Why is sustainability important?
As a society, striking a balance between social responsibility, environmental protection and economic viability, is critical for sustaining our lifestyle. Sustainability means that we must be able to meet the needs of today, without comprising the needs of tomorrow.
Historically, sustainability used to be a local matter. The old solution was to build higher chimneys, but that approach does not work anymore. Climate change is a global problem affecting everyone. As an investor, it makes financial sense to invest in companies that strike a balance between people, planet and profit. Well managed companies meeting these criteria have a long-term sustainable business model and well positioned for the inevitable transition to a more sustainable society. Sustainable investments in green bonds help finance infrastructure project speeding up the transition to a more sustainable society.
At the end of the day, we only have one planet so we must take care of it for generations to come.
What is E?
E stands for ‘Environmental’ and relates to any strategy that evaluates the impact an investment opportunity will have on the environment. This analysis can include a wide variety of environmental factors, such as:
- the contribution a company or government makes to climate change through;
- greenhouse gas emissions;
- waste management;
- energy efficiency;
- environmental hazards in the air, water and soil.
Overall, an investment opportunity scores well on these factors if the underlying company, government or security integrates environmental considerations into their strategy and policies.
What is S?
S stands for ‘Social’ and relates to any strategy that evaluates the impact an investment opportunity will have on society and the people within it.
Societal considerations are wide ranging and include factors such as:
- Human rights
- Labour standards in the supply chain
- Any exposure to child or forced labour
- Diversity and inclusion policies
- Workplace health and safety
- Integration with local communities
Overall, an investment opportunity scores well on social issues if the underlying company, government or security considers the impact they have on all local stakeholders and the welfare of society as a whole.
What is G?
G stands for ‘Governance’ and is predominantly focussed on corporate governance, although can equally apply to the governance structure within public entities as well. This relates to any strategy that evaluates an investment opportunity in relation to the basic principles, rights, responsibilities and expectations of an organisation’s board of directors.
A well-structured governance system aligns the interests of all stakeholders, supports the company’s/public entity’s long-term strategy and aims to improve risk management, remuneration policies, shareholders’ rights and transparency.
History of ESG
50s – 60s For the first time pension funds invest in social opportunities like affordable housing projects and health care facilities.
1971 General Motors introduces a Code of Conduct, the Sullivan Principles, for practising business with South Africa given the apartheid regime leading to large disinvestments in South Africa.
1988 J.S. Coleman writes the article “Social Capital in the Creation of Human Capital”. He challenges a part of the Friedman Doctrine. Coleman argues that social responsibility does not necessarily have a negative impact on a business’s bottom line.
1998 John Elkington introduces the Triple Bottom Line (TBL), an accounting framework where besides financial factors, environmental and social factors should be taken into account.
1999 Kofi Annan announces the UN Global Compact, a non-binding pact with 10 principles around human rights, labour, environment and anti-corruption intended for corporates. The UN Global Compact helps found the UN PRIs. (Launched in 2000)
1999 The Dow Jones Sustainability Index is launched.
2000 The Millennium Development Goals (MDGs) are introduced containing 8 goals for the year 2015 (effective per 2005) which are established during the UN Millennium Summit.
2005 The term ESG is used for the first time in an article called ‘Who Cares Wins’.
2006 The UN Principles of Responsible Investing (PRI) are established. 6 principles to integrate ESG within the investment making process. The term ESG becomes widely adopted.
2008 The first Green Bond is issued by the World Bank.
2010 The UK Stewardship Code is launched by the Financial Reporting Council (FRC). Institutional investors should engage with investee companies taking the best interest of beneficiaries into account based on 7 principles.
2011 Based on the ‘Fortune 100 Best Companies to Work for’ lists by Moskowitz (started in 1998), Alex Edmans shows an outperformance of the 100 best companies to work for compared to peers and thereby challenges the assumption that investing based on ESG factors reduces returns.
2015 The UN Sustainable Development Goals (SDGs) are established (effective per 2016).
2015 The Paris agreement becomes effective.
2015 The Task Force on Climate-Related Financial Disclosures (TCFD) is founded. UN PRI signatories can choose to comply with the TCFD recommendations related to climate-related financial disclosure.
2016 The Paris Agreement becomes effective.
2017 First recommendation by TCFD
2019 The Dutch Stewardship Code based on 11 principles becomes effective
What are the requirements for my SIP?
As of 1 October 2019, DC trustees are required to publish their SIPs on a publicly available, free to access website. Similar rules come into effect for DB Trustees as of 1 October 2020.
As of 1 October 2019, the required content in a Scheme’s SIP expanded considerably. This expansion was to include all relevant aspects of the Occupational Pension Schemes (Investment and Disclosure) 2019 Regulations.
Trustees for both DC and DB Schemes are now required to include the following information in their SIP:
- Provide additional information in their stewardship policy, for example, how they monitor the investee company on capital structure and how they manage actual and potential conflicts of interest in relation to their engagement.
- Set out their policy in relation to their arrangements with their asset managers. This policy must set out the following matters, or explain the reasons as to why the following matters are not set out:
- How the arrangement with the asset manager incentivises the asset manager to align its investment strategy and decisions with the trustees’ investment policies.
- How that arrangement incentivises the asset manager to make decisions based on assessments about medium to long-term financial and non-financial performance of an issuer of debt or equity and to engage with issuers of debt or equity in order to improve their performance in the medium to long-term.
- How the method (and time horizon) of the evaluation of the asset manager’s performance and the remuneration for asset management services are in line with the trustees’ investment policies.
- How the trustees monitor “portfolio turnover costs” incurred by the asset manager, and how they define and monitor targeted portfolio turnover or turnover range.
What can I expect regarding upcoming regulations?
Overall, the main thing to expect from upcoming regulations is increased accountability and the need to evidence how Trustees are integrating good principles and practices into their investment strategy. The Pensions Regulator in the UK has made extensive changes to the reporting and disclosure requirements for pension schemes, with the aim of improving transparency and engagement between all stakeholders.
From 1 October 2020, DC Trustees are required to produce and publish an annual implementation statement, detailing how they acted on the principles set out in their SIP during the accounting year. Similar regulations will apply to DB Trustees from 1 October 2020, however, the contents of a DB Scheme’s implementation statement will be more specific, focussing on:
- how and the extent to which they have followed their engagement and stewardship policies;
- describing the voting behaviour by and on behalf of the Trustees, including the most significant votes cast by Trustees or on their behalf.
ESG and investing
What is responsible investing?
Responsible investing is an approach that considers material Environmental, Social and Governance factors. However, it stops short of insisting that the investment creates long-term value for the economy, society and the environment. In other words, whilst the Responsible Investor is aware of ESG factors, he/she does not measure the real-world impact of the investment over the long-term. An investment that has negative real-world impacts, such as pollution, might still be considered “responsible” if the investor believes that the price fully reflects the pollutive impact of the investment and it is still thought to provide a good financial return.
What is social responsible investing (SRI)?
An investment strategy in which investments are made based on certain moral values while generating long-term financial returns. With SRI an investor is not allocating funds to certain activities, like tobacco, fossil fuel, etc.
SRI can be considered as a subset of responsible investing whereby investments are made based on certain moral values.
What is Sustainable Investing?
Sustainable Investing aims to create long-term value for clients and beneficiaries leading to sustainable benefits for the economy, the environment and society. Sustainable Investing goes a step beyond Responsible Investing in that it aims to avoid doing harm (ideally doing good). Sustainable businesses ought to offer better risk adjusted returns as they attempt to avoid or mitigate negative real-world impacts, or they actively seek to enhance positive real-world impact. The impacts are considered through the lens of the ESG factors. Sustainable Investing aims to favour businesses that show these behaviours and aims to measure and assess the extent of the impact of the investments in terms of real-world consequences, not only financial risk/reward.
What is Impact Investing?
Impact Investing is an approach to investing where there is a clear and intentional focus on creating specific positive real-world impact (e.g. providing clean water). This may at times come with a normal commercially attractive risk adjusted return, but sometimes Impact Investing is more about the impact than the financial risk reward. Ie, financial reward may be sacrificed because impact becomes the primary driver.
What makes an investment green?
When the investment activities of an investment involves activities which are aimed to improve or preserve the environment. This can range from investing in companies which are developing alternative (green) energy technology to companies which have best environmental practices.
What is a green bond?
A green bond is a bonds of which the proceeds are used to finance projects which aim to preserve or improve the environment.
What is greenwashing?
Greenwashing refers, in the context of investment, to the practices of making an investment appear more sustainable than is actually true. For example, by making investors believe that a company is putting more effort in improving its sustainability than is actually the case. When it comes to light a company is greenwashing its activities, this could impose serious reputational damage.
What is engagement?
Engagement is the practice of actively considering a concept or idea (typically concerning environmental or social matters), and then implementing changes as a result of those discussions. For example, when considering a pension scheme’s investment strategy, Trustees will typically establish an ‘engagement policy’ to confirm how they will exert influence onto the underlying assets and asset owners. This framework enables clear decision making, accountability and a repeatable process that can be progressively improved through clear reporting and feedback.
What are the best practices?
Here are many ways for asset managers and asset owners to integrate sustainability into their investment process. The most commonly used tools are:
Portfolio construction: Only invest in companies which contribute to your sustainability goals. Integrating sustainability in the portfolio construction process can be done in multiple ways, one of which is to use sustainability criteria in determining the investable universe. By considering sustainability in the portfolio construction process, you allow sustainability to be the backbone of your investment portfolio.
Engagement: Engagement refers to interactions between the investor and current or potential investees (which can be companies, governments, municipalities, etc.) on ESG issues. Engagements are undertaken to influence ESG practices and/or improve ESG disclosure. (Find out more here)
Asset managers or asset owners can engage individually with one or multiple engagement topics, but they can also join forces with others and participate in engagement initiatives such as Climate Action 100+.
Climate Action 100+: is an investors initiative which is founded to ensure the world largest greenhouse gas emitters take necessary action on climate change. Signees of the climate action 100+ engage with the 100 systemically important emitters on reducing emissions, improve governance and strengthen climate-related financial disclosures.
Disinvestment: A more aggressive approach to sustainable investment is excluding certain investments which do not meet the investors sustainability criteria. For example, excluding tobacco companies from your investment portfolio.
What are my options in regards to my scheme?
For a pension scheme, implementing responsible investing based on the ESG factors and fulfilling the stewardship obligations is the art of what is possible. A large scheme with an internal team including several ESG specialists has another starting point than a smaller scheme without an internal team.
What is common for all schemes is that trustees set the direction in the Statement of Investment Principles (SIP) and they are responsible for following up that it is implemented across all aspects of their investment portfolio.
Eight tips for trustees:
- Undertake regular training on responsible investing and climate change in order to stay up to date with industry best practice and new regulation.
- Ensure that you understand how the ESG factors are incorporated in your portfolio.
- Make an inventory of the current and potential future legislation covering the ESG factors and Climate Change.
- Measure the ESG activity in the current portfolio and identify potential gaps with respect to upcoming and future legislation.
- Make an action plan, together with your providers, and set targets for closing potential gaps.
- Establish a reporting process, including regular meetings, on ESG factors and Climate Change with your providers so that you have the full picture across all your investments.
- Discuss how you can go beyond the current legislation, one example could be targeting a net zero carbon emission by 2050 and making an action plan for achieving this.
- Include the most dominant ESG related financial risks, such as Climate Change, in your IRM (Integrated Risk Management) analysis and when preparing your recovery plan.
Trustees of a scheme using a fiduciary manager should engage with their provider to make sure that the ESG factors and climate change are implemented in accordance with the SIP. It is the fiduciary manager job to make sure that the SIP is reflected in all Investment Management Agreements (IMA) with asset managers, monitor that the asset managers follow the IMA and consolidate the reporting across all investments and asset managers.
How to measure ESG in portfolios
There are roughly two ways of measuring the sustainability within an investment portfolio:
This requires a good and thorough research and understanding of the activities of the investees. Quality sustainability assessments are performed by (sustainable) investment analysists and are commonly presented in the form of and sustainability report. Oftentimes, these qualitative assessments form the basis for the development of quantitative sustainability measures.
When investors have a large investment portfolio it is not possible to assess all investment individually, then one could use quantitative sustainability measures in the form of sustainability scores. Most of these sustainability scores are a combination of quantitative (greenhouse gas emissions) and qualitative (greenhouse gas reducing policy) information.
Global ESG agreements
When pension schemes look to work with service providers or invest into managers, they should consider whether the ESG objectives held by the third party are aligned with their own. Third parties will publicly sign principles that they agree with and work to uphold. Trustees can compare which service providers/managers have signed these principles and decide who best fits their objectives.
UN Global Compact
The UN Global Compact was announced by UN Secretary-General Kofi Annan at the World Economic Forum on 31 January 1999 and was officially launched on 26 July 2000. The Global Compact is the largest corporate sustainability initiative with 12,000+ signatories from 160 countries. The Global Compact has 2 main objectives:
1) Stimulate actions regarding other UN initiatives like the MDGs (Millennium Development Goals) and SDGs (Sustainable Development Goals).
2) To serve as a non-binding pact containing 10 principles related to human rights, labour, environment and anti-corruption.
There principles are split into Human rights, Labour, Environment and Anti-corruption.
Principle 1: Businesses should support and respect the protection of internationally proclaimed human rights;
Principle 2: Make sure that they are not complicit in human rights abuses.
Principle 3: Businesses should uphold the freedom of association and the effective recognition of the right to collective bargaining;
Principle 4: the elimination of all forms of forced and compulsory labour;
Principle 5: the effective abolition of child labour;
Principle 6: the elimination of discrimination in respect of employment and occupation.
Principle 7: businesses should support a precautionary approach to environmental challenges;
Principle 8: undertake initiatives to promote greater environmental responsibility;
Principle 9: encourage the development and diffusion of environmentally friendly technologies.
Principle 10: Businesses should work against corruption in all its forms, including extortion and bribery.
UN Principles of Responsible Investing (PRI)
The Principles were launched in April 2006 at the NYSE. The PRI can be considered as an international network of investors (signatories) which all take 6 principles into account, providing a framework for considering ESG issues within their investment choices. Worldwide 3,000+ asset owners, investment managers and service providers have signed up to the PRI as signatory.
- Principle 1: We will incorporate ESG issues into investment analysis and decision-making processes.
- Principle 2: We will be active owners and incorporate ESG issues into our ownership policies and practices.
- Principle 3: We will seek appropriate disclosure on ESG issues by the entities in which we invest.
- Principle 4: We will promote acceptance and implementation of the Principles within the investment industry.
- Principle 5: We will work together to enhance our effectiveness in implementing the Principles.
- Principle 6: We will each report on our activities and progress towards implementing the Principles.
UN Sustainable Development Goals (SDGs)
The SDGs were created by the UN in 2015. They serve as the global sustainability agenda for the period 2016 – 2020 and replace the Millennium Development Goals (MDGs) (2005 – 2015). All UN member states have adopted the 17 SDGs.
- Zero poverty
- Zero hunger
- Good health and well-being
- Quality education
- Gender equality
- Clean water and sanitation
- Affordable and clean energy
- Decent work and economic growth (in a sustainable manner)
- Industry, innovation and infrastructure (in a sustainable manner)
- Reduce inequalities
- Sustainable cities and communities
- Responsible consumption and production
- Climate action
- Life below water (sustainable use of water and water life)
- Life on land (sustainable use of land and land life)
- Peace, justice and strong institutions
- Partnerships for the goals
Task Force on Climate-Related Financial Disclosures (TCFD)
The TCFD was established in December of 2015. On a voluntary basis UN PRI signatories can choose to comply with the TCFD recommendations related to climate-related financial disclosure. In 2017 the TCFD made its first recommendations regarding disclosure. 4 core elements regarding disclosure are specified:
- Governance around climate-related risks and opportunities.
- Strategy around actual and potential impact of climate-related risks and opportunities on organization, business, strategy and financial planning.
- Risk Management around processes used to identify, assess and manage climate-related risks.
- Metrics and targets used to assess and manage relevant climate-related risks and opportunities.
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