US regulators seek to untangle ESG duty as UK pushes ahead

Pension fund investors in the United States may need to prove allocations made under their environmental, social and governance policies are primarily aiming for a financial return should proposed new rules be enacted.

At the end of June, the Department of Labor (DoL) announced it was recommending the enactment of a rule that would provide “clear regulatory guideposts for plan fiduciaries in light of recent trends involving ESG investing”.

The rules centre on the duties that were initially bestowed on trustees and others under the Employee Retirement Income Security Act (ERISA) of 1974, but has been regularly updated over the past 45 years.

A statement from the DoL said: “The proposal is designed, in part, to make clear that ERISA plan fiduciaries may not invest in ESG vehicles when they understand an underlying investment strategy of the vehicle is to subordinate return or increase risk for the purpose of non-financial objectives.”

Put plainly, unless the primary purpose of an investment is to make a financial return – rather than make an improvement to the environment or society – a pension plan may fall foul of the rules.

“Private employer-sponsored retirement plans are not vehicles for furthering social goals or policy objectives that are not in the financial interest of the plan,” said Secretary of Labor Eugene Scalia. “Rather, ERISA plans should be managed with unwavering focus on a single, very important social goal: providing for the retirement security of American workers.”

The proposal, which makes five core additions to the regulation, acknowledged that “ESG factors can be pecuniary factors, but only if they present economic risks or opportunities that qualified investment professionals would treat as material economic considerations under generally accepted investment theories”.

In other words, the risk mitigation or opportunity of the ESG-focussed investment must be clear enough for it to fall within generally accepted standards around asset management and portfolio strategies. Otherwise, it would not be classed targeting financial return or risk management.

Despite the proposal seeking to clarify duties for trustees, there is increasing evidence that considering ESG factors when constructing a portfolio or asset allocation strategy actually improves the financial return.

Although based on small numbers, global ESG funds outperformed the broader market by a little more than 1% on a net basis in the first quarter of 2020, according to Refinitiv.

The difference between approaches – by regulators and investors – across the Atlantic are stark.

Around the same time the DoL issued its proposal, the £8bn Lothian Pension Fund – Scotland’s second largest local government scheme – published its updated Statement of Responsible Investment Principles.

Chief investment officer Bruce Miller said: “We’re very clear that our primary responsibility is to be able to pay the future pensions of our members, but it’s important to all stakeholders that we invest in a manner that the average member sees as fair and reasonable.”

David Hickey, a European Equity manager at the Scottish fund, who has led the scheme’s overall approach to responsible investment since 2015, said the fund would now follow an ‘Engage our Equities, Deny our Debt’ mantra.

Hickey said: “Lothian Pension Fund will no longer supply new funding to non-Paris aligned companies either through new bond issuance or through new equity issuance.”

The reason behind this stance is simple, according to the fund: “This is not only against our values as an organisation committed to the goals of the Paris Agreement, it’s also a huge business risk, tying capital to assets that are likely to become stranded in a decarbonising economy and therefore increasing the risk of capital impairment of our investments. Neither of these are acceptable outcomes.”

The UK’s financial regulators have also pressed forward with guidelines on how asset managers and other institutional investors need to identify, monitor and manage climate change risk in their portfolios.

Announcing the publication of a guide co-authored by the Financial Conduct Authority and the Prudent Regulation Authority, the regulators’ combined taskforce, the Climate Financial Risk Forum (CFRF), said “minimising the future risks from climate change requires action now”.

Sarah Breeden, the PRA co-chair of the CFRF and executive sponsor for climate change, said it presented both significant risks and opportunities for the financial sector.

“By providing practical assistance to help all financial firms develop workable solutions, today marks a significant step forward in building a UK financial system resilient to the risks from climate change and supportive of the transition to a net-zero economy,” said Breeden.

Sheldon Mills, the FCA co-chair of the CFRF and interim executive director of strategy and competition, said: “The CFRF is a positive example of collaboration between regulators and industry to find common ways to overcome barriers to meeting this challenge.”

Last Updated: 3 July 2020
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