The proliferation of ethical investment funds and the sensational increase in assets invested in these funds underlines the importance institutional investors are increasingly attributing to responsible investing. Boston Consulting Group, a management consultancy headquartered in the US, estimated that assets managed under some form of sustainable, responsible investing mandate across the globe grew from $18 trillion in 2014 to $23 trillion in 2016, representing more than a quarter of total managed assets.

Investment managers are increasingly likely to be signatories to the United Nations supported Principles for Responsible Investment (“UNPRI”), a set of six principles drawn up by a group of experts from the investment industry, intergovernmental organisations and civil society, that seek to protect the interests of beneficiaries by incorporating environmental, social and governance (“ESG”) factors into the investment process. Whilst pension scheme trustees cannot directly influence a manager’s policies on ESG factors, or on the exercise of investment rights where a scheme holds assets in a pooled fund, trustees do, however, often consider ESG policies when selecting an investment manager and monitor their general policies in line with the UNPRI.

The range of polices that trustees consider is wide ranging and extensive, and isn’t just limited to those regarding environmental and social concerns, such as whether a company complies with all environmental laws and regulations, or whether it takes appropriate action to ensure decent labour standards are adhered to. Responsible investing also seeks to incorporate factors that allow for the better management of risk and the generation of sustainable long-term returns. 

Proposed regulatory changes, at both a national and European level, are likely to see pension schemes and other institutions facing additional obligations with respect to ESG factors. For example, following a consultation back in March, the Government’s Environmental Audit Committee recommended that the Department for the Environment and Rural Affairs obligate the Pensions Regulator, the Financial Conduct Authority and the Financial Reporting Council to produce climate adaptation reports, using powers ascribed to it under the Climate Change Act.

A further consultation by the Department for Work and Pensions will require pension scheme trustees to take account of ‘financially material considerations, including (but not limited to) those arising from ESG considerations’, when producing or updating a Statement of Investment Principles, and also when formulating or updating a default investment strategy.

Due to the increased importance of ESG factors for pension schemes and other institutional investors, investment managers now employ a range of measures which seek to satisfy scheme trustees of their credentials in relation to responsible investing. Some, such as Aberdeen Standard Investments, use the UN’s Global Compact’s four areas of focus as a basis when assessing the performance of potential investee companies. These cover:

· Environmental responsibility  which ensures compliance with all environmental laws and regulations

· Employee relations - which expects the investee company to take appropriate action to ensure decent labour standards are adhered to

· Human rights and international operations - which ensures international human rights standards, such as the UN Declaration of Human Rights are respected

· Business ethics - which expects stringent anti-bribery and corruption policies to be maintained.

Others use similar benchmarks when assessing the conformity of companies to ESG principles.

Investors have, in the past, assumed that employing an approach that takes ESG factors into account would result in lower returns Industries and sectors which often pay high dividends, such as tobacco companies and defence stocks, are often excluded from ethical indices, potentially biasing returns downward.

However, the evidence paints a different picture. Whilst the FTSE100 index returned 7.2% p.a. over the past 5 years (up to 30^th September), the FTSE4Good UK index, which excludes companies involved in the production of tobacco, the manufacture and development of conventional and nuclear weapon systems, as well as companies that operate power plants that use fossil fuels, outperformed, returning 7.6% p.a.

Proponents of responsible investing suggest that minimising certain business risks, such as those related to health and safety or environmental issues, could boost profits and ultimately long-term returns. By taking into account the environmental impact of their actions and saving energy, providing the employment protections and high-quality working environments that incentivise employees, and having governance structures that allow management to concentrate on the long term, financial performance can be improved.