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ESG forever

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First coined around a decade ago as an abbreviation for ‘Environmental, Social and Governance’, ESG only really entered common currency this year; yet confusion abounds as to what it’s all about.  

As far back as July 2014, guidance from the Law Commission acknowledged this and concluded that “it would be preferable to think in terms of financial and non-financial factors”.

This observation has guided subsequent government thinking. From 1 October 2019, trustees of schemes required to prepare a Statement of Investment Principles (SIP) must specify policies in relation to (among other things) “financially material considerations” over the appropriate time horizon of the investments, including how those considerations are taken into account in the selection, retention and realisation of investments.

The governing legislation says “financially material considerations” includes (but is not limited to) environmental, social and governance considerations (including but not limited to climate change), which the trustees of the trust scheme consider financially material.

“Non-financial matters” means the views of the members and beneficiaries including (but not limited to) their ethical views and their views in relation to social and environmental impact and present and future quality of life of the members and beneficiaries of the scheme. All the SIP must say about such matters is the extent (if at all) to which they are taken into consideration.   

These basic facts are important. One persistent misunderstanding is that ‘E’ stands for ‘Ethical’, and so ‘ESG’ is some kind of optional extra, or ‘nice to have’. Such beliefs have fuelled ‘greenwashing’ by fund managers, using terms like ‘climate tilt’. Trustees might invest in a fund labelled ‘ESG’ and consider ‘job done’.

Further confusion surrounds the use of terms like ‘sustainable’, ‘responsible’, ‘stewardship’ and ‘impact’. These are all, in my opinion, relevant and complementary rather than wholly interchangeable or synonymous with ESG. The Investment Association has taken a lead in distinguishing them, and adopted the definition of ESG integration in the UN Principles for Responsible Investment: “The systematic and explicit inclusion of material ESG factors into investment analysis and investment decisions”.
Things are hotting up.
 Current Government proposals will require larger schemes to have effective governance, strategy, risk management and accompanying metrics and targets for the assessment and management of climate risks and opportunities. Furthermore trustees will have to explain what they’ve been doing, in line with the recommendations of the international industry-led Task Force on Climate-related Financial Disclosures (TCFD), published in 2017.

Although climate change is now on (almost) everyone’s agenda as the most salient Environmental risk, ESG is about much more. Poor working practices in a supply chain are a classic example of an ‘S’ for ‘Social’ risk factor.

Few can have been unaware of the recent woes of the fashion firm Boohoo: its share price halved in July in response to revelations that some of its suppliers in Leicester had not been paying the minimum wage. The horrifying word ‘slavery’ was invoked to emphasise that this was not a trivial matter affecting one or two people. Ironically, some 20 self-described ‘ESG funds’ had invested in Boohoo, having been overly-reliant, it seems, on third-party ESG rating systems.

What about the ‘G’ factor? Corporate governance risks include corruption and bribery, tax and accounting fraud, political donations, board structure (eg diversity and independence of non-execs,) disclosure and protection for whistleblowers.  Poor corporate governance damages investor confidence: companies can go bust almost overnight. Think Wirecard, for example; or further back, Enron.

There is growing evidence of a positive link between financial performance and strong corporate ESG policies and practices. That’s why ESG risks are deemed ‘financially material’ now.

Evidence is emerging too in support of a holistic approach to ESG risk assessment. The activities of mining companies are not only an Environmental risk: Social as well as Governance risks were exposed in the destruction of a 46,000 year-old Aboriginal rock shelter by RioTinto this year. The board responded by cutting directors’ bonuses; investor outrage at the perceived inadequacy of this led to the exit of its CEO.

Fixed interest investments can carry similar risks: corporate bonds such as last year’s Saudi Aramco issue most obviously, but even government bonds these days. Mismanagement of the COVID-19 pandemic in some countries has increased the risk of government default. After all, investors in fixed interest expect to get back their principal original investment as well as promised income streams.

ESG risk assessment should now be at the core of all pension fund investment. It is essential to sustainable investment and effective stewardship by trustees exercising their fiduciary responsibility. ESG is now and forever.
Ian Neale
Director, Aries Insight