ESG factors are important to the LGPS, but views differ on their role and how to approach them. Jimmy Nicholls reports.
- Keith Bray, forum officer, Local Authority Pension Fund Forum
- John Harrison (chair), interim chief investment officer, Border to Coast Pensions Partnership
- Denise Le Gal, independent chair, Brunel Pension Partnership
- Jo Ray, pension fund manager, Lincolnshire CC
- Dawn Turner, chief executive, Brunel Pension Partnership
- Paul Tysoe, funding and investment manager, LGSS Pensions
- Peter Wallach, director of pensions, Merseyside Pension Fund
- Ben Yeoh, senior portfolio manager, RBC Global Asset Management
A decade after the 2008 financial crisis, businesses – particularly those connected to finance – face constant demands to show they do more than generate cash for their owners.
Among investors this has emerged through a focus on so-called environmental, social and governance (ESG) factors. These concern wider, non-financial impacts, whether it be in the places in which a firm operates, the people it interacts with or the mechanics of its leadership.
With much media commentary noting the 10th anniversary of the crash, it made sense to consider how the Local Government Pension Scheme (LGPS) can best account for ESG factors in its investment – the subject of a roundtable organised by LGC and RBC Global Asset Management.
Ben Yeoh, senior portfolio manager at RBC Global Asset Management, began the conversation with a simple statement. “ESG for us is a returns source,” he said. “I think you’re getting better risk-returns from it.”
He noted that machines, algorithms and quantitative analysts – so-called ‘quants’ – have an edge in certain elements of investing. Some of it is found in factor investment, which focuses on things like value, momentum or return on equity.
But machines do not have all the advantages. “I contend that computers still don’t read a lot of ESG or intangible information very well,” Mr Yeoh said. “They still can’t do things like corporate culture, innovation, long-term sustainability, human capital, environmental capital – those type of elements.
“Partly it’s because the reporting is not very good, and partly it’s because some of these things are always going to be in the hands of judgment.”
John Harrison, interim chief investment officer at Border to Coast Pensions Partnership and chair of the roundtable, said: “What you’re making a case for is that intangible assets, so to speak, are by their definition heavily involved with the ESG components, cultural components of the business, and that you see that as a source of investment return.”
Addressing roundtable attendees from the pools and partner funds, he asked: “Is the interest in ESG and sustainability about improving return or is it about avoiding risk, whether that be reputation or financial, or is it a bit of both?”
“Both,” said Denise Le Gal, independent chair of Brunel Pension Partnership. “Because we want to be sure that the companies we invest in are not just sustainable, but resilient to shocks.”
Some were less sure that ESG was always a good bet for returns. “What is the duration tolerance of an investor?” asked Paul Tysoe, funding and investment manager at LGSS Pensions.
“A fund manager can have really good ESG policies, engagement and processes, but actually the tolerance of the investor – which is our committees – is whether they are going to deliver a return over a reasonable timeframe.”
Dawn Turner, chief executive of Brunel Pension Partnership, replied: “The advantage of being a pension fund and investing is we can be more patient. We can think about the long term, look at the current situation and say if companies don’t address certain elements in the future whether they’ll be a long-term impact – not necessarily just to that company but to the wider economy.”
The pools’ role in the appointment of investment managers is an important factor in this. “Given that, from a Brunel point of view, you are implementing your ESG policy through the managers you appoint, how do you get them to account for what you’re trying to do, and how do you assess whether they are doing it or not?” Mr Harrison asked.
“It’s a very long question,” Ms Le Gal said, laughing.
Her colleague Ms Turner responded: “When you look at any investment manager you’re looking at their processes. You want to know what their processes are and how robust they are, and how convinced you are that their processes, especially with active managers, are going to deliver what they say they will.
“Part of that is seeing how they manage risk – in fact a significant part. ESG isn’t something that sits on the side. We want to see that they are considering the material financial risks that are relevant for what they’re investing.”
The advantage of being a pension fund and investing is we can be more patient
Dawn Turner, Brunel Pension Partnership
Mr Harrison added: “Border to Coast has just done a selection exercise for UK equities [investment managers]. We had well over 30 submissions and one of the big scoring points was implementation of ESG in responsible investment.
“The thing I found fascinating was that all of them except one had really good responses to responsible investment, which is the words bit of it. I found it a lot more difficult to work out whether those words were implemented in practice, but the marketing of responses has improved immeasurably in the last couple of years.”
Ms Le Gal responded: “That’s because the LGPS has been saying if you don’t do it you’re not going to get a mandate.”
Mr Tysoe agreed: “If you go back five years in responsible investment, our knowledge, our expectations and our demands are now much greater on this front due to awareness and bringing these issues forward.”
“We’re aware of the ESG washing that comes through [selection processes],” said Ms Turner. “We did have a section that asked about it. But we had other questions where we anticipated that if someone wasn’t just washing it through that they would also bring it through in those areas.”
Jo Ray, pension fund manager at Lincolnshire CC, said: “I think it’s much easier in an active mandate. With the big shift into passive and quant strategies one of the real questions is how we ensure that those managers are being responsible investors, because a lot of the indexes they might track and use are backward looking.
“You could potentially throw out some of the big companies that are going to change how we go going forwards. At the moment they might not score well if you look at the R&D that they’re spending on clean energy and things like that. These are some of the companies that a lot of the pressure groups would have us divest from tomorrow.”
Keith Bray, forum officer at the Local Authority Pension Fund Forum, said: “A few years ago everybody started putting ‘ethical’ into the fund they were trying to flog, and now they’re putting ‘ESG’ into the fund they’re trying to flog. We’ve seen it improving but I think we’re still wary about accepting how real that improvement is. Is it just marketing?”
He added that collaboration between different parts of the LGPS was key in forcing the issue. “Even with the largest funds, if they have an issue with a fund manager, a company or the way the industry is going, they will never have as much effect as we [the forum] will when we raise it nationally. And that’s really where our strength is: not looking at individual companies across the board but specific issues.”
“We’ve been passing this on to fund managers for too long,” said Ms Le Gal. “I think we have to take ownership of that whole process.
“We’re on a journey but everyone has their role to play and we can’t just talk about fund managers. We have to talk about the asset owners. I think part of the reason why the fund managers have all jumped on this bandwagon is that we have been saying the last few years we expect this of you.”
“That’s an interesting point,” said Mr Tysoe. “But who’s really responsible in the pooling environment: the fund or the pool? And how is that demonstrated?”
“My answer is it has to be both,” said Ms Turner. “The regulations state that for each of the funds they need to make a statement about what they’re doing, and Brunel itself has its own responsible investment policy.
“If we’re going to service our clients really well that responsible investment policy must be a reflection of what they’re looking for within their investment strategy statements. We’re fortunate that we’re aligned on that one which therefore makes our role easier. But I’m aware that doesn’t necessarily resonate throughout the LGPS.”
Who’s really responsible in the pooling environment: the fund or the pool?
Paul Tysoe, LGSS Pensions
Mr Harrison said: “From a Border to Coast point of view there’s a responsible investment policy agreed with the partner funds which informs how the pool will behave.
“While there is a continuing agreed common policy, it’s quite easy to see how we can have an effective voice. The problem would come if you end up with the partner funds deciding they have different things they want to do.”
On the week of the roundtable, local pension funds had been targeted by a Friends of the Earth campaign, calling for divestment from energy firms involved in fracking, which involves injecting liquid underground to extract oil and gas, and has raised concerns over environmental risks. This prompted a debate on the merits of divestment against shareholder engagement.
“One of the principles of responsible investment policy Border to Coast has, which all its partner funds have shared, is that they believe engagement is more effective than divestment,” Mr Harrison said.
“But there is quite a lot of pressure on individual funds at the moment from various different interest groups to move it into a divestment agenda. And it will then become quite difficult from a Border to Coast point of view to have as an effective a voice as it would have had otherwise.”
Ms Ray said: “I think this is sometimes where the LGPS governance structure doesn’t help in the four-yearly potential full turnover of pensions committees, and in the political makeup bias of the committees. That should not be a factor in the decision-making – however it is in some cases. And it goes back to the point about long-term investment.”
Ms Le Gal proposed a potential solution to this. “Some of the funds have started to opt for independence, so they don’t have this reliance on councillors,” she said.
“The question to my mind is whether it means we need to review and go down a different model, something akin to what the Canadians do with some of their pension plans, where we don’t have this reliance on people who are not qualified and need the training. If you’re only there for three years, it’s a big ask for something that meets four times a year. That’s an existential question.”
Ms Ray agreed: “The issue as to whether our current setup in pension committees actually is fit for purpose.”
Referring to the quality of the many pensions committees he had addressed, Mr Bray argued that “the quality, the approach, the culture varies enormously in terms of the committee as a group and also with individuals”.
“You might have a window cleaner on the committee or you might have an actuary on the committee,” he added. “Quite often the sensible question comes from the window cleaner, because they’re not trying to prove anything.”
Peter Wallach, director of pensions at Merseyside Pension Fund, said: “I thought you hit the nail on the head with the philosophical approach to responsible investment: is it divestment or is it engagement? We are actually having a fundamental review of our investment approach at the moment to try and capture some of the softer issues.
“I think ultimately they’ll be evolution rather than revolution. I’m still very much of the mindset of responsible investment as a risk mitigant rather than as a performance enhancement. But it could be that if you go for an active approach you don’t need to worry about the divestment-engagement issue, and you can see it as a performance enhancement.”
Discussing what pension funds can tell pressure groups about engagement versus divestment, Ms Le Gal said: “You can point to all the things that have happened where it has made a difference. With some of the oil companies – Shell or BP – there’s tangible examples where corporate behaviour has changed because of pressure put on through engagement.”
Her closing remarks on climate change summarised much of what’s at stake in the debate. “We’ve got to save our planet,” she said. “I don’t want to sound evangelical, but that’s one of the main drivers since the Paris agreement. What’s the point of investing if we’re not going to have a world that’s worth living in?”
This roundtable discussion was sponsored by RBC Global Asset Management. The topic was agreed by LGC and RBC Global Asset Management. The report was commissioned and edited by LGC. See LGCplus.com/Guidelines for more information.
Companies skimping on ESG are creating liabilities
Ben Yeoh, senior portfolio manager, RBC Global Asset Management
Our purpose as a business is to make a positive difference to our clients, to the companies we own and society through responsible, long-term investment.
As such we invest in sustainable, great companies at attractive valuations and steward them for the long-term, using intangible, environmental, social and governance (ESG) and business assessments, combined with strong risk analysis.
Financial analysis and ESG assessment are intertwined in judging businesses, and businesses thrive long-term when they invest in ESG intangible factors that lead to stronger, more sustainable financials. ESG is a non-traditional source of risk and opportunity but it should form part of every fundamental assessment.
The relevance of these issues varies from industry to industry, so we believe it is important to integrate ESG into a company assessment rather than as a pre-screen or overlay. It eases engagement and ensures ESG risks and opportunities are incorporated into the fundamental valuation analysis driving financials.
For us, strong ESG practices are contingent assets, or ESG opportunities, that can enhance a business’s prospects. On the other hand, a company that chooses to compromise the future to flatter short-term results is creating contingent liabilities or ESG risks that could undermine sustainability.
Traditional financial accounting aims to list a company’s financial assets and liabilities on its balance sheet, but that is only one form of capital: financial. Other forms of capital also exist: human, environmental, and regulatory, for example.
In the same way a company can borrow against financial capital by taking out loans, it can also borrow against extra-financial or ESG capital. This can take many forms: borrowing from suppliers by not paying them on time; borrowing from employees by compromising on training; or borrowing from the environment by not tidying up. This does not appear in the accounts, but it creates a contingent liability which, when realised, impacts financial capital and the value of the business.
Conversely, companies that invest in these other forms of extra-financial capital can create contingent assets. These are assets that may not be visible, but they have the power to determine the path of a company’s long-term financial performance. For example, good client service is easier to deliver with engaged, motivated employees.
Ultimately, we view ESG as a tool to enhance superior risk-return for our stock selection and portfolios.