Amid surging interest in ESG issues, Charlotte Moore looks at how the LGPS is pursuing responsible investment
The Local Government Pension Scheme (LGPS) has been at the forefront of the responsible investment trend, with many local authority funds ahead of their private sector counterparts. The next step is for the newly formed pools to form their own policy and implementation strategy.
This might be more complex than it might seem. The onus to be a responsible investor can be interpreted in different ways, making it harder for some pools to create a clear environmental, social and governance (ESG) policy and implement it.
Some schemes think that responsible investing is about not owning stocks in certain sectors. Others focus on specific aspects of ESG such as managing the risks posed by climate change.
Many think ESG factors should be embedded in the investment process for all asset classes. And a few are thinking about impact investing and how they can help the world meet the UN’s sustainable development goals.
Pools that have already developed a clear policy could provide a roadmap to others in the process of grappling with this issue.
Michael Marshall, director of responsible investment & engagement at LGPS Central, says: “Our longstanding commitment to responsible investment means we have ensured it is at the heart of our investment process.”
This was put in place before the pool was launched, as was also the case for the Local Pensions Partnership (LPP). The founding funds – the London Pensions Funds Authority and Lancashire County Pension Fund – were both committed to integrating ESG factors into their investment processes.
Both funds were signatories to the UN-backed Principles for Responsible Investment. Frances Deakin, responsible investment manager at LPP, says: “That isn’t common in the LGPS.” It was important to both partner funds this commitment continues, she adds.
Central’s commitment to responsible investing (RI) is reflected in the pool’s organisational structure.
Mr Marshall sits on the investment committee to ensure the head of responsible investment has a direct input into conversations about investment process and policies.
In addition, newly recruited investment directors must show responsible investment skills and expertise. Mr Marshall says: “This is a requirement for all asset classes, not just listed equities.”
Ensuring these skills are well represented across all senior executives enables the pool to fully integrate this approach across their portfolio.
It is also important that the pool works together with its partner funds. “An RI working group has been established so the pool can ensure the strategy we are pursuing meets their own requirements,” says Mr Marshall.
LPP took a similar route, establishing the role of the responsible investment manager. Ms Deakin says: “My role is to help the pool and internal staff to focus on this issue, as well as providing support to the partner funds to develop their ESG policies.”
Developing a policy for LGPS Central required reviewing the investment beliefs of all the partner funds. Mr Marshall says: “Most of our funds had already articulated an RI strategy, while some had signed up to the stewardship code.”
Putting a policy in place for the pool was relatively straightforward as the partner funds had a similar attitude. “There were no major deviations in approach or major inconsistencies in their investment beliefs,” Mr Marshall says.
The partner fund policies were used to build a set of investment beliefs for the pool. These include the importance of corporate governance as well as diversity, and that responsible investing determines long-term returns.
Climate change is considered financially material and a risk factor managed through stewardship. Referencing the debate as to whether funds should divest from polluting companies, Mr Marshall says: “We have a preference for engagement over exclusion.”
LPP wanted its ESG approach to future-proof its investment approach. The pool recognises what happened in the past is not necessarily a guide to the future. “We seek forward-looking information which can help us to anticipate the influence of new issues,” Ms Deakin says.
The organisation also wants to anticipate trends and build these into the review process. Ms Deakin says: “When we carry out due diligence, we want to look at the impact on both risk and returns from ESG factors.”
For example, a company with a bad environmental track-record is likely to be a riskier investment than one with a low carbon footprint. And a firm that has a better labour policy may well generate higher returns than one which treats its employees badly.
Theory to practice
Developing a series of investment beliefs is an important first move, but to be a responsible investor requires the pool to translate aspirations into practical steps.
“We take a three-pillar approach: selection, stewardship and transparency,” Mr Marshall says. This translates into due diligence processes which apply for both the internal team and external fund managers.
For the internal team, the selection process involves close scrutiny of ESG factors before an asset is acquired. External fund managers need to demonstrate they can implement a similar policy.
The pool has an active stewardship programme which involves engagement with companies and policymakers. Mr Marshall says: “We are also participants in a number of forums such as the Institutional Investor Group on Climate Change, the Transition Pathway Initiative and the Principles for Responsible Investment.”
Transparency is not unique to the pool’s responsible investment strategy – it permeates the organisation. But there are specific RI strategies. Mr Marshall says: “For example, we support the taskforce for climate-related financial disclosures.”
Not only does Central use these recommendations to disclose its own approach to climate risk but it also lobbies companies, regulators and listing authorities to do the same.
By using this three-pillar approach, the pool is able to integrate its responsible philosophy into every investment it makes.
LPP takes a similar approach. Ms Deakin says: “We have procedures which turn our beliefs into practice.” These accommodate different asset class and mechanisms of investment.
For example, the internal equity team will examine the individual ESG characteristics of each company they are thinking of adding to their portfolio. And when a pool wants to appoint external managers, it will evaluate their current approach to ESG.
Mr Deakin says: “We look for managers to be aligned with our own approach as well as looking for their intention to evolve their ideas and practices in the future.”
For both the LPP and Central, developing an RI strategy for the pool was relatively straightforward, but for others this might not be the case. The challenge is that compared with their private sector counterparts, local authorities are more advanced.
John Belgrove, senior partner at professional service firm Aon, says: “Our conversations with our LGPS clients include very detailed climate change scenario work, which includes both assets and liabilities.”
There has also been a broader interpretation of RI by the local authorities, with some choosing not to invest in certain sectors and others considering impact investing.
Mr Belgrove says: “Some local authorities have carried out divestment action from fossil fuel stocks.” Others have reviewed their position following concerns raised by interest groups and decided to pursue engagement rather than divestment, he adds.
This could create problems for a pool if they bring together local authorities with very disparate points of view.
Simon Jones, head of RI at Hymans Robertson, says: “The challenge is for the pools to bring together the underlying funds into an overarching philosophy.”
Mr Belgrove adds: “The pool is effectively delegating policy to the local authorities. They need to ensure they have the right funds to allow the partner funds to express their investment views.”
However, building a common strategy will be challenging if partner funds have very different beliefs.
Mr Jones says: “The pools will need to go through a process of engagement and find the common ground and then develop the philosophy over time.”
Once these challenges have been overcome, however, pooling should make it easier for local authorities to develop and implement RI policies. That is because the pools will provide the necessary scale and resource.
If a small local authority had lofty ambitions for its RI agenda, putting it into practice would be difficult. It is likely it would have to make use of pooled or co-mingled funds rather than a segregated account.
It is much harder to influence an asset manager’s investment philosophy in this scenario because the pension scheme lacks the necessary heft. “A pool with assets of around £40bn will have the necessary resources and clout to develop more sophisticated solutions,” says Mr Jones.
More sophisticated solutions will not only involve greater influence over external asset managers’ ESG policies, but also implementing RI policy in private and public debt markets.
It is much harder to implement an ESG policy in these markets because a debt investor does not have the same voting rights as an equity investor.
Sam Gervaise-Jones, head of client consulting at bfinance, says: “The question is how to influence companies when there is no direct control.”
A pool would be better able to enact this type of policy because it could exert a greater influence over the investment mandates.
“Once the pools have managed to come up with their common policy, they will have the power to integrate ESG into all asset classes,” Mr Gervaise-Jones says.