The latest report from the UN’s Intergovernmental Panel on Climate Change, published in April 2022, made clear that the window for preventing the worst of climate change is closing fast. Plans already in place are not enough to limit global warming to 1.5C above pre-industrial levels, said the report, and more must be done to accelerate the energy transition.
These efforts will require huge levels of capital. The UN has estimated that $90trn in infrastructure investment alone is needed by 2030 to build a sustainable global economy. An important pool of funding for these efforts will be the world’s pension pot.
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OECD data from 2020 tallied the value of assets held by pension funds globally at $35trn, although other estimates put that total at more than $56trn.
Quickly moving this capital away from fossil fuel assets and towards sustainable investments would give a major boost to climate action, yet moving quickly is not something the pension market is renowned for.
Given their long investment horizons and risk aversion, pension funds may be naturally slow movers, but they are also particularly exposed to climate risks and are increasingly responding to the climate emergency with a greater focus on environmental, social and governance (ESG) issues.
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By GlobalDataResearch published in Ecological Economics in January 2022 shows that 129 of the 1,000 largest European pension funds have divested from fossil fuels, representing $2.6trn in assets under management.
A lingering challenge for pension holders and the wider public is that it is not always clear what pension funds are invested in, which is why transparency is also becoming an increasingly important focus for this market.
Pension funds moving (slowly) on ESG
Canada-based data service CEM Benchmarking and news site Top1000funds.com launched the Global Pension Transparency Benchmark in 2021. This research assessed public disclosures of the five biggest pension funds in the 15 countries with the most active private pension markets. It scored the disclosures for both volume and quality across four factors: governance and organisation; performance; costs; and responsible investing.
Michael Reid, a vice-president at CEM, says that the biggest increase in disclosures seen from 2020 to 2021 was information relating to responsible investment, and that funds were now producing many more stand-alone sustainability reports and providing more quantification on ESG strategies.
“Funds are moving beyond just talking about responsible investment and are now putting some metrics around it,” says Reid. “They are moving beyond just greenwashing.”
Jesal Mistry, a senior investment director for defined contribution pensions at Legal & General Investment Management (LGIM), agrees that attitudes within the market have evolved. “The historic view has been that ESG investing means lower returns, but that is changing, and it is getting easier to balance those requirements with fiduciary duties,” he says.
Mistry adds that not only are returns from ESG investment not necessarily lower, but a growing body of evidence suggests that this approach protects against long-term risks such as stranded assets.
Pressure is being applied on pension funds from various angles to prioritise environmental concerns. Governments are increasing regulation around ESG requirements, climate action groups monitor and publicise the activities of investors in fossil fuel assets, and pension holders increasingly want greater oversight of where their pensions are invested.
Regional differences in transparency
The Global Pension Transparency Benchmark found that the major Scandinavian and Canadian pension funds were the best at making public disclosures around responsible investing. The research also found that good practice by one fund in a certain jurisdiction encouraged others to follow suit.
“The funds that increased their scores the most were ones in high-scoring countries such as the Netherlands and Sweden, which had not scored quite as well the previous year,” says Reid. “It really seems like there is peer pressure to disclose more in those countries.”
There is a patchwork of regulation covering responsible investments for pension funds. Globally, there is the Task Force on Climate-Related Financial Disclosures (TCFD), created by the Financial Stability Board to try and develop consistent climate-related financial risk disclosures. Many jurisdictions have their own regulations that complicate compliance, given the international profile of large pension fund investment portfolios.
“I don’t think any market has found that silver bullet,” says Mistry. “In the UK we are a little bit behind in terms of how we present information and how we engage with the end investor.”
Mistry highlights the Australian superannuation funds as leading the market for engagement with individuals. He says the key is balance between openness and not “disclosing too much detailed and technical information that an individual is going to gloss over”.
While Australia introduced compulsory contributions to its superannuation funds in the 1980s, auto-enrolment was only introduced in the UK in 2012. The younger UK market is more fragmented with lots of smaller funds that lack the scale of major pension funds in countries such as Australia and Canada.
Larger funds are more likely to invest directly as they have the scale to employ dedicated investment professionals and to write large-ticket investments. Smaller pension funds will invest through asset managers using a variety of arrangements that provide them different levels of influence and oversight over how their capital is invested.
Michael Jones, a pensions partner at law firm Eversheds Sutherland, believes consolidation of the UK’s defined contribution market could help pension funds meet ESG targets. “Consolidation is really important because schemes need to get to a scale as quickly as possible to be able to gain enough market bargaining power and to be able to invest directly and change their own agenda directly,” he says.
How pressure is applied for greater transparency
LGIM has surveyed its members over several years on ESG issues and Mistry says that the results show they want their fund manager to prioritise environmental and social investments.
“A significant number of people have said that they would divest from certain companies, even if it had a financial impact on them, because of responsible investing,” he adds.
As an asset manager for pension schemes, LGIM is in the middle of a process of pressure exerted from several sides to achieve greater transparency. The schemes are under pressure from government regulation and pension holders, while LGIM is pressuring the owners of the invested assets to meet ESG standards.
Mistry explains that LGIM believes in “engagement over exclusion”, wanting to have a seat at the table of large companies and trying to make them change through active management. They do exclude for a lot of their strategies, however, particularly in defined contributions in areas such as controversial weapons manufacturers or perennial violators of the UN Global Compact.
“We score all of the companies that we invest in on ESG, and that is publicly available information,” says Mistry. “That allows companies to see where their strengths and weaknesses are relative to other companies in their peer group.”
LGIM tilts towards companies that score better while naming and shaming those that score badly, as evidenced in its regular active ownership reports. LGIM has supported, for example, shareholder resolutions at oil majors BP and Shell that have demanded greater commitments to net zero.
“Even when we exclude, we will continue to engage… Occidental Petroleum didn’t recognise its ESG risks, so we excluded it before going through an engagement programme with the company. It has subsequently added ESG targets and strengthened its corporate governance.”
This type of active management can have significant impacts on companies’ behaviour, but refusing to exclude can generate accusations of greenwashing.
“I would say exclusion is still the dominant theme [mentioned in public disclosures] but more and more seem to be talking about engagement,” says Reid. “Some probably do want to legitimately influence these companies, but it is also a way to justify continuing holdings in various areas.”
Mistry says a continuing challenge is having access to reliable and comparable data and a lack of standardisation across the market.
“It is taking longer than I think we would like,” he adds. “We are relying on data being available from companies. We need to provide that information to clients, but also need to receive it, to be able to harvest it from companies and understand it.”
Are regulations helping or hindering transparency?
Another challenge is the burden being placed on pension funds to adhere to new regulations. “Regulations have increased massively, particularly on trustees of defined contribution pension schemes, in terms of disclosure and transparency,” says Mistry.
A drive for greater transparency in the UK is linked to the government’s desire for consolidation.
“By adding more regulation, smaller schemes with smaller budgets or governance bandwidth to deal with it all are either having to spend lots more money and rely on their sponsor to support that, or consolidate,” says Mistry.
The UK’s Financial Reporting Council introduced the Stewardship Code in 2010, which attempted to set standards for those investing money on behalf of UK savers and pensioners. In 2020, it was reformed and expanded to include new asset classes.
Investors have to apply to become signatories of the code and only qualify if they can demonstrate responsible allocation, management and oversight of their capital. In March 2022, 74 new signatories successfully signed up to the code, increasing the combined assets covered by the code to £33trn.
The UK government is consulting on how to make trustees more accountable for their stewardship and considering requiring trustees to review asset managers’ specific voting policies.
It is also seeking to find some way of allowing trustees to influence managers when they don’t have a direct relationship and ultimately are just a notional asset unit holder of a pooled fund. It is hoped that this will encourage trustees to set out their expectations to managers on stewardship priorities.
Jones of Eversheds Sutherland says regulation in the UK has led to “a significant extra governance burden for trustees, almost irrespective of the size of the scheme and irrespective of the benefit structure”.
He adds that besides TCFD, trustees have new or incoming reporting requirements relating to statement of investment principles, voting, net investment return and illiquid assets.
“If you don’t have the infrastructure to be implementing the policy intention, then what is the point of disclosing for disclosure’s sake?” Jones asks.
“My slight concern is that, while what is happening in principle is good, you don’t want too much budget resource to go into investment at the expense of actually running the pension scheme day to day.”
Keeping up the pressure
It is hoped that technology as well as environmental concerns could also be a catalyst for transparency in the pensions market.
Mistry highlights LGIM’s app that allow members to review what they are invested in and says it “clearly drives engagement”. “You are actually getting people to look at their pension funds, which has been a long-term challenge for which billions has been spent trying to solve,” he adds. “[ESG] could be the way we do that.”
Jones says he sees a desire for greater transparency in new ways within the market. “The social element of ESG is becoming even more prevalent… far more questions are being asked on the nature-related implications and the general environmental issues that go with climate change, as opposed to looking at climate as a sort of isolated silo,” he explains.
“I think a lot of schemes are getting to the point where if something looks like it is a non-financial factor but maybe financial in the future, then they are viewing that as something they can base investments on.”
While he acknowledges that change has not been as rapid as some climate activists would want, Jones argues that the market is getting there “as quickly as possible given the way the law stands at the moment”.
Reid, however, is more cautious about whether the trend toward transparency is permanent. “There is a lot of economic turmoil everywhere and we don’t know how that will play out over the next few years in terms of investments,” he says. “Will funds continue to focus on ESG as much? It is going to take a few more years to be able to conclude.”
Pressure from government regulation and pension holders, and concerns over potential stranded assets are all pushing pension funds toward greater transparency and an active role in the climate emergency. That pressure needs to continue to be applied, without impacting the fiduciary duties of pension schemes, if these changes are to be sustained.
