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To ESG or not to ESG, that is the question…

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Following the DWPs new regulations on ESG matters, Melanie Cusack looks at ways trustees should address the issues.

Environmental, Social and Governance issues have been on the trustee radar for some time, but it is only recently that ESG factors have risen to the very top of the agenda. The reason for this is clear. The DWP has published new regulations, which came into force on 1 October 2019, that require trustees of both DB and DC schemes to include in their Statements of Investment Principles (SIPs) an explanation of how they have taken into account material environmental, social and governance factors, including specific reference to climate change, with emphasis on the financial factors.

In the past, the organisations most concerned about ESG factors were charities, not-for-profits and public sector organisations, largely due to perceived reputational risk or emphasis on social values. It is probably fair to say that all trustees were to some extent burdened by a stricter definition of their fiduciary duty, a definition focused exclusively on optimising investment returns, which required a balance to be struck.

One angle on the new regulations is: another day, another demand on trustees’ time and yet more pressure on meeting agendas. Viewed through another lens though, these new obligations merely reiterate what should have been common practice. Taken further, they can be viewed as an opportunity for trustees to improve transparency and even enhance member engagement.

Here are some things to consider when approaching the issue for your scheme as the new regulations take effect.

Be clear on what ESG is… and isn’t
ESG differs from socially responsible investing, or impact investing, or ethical investing (depending on your description of choice) in a fundamental way. In essence, ESG simply concerns risk management – having a process in place to identify and mitigate long-term financial risks in your investment portfolios. Impact investing is more intentionally geared towards making the world a better place – by identifying and investing in businesses that aim to make positive social or environmental impact. Although there is clearly overlap, ESG is about value rather than values, and is therefore something that good trustees have been doing as a matter of course.

Rewarding good governance
Although many diligent trustees already factor ESG risk screening into their investment approach, some may have been worried about their accountability (with sponsors and members) for including apparently non-financial considerations into their decisions. This may have led them to defer to their sponsors in some cases or, for DC schemes, only include ESG-screened funds in their range of self-select funds.

In this respect, the new regulations can be seen in a positive light. Trustees of DB schemes now have a legitimate, evidence-based reason to engage with their sponsors on ESG factors. Furthermore, the new regulations demand that trustees of DC schemes publish their SIPs, explain how they have taken ESG issues into account in designing their default funds, and outline how they have factored member views into their design.

Leverage your ESG activity for positive member engagement
This piece of the puzzle does have the potential to blur the boundary between ESG risk assessment and impact investing, as outlined above, so care should be taken in framing your member communications. Nonetheless, given that effective member engagement is a perennial challenge for trustees, this new obligation should be viewed positively as an additional tool in the box. This is particularly true for engaging millennials, arguably the generation most at risk of poor retirement outcomes.

Numerous studies have shown that millennials outstrip other demographic groups in their concern for social and environmental impact, and in their willingness to invest in companies that target social or environmental goals. Telling positive stories about your approach to ESG factors, and proactively seeking member views, have been shown to enhance member engagement, improve perceived value and could potentially encourage more appropriate contribution levels.

We have a small client in the charity sector where the DC default fund had been largely consistent with the DB section. On the back of just one member’s enquiry about socially responsible funds, a self-select fund was added, and the scheme are now looking to tilt the default fund in a similar way.

Engage with your investment managers
It has been historically difficult for trustees, especially of small schemes predominantly invested in pooled funds, to put the theory of ESG screening in meaningful practice. The good news is that this is changing rapidly. Investment managers are increasingly embedding ESG factors in their investment processes and, with more and more ESG-tilted funds being launched, the marketplace is developing rapidly. We have also seen some excellent work being undertaken by investment consultants to add ongoing ESG monitoring to their normal reporting.

The governance demands placed on trustees are increasingly onerous, and the realm of ESG is no exception. Viewed in the right way, however, these developments are largely positive. At all costs, trustees should resist the pressure for this new process to become a box ticking exercise, instead ensuring the end result is a positive impact for members and improved engagement.

Melanie Cusack, Client Director at PTL