Pension schemes must take ESG factors into account

There are significant changes afoot in how UK pension funds address environmental, social and governance (ESG) issues

Imminent changes mean people’s pensions should soon be invested in ways that reflect the risks to investments from things like climate change, but also the opportunities in areas such as electric vehicles. The driving force was a statement from the Law Commission last year that said the law requires pension schemes to consider “all financially material factors”. Such as what? Well, we already know the probable financial impact of climate change is huge. If we are to keep climate change to well below 2C then we can only burn a third of the oil owned by oil companies, so two thirds of their oil must stay in the ground.

That is clearly material to pension schemes invested in oil. More widely, the governor of the Bank of England has said that perhaps a third of the value of global shares and bonds is exposed to changes in the use of oil and other hydrocarbons that are essential. When you consider other issues – the need to use less plastic, not to deplete non-renewable resources, to treat stakeholders in all countries well and not just those in the West – the scale of value at risk from the range of ESG issues is huge.

Pension schemes must start taking ESG factors into greater consideration

In response to the Law Commission, the government has proposed far-reaching changes in pension schemes investment. From October 2019, trust-based pension schemes will need to say how they take account of financially material ESG considerations including climate change; outline their policy on engaging with the companies in which they are invested, typically through their fund managers; and from 2020 report on how they have done this.

For the fast-growing contract-based pensions market, the Financial Conduct Authority will consult on similar measures. These are significant changes and they should change pension investment for the better; by October 2019, more than 4,500 trust-based schemes will need to have announced their new policies.

The good news is that the UK is a world leader in ESG fund management, and pension schemes can access a wide range of approaches to managing ESG risks and opportunities. Some of these grade companies on their impact and deliberately exclude the worst, so those managers will not invest in companies that pollute or contribute heavily to carbon emission or are bad employers. Others identify areas that will benefit from the necessary changes, so they might invest client money in energy efficiency or water-saving technology.

Pension scheme members given a voice over investments

And increasingly, managers are integrating consideration of ESG factors into all aspects of their decision-making and apply this to every company no matter what its business. Pension schemes will need to look at their fund managers and identify those who “get it”. They will fund many excellent firms and they must fire those that come up short.

Another area is also developing. The Law Commission said the law allowed pension schemes to consider non-financial factors, perhaps ethical matters, as long as there was no risk of significant detriment to the scheme and the members shared the concern.

The government now plans to make pensions schemes publicly outline how they will consider members’ views. This could take us into new territory because the issues may well prove to be contentious; what if there is a vocal minority on an issue? But the direction of travel is welcome. As a nation, we need to save more in pensions, and people will probably be happier doing that in schemes that consider and manage ESG risks and opportunities and which are open to considering members’ views.