The challenge: sustainable development
What policy actions would help move institutional investors closer to the goal of a sustainable financial system? That’s the question the UNEP Inquiry into the Design of a Sustainable Financial System explores in a new report published jointly with CalPERS, the US pension fund giant.
For Henry Jones, Chair of CalPERS’ Investment Committee, it is clear why sustainability matters: ‘Our institution needs to be sustainable in order to deliver the commitments on pension and health benefits we have made to our beneficiaries. This means our investment returns need to be sustainable. This in turn means the companies we invest in need to operate in a sustainable way. And this means the economy, the environment and the society on which they depend must be sustainable too.’
The focus here is squarely on sustainable development: the report addresses the purpose of the financial system, not just tools such as ESG integration or responsible investment. The report shares the emerging view – expressed in the investment beliefs of asset owners such as PFZW in the Netherlands and Australia’s Local Government Super – that long-tem financial returns and sustainable development are mutually dependent.
From ‘what’ to ‘how’ – the need for policy action
Numerous studies have highlighted key priorities such as lengthening investor time horizons to embrace sustainability megatrends, and aligning incentives for all parties along the investment chain.The Inquiry’s report spotlights not just what needs to change, but how the change can be achieved. Voluntary action and enlightened self-interest by investors will not be sufficient to achieve systemic sustainability goals. Proactive policy intervention is needed both in the real economy and within the financial system. Previous interventions have focused principally on disclosure of policies and formal statements of legal duties. They have largely taken fundamental features of the design and operation of the financial system as given. The need now is for a more systemic and dynamic approach – an approach that builds institutional investment frameworks, investment institutions and an investment culture with sustainability at their core.
It’s also important to recognize that interventions focusing on sustainability and investment intersect with other pressing policy objectives. These include long-termism, post-crisis economic recovery, securing retirement incomes for ageing populations, meeting energy, water and food needs, and public trust in the financial system. The potential for ‘multiple wins’ is huge – notably in five key areas: the design of pension systems; investors’ legal duties; asset owner governance; new ‘smart’ forms of investor disclosure; and action to mobilise direct investment in green assets.
Designing a sustainable pension system
It’s a commonplace that defined benefit pensions are giving way to defined contribution systems in most countries. The pace varies, but the trend is clear. Yet there has been little discussion of the implications of these changes for sustainability. DC structures that allow
high levels of member flexibility to switch providers, or which do not protect savers’ interests by clearly imposing fiduciary duties on pension providers, may encourage short-term investment decisions that undermine sustainability goals. Sustainability needs to be a design feature of pension systems alongside adequate retirement incomes and affordability for employers.
Clarifying legal duties
Investors’ legal duties clearly need to be aligned with sustainability. South Africa’s Regulation 28 spells out the obligation on pension trustees to consider all factors that ‘may materially affect sustainable long-term performance’ – including ESG. The UK Law Commission recently provided similar clarification. However, even in these countries doubts are still often voiced about whether it is permissible to take ESG into account. In other markets legal advisors and consultants frequently argue that trustees simply cannot look at (supposedly) ‘non-financial’ issues such as climate change or human rights. Yet as Henry Jones puts it, ‘At CalPERS we have no doubt that our focus on sustainability is entirely consistent with our fiduciary duty – indeed it is an essential part of it. Where doubts on this score remain, they must be dispelled’. Every country should clarify that fiduciary duty and prudent investment require that all potentially material issues, including ESG, be considered. Coordinated action by governments to establish an international level playing field here would be extremely helpful.
Strengthening asset owner governance
However, experience and the Inquiry’s own work show that just clarifying the law is not enough. A fund’s available ‘governance budget’ – comprising time, expertise and decision-making capacity – can stand in the way of fully embedding sustainability in its investments. Strengthening asset owner governance is a crucial prerequisite forsustainability. Well governed asset owners, with strong capabilities and an understanding of the implications of sustainable development for their core mission and purpose, are well placed to develop investment beliefs and strategies aligned with sustainability. They will generate demand for services from other parties in the investment chain that reflect sustainability. They will also be able to exercise more effective stewardship over companies and markets.
Prudential regulators have an important part to play here. Regulators in countries including Australia, Denmark, the Netherlands, South Africa and the UK are already focused on improving pension governance. The Dutch Central Bank is using its mandate of promoting ‘sustainable prosperity’ as a platform for exploring pension funds’ responsible investment activities. Regulators could encourage or require sustainability knowledge and competence on the part of board members (e.g. including sustainability in definitions of a ‘fit and proper’ person). At the same time, care is needed to ensure that the benefits of board diversity, including member representation, are not lost. Regulators can also consider whether some funds are too small and weakly governed to serve their beneficiaries effectively or to incorporate sustainability into their investments, and whether consolidation is warranted.
Investor disclosure is another area where more ambitious approaches are needed – and are starting to emerge. ‘First generation’ approaches required investors to disclose policies on ESG – often on a comply or explain basis. ‘Smart disclosure’ now needs to focus on real investment behaviour and outcomes – for example carbon and other sustainability risk in portfolios, investment beliefs, investment strategies and portfolio management (e.g. turnover). France has already introduced mandatory
carbon footprint reporting, and the proposed EU Shareholder Rights Directive could require disclosure on company engagement, voting, the use of company long-term performance information, and portfolio turnover.
Mobilising green capital
Our final example here is policy action to mobilise investment in green assets. Investors argue that risk-based funding and solvency rules introduced in the wake of the financial crisis impede the long-term investments in asset classes such as infrastructure that are needed for the green economy (by giving them high risk weightings). These rules should be revised to ensure that they do not unintentionally obstruct green investment. There is a wide range of other action that can be taken. Numerous risk mitigation tools is now available, waiting to be deployed at scale. The green bond market should be accelerated by including green assets within covered bond regulations, and building investor confidence by supporting the development of standards on eligible project categories and transparency on the use of bond proceeds. Public agencies should issue and buy green bonds. In the run-up to COP21 we have seen a flurry of commitments to invest in green assets – more are needed. Governments should give sovereign wealth funds green investment mandates, and work with institutional investors to develop investment vehicles that meet their risk-return needs.Agenda for the years ahead
In October, the UNEP Inquiry will publish its global report, identifying policy options to build a more sustainable financial system. Institutional investors sit at the heart of the change process – responding to the expectations of the world’s savers, deploying capital for long-term development, governing corporations and stimulating innovation on global capital markets. What the Inquiry has found is a ‘quiet revolution’ in the ways in which the stewards of the financial system – finance ministries, central banks and financial regulators – are reinterpreting their mandates in light of the need to accelerate the transition to sustainable development. It seems we are just at the start of a new phase in the evolution of responsible investment – this time driven by a new dynamic between investor practice and policy frameworks.
Rob Lake is the author of the UNEP Inquiry working paper Financial Reform, Institutional Investors and Sustainable Development.
Nick Robins is Co-Director of the UNEP Inquiry into the Design of a Sustainable Financial System.
About The UNEP Inquiry
The Inquiry into the Design of a Sustainable Financial System has been initiated by the United Nations Environment Programme to advance policy options to improve the financial system’s effectiveness in mobilizing capital towards a green and inclusive economy—in other words, sustainable development. Established in January 2014, it will publish its final report in October 2015.
Link to UNEP Inquiry