Pensions and ESG: the evolving legal and regulatory landscape’ - new paper from Royal London and Herbert Smith Freehills

Global law firm Herbert Smith Freehills and mutual insurer Royal London have joined forces to produce a new guide for employers, trustees, pension providers and advisers on ‘ESG investing’.

Exploring the way in which Environmental, Social and Governance issues can – and in some cases must – be taken into account by pension schemes when investing money on behalf of their members, it has been released ahead of new rules which come into force next week (1st October).

The guide also explains what pension fund trustees, pension providers and asset managers need to do and how they can factor ESG risks into their investment strategies.

Key points from the report include:

• from 1st October, pension scheme trustees will have to set out their policy on how they take account of financially material factors, including ESG considerations, in their investment decision making
• considering ESG factors is increasingly seen as relevant to optimising financial returns and effective risk-management by pension schemes and asset managers in a marked change from the past when they were regarded by many as non-financial factors
• 57% of the UK public with a pension believe that ‘…investment managers have a responsibility to ensure holdings are managed in a way that is positive for society and the environment’ suggesting that savers are increasingly interested in how their money is invested*
• there is now a growing risk of legal challenge to trustees and pension providers who fail to take account of ESG factors;  the paper cites an Australian case where a member is taking a large pension fund to court for failing to disclose information on the potential impact of climate change on his investments
• multiple research studies into the impact of ESG factors on investment performance show that there is generally no reduction in returns from ESG investing and in many cases an improved return can be achieved;  for example, studies show that companies that demonstrate strong performance on ESG have better corporate financial performance generating higher stock returns than those with weaker ESG performance.  The corporate bonds of those companies exhibit lower costs of debt and are less likely to be downgraded.

Commenting on the paper, Samantha Brown, Head of Pensions at Herbert Smith Freehills said:  “ESG is no longer an optional extra for trustees, pension providers and asset managers. New legal requirements mean that trustees have to develop and publish their policy on how they take account of material financial risks, including environmental, social and governance risks, in their investment decision making. Where ESG risks may materially impact the financial performance of a fund, the question is 'how' not 'if' they should be taken into account.

It is essential that trustees and providers are able to demonstrate that they are taking ESG factors seriously and that they don't just treat this as a tick-box exercise. There is a growing risk of legal challenge for schemes that fail to do this. Failure to act also runs the risk of causing reputational damage to the scheme and also the scheme's sponsoring employers.”

Co-author Steve Webb, Director of Policy at Royal London said: “The flow of new rules from government and regulators, both at home and abroad, is going in only one direction – trustees and asset managers are going to be expected to take much more account of ESG factors in their investment decisions in the future.  The good news is that the balance of the research suggests that this need not involve sacrificing returns and in some cases can generate enhanced performance.  Those responsible for managing other people’s money will need to ensure that they are not behind the curve when it comes to taking account of these important issues.”

* YouGov research, May 2018