Pension funds in the UK hold significant financial clout.
Assets in UK pension funds reached around £2.1 trillion in 2017, making the UK the second largest global market in terms of pension assets. Yet as recently as last November, only 5% of the UK’s biggest corporate pension funds, which collectively oversee £479 billion in assets, had a policy on climate change.
There have been increasing calls in recent years for pension funds to wield their economic power responsibly, by incorporating environmental, social and governance principles into their investment strategy.
Around seven in ten defined contribution pension scheme members agree that it is a good idea to include responsible or ethical investments in default funds. Indeed, the amount of assets held in ethical funds has increased from £4.5 billion in 2008 to £16.7 billion in 2018. This trend has caught the attention of the UK government, which from October 2019 will require pension fund trustees to disclose the risks to their investments arising from ESG considerations.
Few people would disagree that encouraging ESG investment is a laudable aim. However, there are both conceptual and financial issues that must be addressed to ensure that ESG-based investing is a viable strategy for Britain’s pension funds.
'But there is good reason to think that ESG can hold its own financially. A meta-analysis of over 2,200 individual studies found that the vast majority showed a positive relationship between ESG and corporate financial performance.'
First, terms such as ‘ethical’, ‘responsible’ or ‘sustainable’ mean wildly different things to different people. There are strategic disagreements on whether pension funds should dump shares in ethically questionable companies (‘negative screening’) or engage with such companies to change their direction from within. Norway’s Sovereign Wealth Fund has recently taken steps to move away from oil and gas exploration and Ireland’s Sovereign Wealth Fund has moved to divest from fossil fuels.
On the other hand, the chief investment officer of Japan’s Government Pension Investment Fund has stated that he is strongly opposed to ‘negative screening’ on the grounds that “the one thing you know for sure about the people to whom you sell the shares … is that they will be much less concerned about climate change than you are.”
There is widespread confusion over how ESG should be defined. While many savers assume that funds promoting ‘responsible’ investing will shun oil and tobacco companies, this is not always the case; even if a company’s practices are not environmentally friendly, it may still qualify for investment by being well-run and satisfying the ‘governance’ criteria.
This issue is not helped by the numerous different ESG standards that abound, which can lead to wildly varying estimates of the total size of ESG assets worldwide at as much as $31 trillion or as little as $3 trillion. Indeed, there is a risk that a “baffling array of unverified, opaque and incompatible” measurement frameworks will stunt investment. When it comes to marketing, the fuzzy definition of ESG leaves room for manipulation, which highlights an urgent need for clearer data and accountability.
It is also not enough for pension funds to be virtuous; ultimately, they must deliver returns for their members. The conventional view is that ESG-based or ethical funds perform poorly in this respect. Research by Fund Expert found that someone investing £100,000 in the past decade’s top performing ethical fund would have received £302,650 less in returns over ten years than if they had invested in the top ‘unfettered’ fund. Similarly, a US study concluded that ‘sinful’ investors outperformed their ethical counterparts.
But there is good reason to think that ESG can hold its own financially. A meta-analysis of over 2,200 individual studies found that the vast majority showed a positive relationship between ESG and corporate financial performance.
The FTSE4Good index, which measures the performance of companies with strong ESG practices, has outperformed its non-ESG counterpart. The FTSE4Good US index returned 349% against the S&P 500’s 287% over ten years, while in the UK the performances of the FTSE4Good and FTSE All Share index are roughly equal, returning 43% and 42.5% over five years respectively.
There is clearly a demand from savers for more responsible investment strategies, and there are indications that ESG can achieve strong financial performance.
But with the definition of ESG still being contested, there are looming risks of misleading marketing and a perplexing landscape for investors. The time has come to set a clear policy framework to enable a strong ESG market to take shape.
