It is huge step forward that pension funds will be required to state their policy on ESG and stewardship in the fund’s ‘Investment Strategy Statement’. This is far more progressive than the previous requirement to state the extent (if at all) to which social, environmental or ethical concerns are considered and certainly in stark contrast to the approach by the Department of Work and Pensions (DWP) to reject the Law Commission’s recommendations just a few months ago.
However, Greg Clarke, the Secretary of State, has made it clear that consideration of non-financial factors should not lead to investment policies which run contrary to UK foreign policy. This is concerning because the government has on several occasions – including in the consultation document itself – conflated financially material environmental, social and governance factors with non-financial factors.
The Law Commission was very clear: trustees should take into account all financially material factors including ESG. Local authorities are not trustees in the same sense as trustees in private defined benefit schemes, but Nigel Giffin QC’s helpful 2014 opinion clarifies they nonetheless hold fiduciary duties towards scheme members. The Law Commission’s report on fiduciary duties should be used as the foundation on which the new regulations are built.
There are various issues with the proposals and below we summarise our five key concerns that need to be addressed by the government when it responds stakeholder feedback.
The misperception that non-financial factors and financially material ESG factors are the same is dangerous and wrong. Many fund managers in the UK now have entire teams tasked with analysing current and emerging environmental, social and governance factors to enable them to identify long-term risks and opportunities in line with their fiduciary duties.
An example of the distinction is as follows: Withdrawing from tobacco because the risk of litigation makes it a bad long-term investment is based on a financial factor. Withdrawing from tobacco because it is wrong to be associated with a product which kills people is based on a non-financial factor. It is crucial this distinction is explicitly recognised by the government.
First, the government’s views on the use of pension policies to pursue boycotts, divestment and sanctions in relation to UK foreign policy have been made clear. But it is unreasonable to expect funds to continuously analyse the extent to which their investment policies are in line with the foreign policy of the government of the day and amend them where appropriate. The government should clarify that this does not apply to investment policies that integrate financially material ESG factors.
Second, this should not exclude authorities from considering other non-financial factors during the investment process. It remains unclear why LGPS members should not have their values reflected in their investments like members of private DB schemes.The ability for funds to consider the extent to which ethical considerations are taken into account should be reinstated in the regulations. What is important here is the views of the scheme members (i.e. the fund’s investment policy should not be decided via a council vote) and that there is no risk of significant financial detriment to the fund.
Much more detail is needed on the Secretary of State’s power of intervention. Greg Clarke’s views on appropriate investment policies have been made clear, but the power to intervene should only ever be used when an administering authority has breached its fiduciary duty. The power to determine what is or is not an appropriate investment strategy should remain with the administering authority. The regulations should be clear that this power will only be used when an authority is in breach of its fiduciary duty.
Reference is needed within the regulations in relation to responsible investment i.e. ESG integration and stewardship. The consultation states the regulations aim to ensure authorities’ investments are made prudently and reference to this aim within the regulations would be very helpful. A definition of what ‘prudence’ entails would also be useful. LGPS funds are international investors and should therefore be expected to adhere to international best practice. An expert working group should be set up to establish best practice and this should be reflected in guidance.
Pooling of funds will result in benefits of scale for some LGPS funds, and active ownership and stewardship have rightly been recognised by the government as helping to enhance the value of investments. However no details have yet been given on how stewardship activities will be conducted on investments from pooled funds. More thinking needs to be done on this, one option is for each of the new “British Wealth Funds” to sign the Stewardship Code or join the Local Authority Pension Fund Forum (LAPFF) and for each to have an individual approach and policy on stewardship.
It is important to recognise the significant progress that has been made in requiring funds to have policies on ESG and stewardship so soon after DWP failed to do the same for private DB schemes. However, this will count for nothing if the distinction between financial and non-financial factors remains unclear. Ultimately we want to ensure publication of a robust set of rules for LGPS funds which help to facilitate and further encourage responsible investment. We will continue to work with the Department for Communities and Local Government (DCLG) and others in the sector to achieve the necessary changes to the draft regulations on key issues outlined above. UKSIF’s detailed submission to the consultation is available here.
Fergus Moffatt is Programme Director and Head of Public Policy at the UK Sustainable Investment and Finance Association.