Taking a responsible approach to investment (Sponsored)

With the retirement and investment market facing a period of significant change, Aon’s Betty O’Reilly assesses the shift towards impact investing and what it means for investment managers and pension fund trustees.

Responsible investment, the strategy and practice of incorporating environmental, social and governance (ESG) factors in investment decisions, has come to the fore in recent years. But it is by no means an entirely new development. “It’s been there for a long time,” says Betty O’Reilly, Senior Investment Consultant at Aon. “It started out as ethical investment many years ago. This involves the exclusion of companies that engage in the sale of tobacco, alcohol, controversial weapons and so on from investment choices.”

Climate change has brought new energy to these issues, and the conversation and approach have moved on from beliefs-based investing, of the old ethical style, to one of risk management. The EU has also put its weight behind it and has taken several steps to encourage investors and other financial markets participants, including pension funds, to act responsibly.

Of course, investment managers and pension fund trustees have a duty to seek the best returns possible for investors and members, and questions have been raised regarding the efficacy of responsible investment. “There have been a number of studies looking at the return on responsible investment funds versus the traditional approach,” says O’Reilly. “The data from those studies certainly show that the approach doesn’t do any harm. The funds are not just investing in companies doing good things in relation to climate change and other factors, but in good, well-managed companies that are carrying out their activities in a responsible way.”

According to O’Reilly, three particular pieces of European regulation are driving ESG factors to the top of the investment agenda. “The key one for pension funds is the IORP II directive,” she says. The EU adopted the second directive on the activities and supervision of Institutions for Occupational Retirement Provision (IORP II) in 2016. It introduces several new requirements for Irish occupational pension schemes covering governance and risk management, member communication requirements, and other areas.

“Ireland is the last country in the EU to convert the Directive into local regulation,” says O’Reilly. “We are now quite late, but the Pensions Authority says it will be done soon. The Directive requires pension schemes to disclose how they take ESG factors into account in their investment strategy and to consider ESG risk when making investments.”

The second regulatory requirement is the EU Shareholders Rights Directive II (SRD II), which sets out to strengthen the position of shareholders and ensure that decisions are made for the long-term stability of a company. It requires institutional investors and asset managers to be transparent about how they invest and how they engage with the investee companies. The aim is to encourage investors to adopt a more long-term focus in their investment strategies and consider social and environmental issues. The directive adopts a ‘comply or explain’ approach. If an investor decides not to comply with the rules, they need to explain why not.

“It’s already enacted and requires investing entities to state publicly how they are making their decisions regarding climate and other factors,” she adds.

Then there is the EU Sustainable Finance Disclosure Regulation, which came into force on 10 March 2021. This introduces new disclosure obligations on financial market participants and financial advisers to integrate ESG factors into their investment and risk management processes. The Disclosure Regulation is aligned with other parts of the legislative package, including the Taxonomy Regulation, which establishes an EU-wide classification system to provide businesses and investors with a common language to identify to what degree economic activities can be considered environmentally sustainable.

Draft guidelines on the Disclosure Regulation have been produced, but it is not clear how rapidly it will be implemented. “Pension schemes and investment managers are affected by this regulation. It will be supervised by the Central Bank, which will require statements on sustainability in relation to investment products and strategies. It will make sure that investors are not just paying lip service to ESG. If you’re not actually doing something, you will have to say why not.”

The regulations apply to investment firms, investment products and financial advisers as well as to pension schemes. They will have to declare reasons for investing the way they do publicly, and there can be a reputational issue if they are not seen to engage in responsible investing.

Regulation isn’t the only driver. “There is also pressure coming from pension scheme members,” she notes. “Defined contribution pension scheme members may request particular funds. Our global research shows an increased focus on responsible investing on the part of pension scheme members.” 

And ESG doesn’t begin and end with climate change. “ESG is about the environment, social and governance,” O’Reilly emphasises. “The environmental factor encompasses climate risks, biodiversity, resource scarcity, and that’s what’s exercising most people’s attention at the moment. The social dimension covers business relationships, labour practices, communities, and overall social impact. Governance factors include how boards are structured, how companies meet the needs of shareholders, business ethics and so on. Investment managers and consultants like Aon now take all of these factors into account.”

Aon prides itself on leading the way in this regard and is the first global professional services firm to sign up to the Principles for Responsible Investment network. It is a United Nations-supported international network of investors that works to implement a voluntary and aspirational set of investment principles and actions to incorporate ESG issues into investment practice. Aon is also a member of The Investment Leaders Group (ILG), a global network of pension funds, insurers and asset managers committed to advancing the practice of responsible investment.

Facilitated by the University of Cambridge Institute for Sustainability Leadership (CISL) and supported by academics at the University of Cambridge and elsewhere, the ILG holds a unique position at the intersection between academic research and cutting-edge corporate leadership.

Aon’s clients benefit from the work of the ILG. “We have developed a methodology to help clients understand responsible investing and develop their own policies in relation to it. We also advise clients on how to incorporate ESG factors into their investment strategies. For our fiduciary clients, we have incorporated ESG factors into the Aon funds. For example, the default investment strategy for participants in the Aon Ireland MasterTrust includes climate change and social responsibility factors in the equity allocation. We are also about to bring an impact investing fund to the Irish market. This takes a gold star approach to ESG investment, which aligns with the UN Sustainable Development Goals by selecting managers who invest only in companies that achieve positive, measurable social and environmental outcomes alongside competitive financial returns.”

ESG and responsible investing will continue to grow in importance, O’Reilly believes. “The climate change issue will intensify, so it’s important for pension schemes to become compliant with the new regulations. But many will rightly go further and embrace these issues more holistically in their investment decisions. We are helping clients work their way through that. Also, some studies show that the best ESG performers have outperformed the best non-ESG. There is now a range of low-cost passive ESG equity funds investors can select, for example. It has been interesting to see how impact investing has become more and more popular, and we expect this will continue to be the case.”

Betty O’Reilly is Senior Investment Consultant at Aon.