Although the Covid-19 crisis intensified consumer and investor focus on business behaviour in 2020, environmental and social and governance (ESG) has been on the radar of occupational pension scheme trustees for several years.
ESG investments were attracting particular attention pre-pandemic, as they were generally assessed to be outperforming the market and to have lower levels of volatility in the long term.
While ESG obligations apply to almost every sector of the UK economy, pension schemes are directly in the firing line, as far as the government is concerned, for trying to ensure society takes greater responsibility for ESG matters.
Few British industries involve such large sums of money or touch as many lives as its pensions sector.
Although individual companies are responsible for their own ESG practices, the government has decided to focus on pension funds as major investors in those businesses, by requiring trustees to establish and implement ESG policies that filter down to the corporate level.
Guided by these policies, it is hoped that pension funds, via asset managers, will refuse to invest in companies with poor ESG records, providing an incentive for businesses to improve their approach to ESG matters.
October 2019 changes
October 2019 saw the first set of deadlines for pension trustees to document their approaches to ESG in their Statement of Investment Principles (SIP).
Since 1 October 2019, trustees of defined benefit (DB) and defined contribution (DC) schemes with more than 100 members have been required to include in their SIP their policies on:
- The duty to take into account "financially material considerations" over an "appropriate time horizon" (financially material considerations expressly include ESG issues, such as climate change; appropriate time horizon refers to the length of time trustees judge is required for the funding of future benefits by the scheme's investments);
- Their stewardship responsibilities, encompassing how rights relating to scheme investments (including voting rights) are exercised;
- Their approach to non-financial matters – i.e., the extent to which (if at all) non-financial matters (including the ethical, social and environmental views of members and beneficiaries) play a role when trustees are deciding whether to select, retain or realise scheme investments.
The regulations introducing these amendments are the Pension Protection Fund (Pensionable Service) and Occupational Pension Schemes (Investment and Disclosure) (Amendment and Modification) Regulations 2018.
The 2019 changes to the Occupational Pension Schemes (Investment) Regulations 2005 also place new requirements on DB schemes to publish their SIPs online by 1 October 2020 and report annually on the implementation of their policies around voting and stewardship behaviour from 1 October 2021.
October 2020 changes
By 1 October 2020, trustees will need to include further detail in their SIPs on their stewardship policy and arrangements with asset managers, including:
- How their arrangements with asset managers incentivise managers to: align investment strategy and decisions with trustees’ investment policies; assess and make decisions based on medium to long-term financial and non-financial performance of issuers of debt and equity; and engage with issuers to improve this medium-long term performance;
- How the method and time horizon of the evaluation of the asset manager’s performance, as well as the manager’s remuneration, is aligned with the trustees' investment policies;
- An updated stewardship policy for engaging with and monitoring investee companies in terms of their capital structure and how actual or potential conflicts of interest are managed;
- How they monitor the portfolio turnover costs incurred by the asset manager;
- The duration of their arrangement with the asset manager.
The Pensions Regulator (TPR) intends that this will help ensure action follows words and the obligation to publish both the SIP and an implementation statement should mean trustees will lean on asset managers and consultants to produce evidence of compliance.
TPR's DC and DB investment guidance respectively provide information on what trustees may look to include in their implementation statements and on the regulator's current thinking on ESG.
Non-compliance with the legislative requirements is subject to discretionary penalties under s10 of the Pensions Act 1995 and Regulation 5 of the Occupational and Personal Pension Schemes (Disclosure of Information) Regulations 2013.
Is it working?
While pension funds are being targeted by the UK government as the principal vehicles for driving higher ESG standards in business, there is evidence to suggest that many pension funds have been slow to change course.
A report by the UK Sustainable Investment and Finance Association (UKSIF) published in January 2020 found most trust-based defined contribution schemes had ESG investment policies that were "vague and non-committal".
It also found that two-thirds of schemes had failed to comply with the minimum legal requirement to publish their SIP.
Such non-compliance places trustees in breach of their fiduciary and regulatory duties – although to date there has been little or no meaningful enforcement of pension funds' obligations.
Moreover, provided that a pension fund publishes a detailed SIP and implementation statement, there is at present no penalty if it fails to meet the ESG targets it sets out to achieve.
The approach the government is taking is not to use a big stick to beat pension funds to comply, but to use public opinion to force pension scheme trustees to publish and implement their policies and/or investment strategies.
This is the rationale behind requiring pension funds to make their SIPs public, and to provide increasingly detailed information on the implementation of ESG policies. It is envisaged that this will give activist bodies the information they need to put pressure on schemes to engage more rigorously with ESG issues.
Problems with the public opinion approach
One of the potential pitfalls of relying on public opinion to encourage pension funds and their investee companies to adopt "good" ESG is that the public is several steps removed from the businesses whose job it is to implement ESG practices.
Most pension schemes do not invest directly in companies, but rather in pooled funds run by asset managers, which then invest in companies.
Some pension trustees have been concerned whether the changes to investment regulations mean they should be consulting members' views on ESG.
As outlined above, since 1 October 2019, pension funds have been required to include in their SIP details of the extent to which (if at all) non-financial matters (including the ethical, social and environmental views of members and beneficiaries) play a role in trustees' investment decisions.
However, there is no strict requirement to consult members, but rather for trustees to continue to act in the best financial interests of beneficiaries and generally to disregard personal preferences or ethical views of members (or indeed of the trustees themselves).
Even if a pension provider did try to ensure that the fund's investments met the ESG expectations of the individual contributors to the pension scheme, those individuals would have very little visibility on what the underlying companies are actually doing.
And, given that most people who pay into workplace pensions have little or no say in which pension provider their employer uses, the connection between pension schemes and their beneficiaries is arguably too weak for the members to move the dial.
How can lawyers help?
With the arrival of new and stricter legislation on ESG obligations for pension funds comes a need for legal guidance.
While it is not a lawyer's role to audit pension investments, they can advise trustees on what needs to be done to comply with their various obligations and what kinds of questions they should be asking asset managers to put to the companies they invest in.
They can also advise on litigation risk, where there is a possibility of pension funds being sued by stakeholders in relation to their investments on ESG grounds.
Responsibilities of trustees as stewards to ensure compliance with best practice generally refer to the conduct of investment managers, rather than the underlying companies – and how to align remuneration of investment managers with ensuring that underlying companies are meeting appropriate ESG targets.
A large proportion of pension schemes are run by lay trustees, however there is a growing band of professional trustees (and professional trustee organisations) involved in running schemes. These are seen as being potentially the most influential drivers of better ESG standards as they have more power to influence the behaviour of investment managers, and have shown themselves to be more open to taking legal advice.
While ESG reforms to pension investments are a welcome step in the direction of improving corporate ethics and sustainability, further action is needed to ensure companies set and actually meet meaningful ESG objectives.
In time, there will need to be mandatory targets coupled with legally enforceable penalties for failing to achieve them.
The risks to businesses and economies are material if pressing environmental issues like climate change, air and water pollution and biodiversity loss are not addressed, while the cost of allowing poor social practices and governance to go unchecked have become increasingly evident in recent supply chain and corruption scandals.
Interventionist legislation giving government and stakeholders power to take action on ESG should provide the missing push factor to coerce rather than persuade companies to comply with legislative aims.
The shift on environmental matters is supported by a number of industry groups, such as the Pensions Climate Risk Industry Group, which was established in summer 2019 and recently produced draft, non-statutory guidance on assessing, managing and reporting climate-related risks in line with the Task Force on Climate-Related Financial Disclosures.
While many stakeholders currently look at company ESG ratings compiled by respected agencies, rather than evidence of legal compliance, such ratings may become less relevant as the volume and coherence of legislation increases, and if/when penalties for non-compliance become a greater deterrent.
Looking ahead, the latest draft of the Pension Schemes Bill has been amended to include the power to make regulations that could require schemes to report on their exposure to climate change risk. This demonstrates the UK government’s intention to further regulate trustees’ actions in this area, although it stops short of directing how trustees should invest.
The EU working group on Taxonomy Regulation – which aims to codify what a "green product" is in an investment context – will help investors compare like with like and stop companies/funds from effectively 'marking their own homework' on ESG.
Although there is currently no obligation to comply with the EU's financial disclosure regime, this looks set to change in the UK partly as a result of the Green Finance Initiative, which seeks to align investment with carbon reduction and related environmental resilience goals.
A version of this article first appeared in Pensions Expert on 1 October 2020.
Michael Calvert and Jeremy Harris are specialist pensions lawyers at European law firm Fieldfisher.
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