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ESG: the next sticking point for pools

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For pooling to be successful, the investment philosophy of the co-mingled funds must reflect the values of the individual schemes. If there is a mismatch, this could create problems when mandates are to be awarded collectively.

The approach to environmental, social and governance (ESG) factors is one such area with the potential to create discord. There is a wide variation in opinion on the importance of this investment style. 

At one end of the spectrum, ESG investing is still considered through the prism of socially responsible investing and seen as ‘nice to have’ rather than a necessity. At the other end are those who want to embed ESG principles in their investment process across all asset classes. 

The LGPS Investment Regulations, introduced in 2016, played a part in bridging the gap between different schemes’ attitudes to ESG investing. 

Dawn Turner, chief executive of the Brunel Pension Partnership, says: “These regulations placed a greater emphasis on ESG and required schemes to show how they had considered these principles before making an investment.” 

The heft of a pooled fund makes it easier to undertake more sophisticated investment techniques than would be possible for an individual scheme. 

Peter Walsh, head of asset management company Robeco UK, says: “A large pool of public money needs to demonstrate that not only is it adhering to its fiduciary obligations but it also has a greater social responsibility.” 

Ensuring the pool’s approach to ESG investing commands the support of all participating schemes starts early on. The Brunel Pension Partnership thought about its agreed investment principles last year while it was still exploring forming a pool between 10 schemes. 

There was a diverse range of attitudes towards measuring, managing and monitoring ESG risk among the schemes that make up Brunel. This pool includes the Environment Agency, which is a recognised global leader in their integration of responsible investment. 

Ms Turner says: “We agreed on 12 investment principles which met the needs of all 10 [funds].” While these 12 principles are broad, they form the foundations for the pool to develop its investment philosophy in greater detail. 

“The first principle is that we should be a long-term investor, as this matches our purpose as a pension scheme: to pay out long-term liabilities.” 

If the pool aims to be a long-term investor then it needs to consider how the financial world will develop. Ms Turner says: “That meansensuring financing of those liabilities is sustainable.”

To achieve that goal, the pool will need look to the future. Ms Turner says: “The fund needs to understand the long-term implications of developments around the world, in economies and companies.” 

Those goals will be achieved by integrating ESG risk management into the investment process of the pool, she adds. “Working from our agreed investment principles in this logical manner addressed the different attitudes of [funds] towards the consideration of ESG impacts,” says Ms Turner. 

When the pool looks at its portfolios and manager selection, the partnership has included the appropriate responsible investment assessment for any asset class. Ms Turner says: “We want our managers to demonstrate how they are managing ESG risks.”

The intensity of that focus will vary across both asset classes and industrial sectors. 

As investment managers get to grips with the process of integrating a consideration of ESG principles into their investment process, they are realising that the importance of particular characteristics varies. 

Faryda Lindeman, senior corporate governance specialist in the responsible investment team at NN Investment Partners, says: “For example, carbon data is particularly relevant for the oil sector, while governance is, for instance, more important for banking and insurance companies.” 

Investment managers are now making choices not only on whether ESG factors are more influential but also which particular metric within each gives a strong investment signal.

For example, a logistics company that has both a good stock management policy and strong labour practice is likely to perform better than one that is weak in either or both areas. 

Additional statements from the Law Commission requiring funds to consider ESG principles as part of their fiduciary duty have also been helpful in fostering a common approach. 

Phil Beattie, executive director of index products at MSCI, says: “These recommendations for schemes to take the financial risks pertaining to ESG into account, as part of their fiduciary duty, accelerated the integration trend.”

Ms Turner says: “There is a growing recognition that schemes need to account for all aspects of an investment that could have a financial consequence.”

Potential ESG impacts are too important for them not to be integrated into the investment process. But while Brunel has worked hard to build an investment consensus and its direction reflects that of the regulator, that does not mean building an agreed point of view happened instantly. 

Ms Turner says: “We have managed to resolve all the issues that have arisen by going away and gathering more evidence and research.” 

Passion is not enough to instigate radical change. “It has to be grounded in fact and reasoning,” she adds. This will be the approach that the Brunel Pension Partnership takes as it implements its investment principles including responsible investment and stewardship. 

The next frontier will be impact reporting: managers will need to tell their stakeholders about the impact of their investing. Brunel believes this should be focused on the sustainable development goals. 

Ms Turner says: “Reporting back on the impact of a particular investment in light of a sustainable development goal will add further information to Brunel’s investment processes and it could influence where Brunel chooses to invest.” 

Mr Walsh adds: “The future of ESG will be investment options that either specifically target a particular sustainable development goals or have an investment outcome.” 

This could be thought as revisiting the original the principle of social responsible investment. Mr Walsh says: “There is increasing pressure on the pools to assess the impact of their investments and that is feeding through to the asset managers.”

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