Making the responsible choice (Sponsored)

Responsible investing is growing in popularity as people become more conscious of the environmental and social consequences of investment choices.

Responsible investing is now common within large institutional investors including pensions schemes, but what does responsible investment entail and what impact can it have on future returns?

A number of factors are combining to drive the trend towards responsible investment strategies for pension funds. These include regulatory and legislative requirements, member expectations and the evolving agendas of scheme sponsors. But, as Aon investment consultant Darren Touhy explains, responsible investment can still mean different things to different people.

“There is a lot happening in the space and it’s certainly gaining quite a bit of traction around the world, but defining it can still present a challenge,” he points out. “There are different flavours and responsible investing can mean different things to different investors.”

He says the UN Principles for Responsible Investment offer a useful working definition. It states that responsible investment “is an approach to investing that aims to incorporate environmental, social and governance (ESG) factors into investment decisions, to better manage risk and generate sustainable, long-term returns.”

The impact of such an approach could be to introduce a negative selection process to funds. “A manager could exclude high carbon emissions industries, prison operators, weapons manufacturers and so on,” says Tuohy. “There are a range of selection processes out there and different managers have different approaches.”

Investors are accessing responsible investment in a number of different ways. The first is ESG integration, which can involve a positive or negative selection process. This approach integrates environmental, social and governance criteria into fundamental investment analysis to the extent that they are material to investment performance. This can mean shorting or not investing in a company with governance issues such as bribery, tax evasion or investing in companies with good ESG fundamentals to reduce risk or enhance returns.

Impact investing has a positive selection process. Investments such as alternative energy and micro-funding that have a positive investment return as well as a desired social, economic or environmental outcome are selected.

Mission-related investing also has a positive selection process. It places investments with companies or funds that complement the investor’s mission. These can be in healthcare, senior issues or child issues.

Socially responsible investing attempts to screen out investments in stocks, companies or industries based on a set of ethical values. Areas and activities excluded could include pornography, private prisons, carbon, coal, Iran, Sudan, fossil fuels, nuclear energy and so on.

“You can screen investments or exclude some completely,” Tuohy adds. “ESG can have a positive or a negative selection process when integrated into an investment policy. Managers conducting an index will rate companies and assets on a variety of factors. Environmental could be carbon footprint, climate change risk and so on. Social could be health and safety, HR policies. Governance could by bribery, corruption, shareholder rights, board structures and so on. They will come up with an ESG score for different assets based on these factors. Different managers have different approaches. There have been attempts to standardise it in order to compare like-with-like, but it is a challenge.”

The construction of such an index can be quite complex, he explains. Instead of simply excluding companies with a low ESG score, it may simply give a higher weighting to companies with better scores. At the other end of the spectrum, there could be complete exclusion for companies involved in arms trading, human rights abuses or who are associated with environmental destruction. “A variety of methodologies can be employed,” Tuohy adds.

Of course, the key question for many trustees and scheme members will be performance. Does responsible investment deliver superior or inferior performance? “That’s one of the concerns,” says Tuohy. “Theoretically, there are lots of arguments saying it should provide better performance, but a lot of that is forward-looking.”

The theory is that companies with high ESG scores will be more sustainable and profitable over the longer term. It holds that companies which are set up to deal with every tightening environmental regulation and increasing energy costs due to carbon taxes and other levies will naturally outperform those that are not. Similarly, companies with enlightened social policies will be less susceptible to consumer boycotts, while those with good governance will be less likely to fall prey to corrupt practices and fraud.
But that’s just theory. There are some straws in the wind that support it, however.  Tuohy points to last year’s lawsuit by New York Mayor, Bill De Blasio, against five major oil companies for their role in climate change. Although unsuccessful, the case showed an appetite by a city government to try to force companies involved in the problem to pay for its solution.

“We could be coming to a point where managers might want to exclude companies implicated in climate change in future,” he notes. “There are also lots of investment opportunities around climate change as well, with new companies coming along with new technologies to address it. New types of asset are becoming available to allow investors to transition to low-carbon investments.”

He sees a long-term trend towards increased uptake of responsible investment strategies by pension schemes. “We are moving towards a paradigm shift,” he says. He points to the Aon Responsible Investment Survey, which surveyed a diverse group of 223 institutional investors around the world in 2018, as evidence of this. The research showed that 40% of investors believe that the incorporation of non-financial ESG data results in better investments, while just 25% do not consider responsible investing as an investment criterion.

“This is being driven by a number of factors,” he adds. “In Europe, we are seeing legislation and regulation. For example, the IORPS II regulation requires trustees to consider ESG in investment strategy.”

He mentions the UK National Employment Savings Trust (NEST) in this context. This is the defined contribution workplace pension scheme set up to facilitate auto-enrolment in the UK. “NEST has incorporated responsible investment into its default fund for younger members,” he notes. “We might see something similar in a default fund for auto-enrolment in Ireland in a few years. Also, the establishment of master trusts in Ireland will be driven by IORPS II and providers will have to see how responsible investment fits into those offerings.”

Aon is playing its role in the shift to responsible investment strategies. “We are helping pension schemes implement responsible investment policies,” says Tuohy. “We have developed a six-step framework to help trustees develop and implement an appropriate policy. Aon has the solutions, but it’s for trustees to implement them. We are helping trustees ensure they have responsible investment policies that are right for their scheme members.”