument for signing up to the guidelines is the hope that by doing so, pension schemes in the UK can avoid having to deal with further regulation from Brussels.

The theme has been echoed by George Dallas, director of corporate governance at F&C, who told Pension Funds Insider that the stewardship code represents "an evolution that hopefully will build over time, but if it does not advance sufficiently there is the potential for greater regulatory fiats kicking into gear, which would not be desirable".

F&C have put a stewardship agenda into practice since 2003 with their annual Responsible Investment Report and in 2010 voted against company management in 18% of 72,000 resolutions at the companies they held shares in, rebelling almost twice as often as they did in 2009.

Dallas says that while incidences of boards ignoring shareholder votes could continue, "this behaviour is not sure to be tenable in the long-term". He adds that changes to the UK corporate governance code can enhance shareholder democracy by encouraging companies to hold annual board elections and "if this starts to become a norm there will be a greater possibility that we can collectively hold directors to account".

Analysing the current position of the code, he says one major challenge is to increase the critical mass of assets under management that adhere to the code: "That is beginning to happen from two sources – smaller asset managers in the UK that hitherto have not been that actively engaged but also mobilising the sometimes silent voice of overseas investors."

Going green?

Investors who have made a big thing of responsible stewardship, like F&C, are typically eager to promote the environmental aspect of this engagement. Karina Litvack, the firm's Head of Governance, says: "We need to be mindful of the ripple affects that individual decisions might have across the whole of the economic system, which is why we focus on tackling corruption, climate change and biodiversity losses; the kind of issues that can disrupt the wider health of our investments."

The investment manager's 2010 Responsible Investment Report states that the group is "encouraging companies to understand, value and protect the ecosystem services on which their businesses depend". A recent example of such encouragement saw F&C make some stern recommendations to the board of an Asian palm-oil producer which was dropped from Unilver and Nestle's client list due to excessive deforestation. 

While individual pension funds do not pack the same weight as a large investment manager, pension funds should have a definite interest in the environmental sustainability of their portfolio, claims Mercer. A recent report from the consultant estimated climate change might count for up to 10% of total portfolio risk over the next two decades.

Many trustees have already got the message. Howard Pearce, head of management at the Environment Agency's £110 million pension fund recently said that climate change mattered to the organisation "because we know that we will need to be paying out pensions to our fund members well into the 21st century."

Pearce also believes that all pension funds will need to adopt a "climate change-proofed financial investment strategy" in the future to enable them to fulfil their fiduciary duties. The Environment Agency's pension fund has 13% in alternative assets which hedge climate risk like agriculture and infrastructure, and is considering increasing this share to 25% in the next few years. The agency may be an obvious example, but it is by no means alone.

The Mercer report advocates diversification of assets as a way to combat climate risk. "Mitigating climate change risks will require a new approach for investors," it claims.  "The short-term horizon of traditional equity and bond investments means that it will be more difficult for investors to price in long-term risks around climate change compared to some of the more climate sensitive areas. Consequently, the traditional way of managing risk through a shift in asset allocation into increased holdings of more conservative, lower risk, lower return asset classes may do little to offset climate risk."

The way ahead

One logical destination for this risk-mitigating investment is low-carbon technology, which has received high-profile UK government backing. The UK's Green Investment Bank will start operations a year earlier than planned in 2012 with £3 billion of public funds. Mercer reckons there are $5 trillion worth of opportunities waiting to be found in the area and a number of UK funds have taken the plunge, according to Chris Armitage, head of specialist green energy and commodity investment house Four Winds Capital Management. 

Armitage told Pension Funds Insider: "There is a strong tendency amongst the larger pension funds to seek out sustainable funds. Although at times it seems like more of an aspiration on behalf of their trustees – when it comes down to it they tend to fall back on more sustainable asset classes, particularly in difficult periods such as 2008."

He added: "The funds most likely to actually invest, rather than just investigate, are those that have a 'special ideas' or new ideas bucket." Many of Australia's large superannuation funds fall into the category of large funds taking a proactive interest in sustainability, and Tarnia Puchlenko, a spokesperson for VicSuper, one of those funds, said that 19% of its $5.5 billion fund was invested in 'climate sensitive' assets of real estate, infrastructure, agriculture, timberland, sustainable equities and clean tech.

The active approach of large funds is the envy of some conscientious UK trustees who have criticised the typically small funds on these shores for having a nominal interest in sustainability that has been lost in surrendering effective investment policy control to consultants. An obvious point of scepticism, however, is that real estate and infrastructure might be earning a sustainable tag that belies the actual impact of these industries.

BT recently gave a hint that they will also look to infrastructure to hedge climate risk, with their £34 billion scheme's head of management Helene Winch saying: "Our trustees are encouraging us to look at investing in climate risk mitigation. We are hoping to allocate more to infrastructure and if we can do that in a sustainable way to help the UK government move towards a low carbon economy that helps everybody."

Winch said that the scheme "can combine high returns with sustainability". With a stuttering equity market argued from some quarters to be a sign that time is starting to gradually run out on the world's oil-driven economy, this assertion may have to hold true. 

dbillingham@wilmington.co.uk

First published 24.03.2011