Does consideration of environmental, social and governance (ESG) factors fit with fiduciary responsibility?
This question – which has vexed pension funds, investment managers and lawyers for many years – has again raised its head. The OECD issued a report Investment governance and the integration of environmental, social and governance factors, which sets out the evolving perspective on this question. In particular, it draws a distinction between socially-responsible investing (SRI) and the consideration of ESG factors in investment decisions. The key message from the OECD is that ESG issues are now critical to the health and prospects of any company. Their consideration therefore sits squarely within an institution’s fiduciary duty. This has profound implications for firms’ investment decision-making processes.
Fiduciary standards and their application vary across different legal systems, cultures and contexts, but the common aspects are duties of care and loyalty on fiduciaries to beneficiaries, a focus on behaviour and processes rather than outcome, and flexible and adaptable interpretations of fiduciary duty. Historically, courts of law and investors have interpreted the duties of care and loyalty as requiring fiduciaries to consider only the financial interests of beneficiaries, but this is changing.
The OECD report asks whether the narrow, financial interpretation of fiduciary duty is losing influence. Perhaps it is not so much that it is losing its importance but that the definition of what is in beneficiaries’ financial interests is changing. Rather than fiduciary duty being a barrier to the integration of ESG factors in investing (still a common view among many pension funds), the changing tide of social and investor sentiment and new laws indicate that consideration of ESG factors is likely to become a must for all fiduciaries.
Climate change, for example, is increasingly seen as an important driver of portfolio risk and return. Indeed, a scientific advisory committee to the European Systemic Risk Board recently recommended that future stress tests of the pensions sector should include climate-related risks. According to the OECD, recent research suggests that the potential long-term economic cost of climate risks in particular could be high and that pension fund portfolios are especially susceptible given that the bulk of their returns are explained by market movement (beta).
Regulatory frameworks have rarely made explicit references to ESG factors, but this, too, is changing. The proposed revisions to the European Directive on Institutions for Occupational Retirement Provision (IORPD II) includes a requirement that the system of governance must include consideration of ESG factors in investment decisions. Also, it will require an IORP to have the aim of spreading risks and benefits between generations – contrary to the traditional view of fiduciary duty, which focuses on the immediate financial returns of current beneficiaries and not the likely impact on future generations.
Such obligations will require changes in other types of financial services firms. For instance, credit rating agencies are not required to analyse ESG factors, but they are increasingly doing so in order to satisfy market demand.
Investment managers, in particular, need to re-think their investment processes. Making available some strategies and fund products that are “SRI” will not be sufficient. They will need to evidence that consideration of ESG factors are embedded across their investment process. Traditional portfolio management theory is making way for the “universal ownership approach”, under which investors are viewed as holding a slice of the whole global economy and capital markets through their portfolios. They can therefore improve their long-term financial performance by acting in such a way as to encourage healthy and stable economies and markets. This model gives more weight to inter-generational concerns and the future sustainability of the economy as factors that will affect future risk-rated returns. It also brings in consideration of non-financial factors.