Why 2020 will be the year Europe’s pension schemes engage with ESG

European pensions

Pension schemes have struggled to get to grips with environmental, social and governance (ESG) issues. However, 2020 is likely to be the year when the growing pressure from regulators to address these issues becomes an avalanche.

Regulators across Europe are demanding action. In the UK, pension fund trustees are being asked to disclose more and more information about how they approach ESG. For instance, from 1 October 2019, trustees have had to state their policies on how they exercise their voting rights, evaluate considerations like climate change, and the extent to which other material ESG risk factors are managed. The disclosure requirements step up again in October 2020.

Parallel changes are happening in France. Asset owners and managers have been asked to disclose their ESG policies and how they are addressing climate change, via Article 173 of the French Energy Transition Law.

The European Commission has also stepped up pressure on investment consultants and asset managers. MIFID II requires them to help their clients to identify their ESG preferences and incorporate them in their asset allocation.

Politicians are also taking note. For instance, the UK pensions minister has written to the 50 largest pension schemes in the country to ask how they are taking ESG factors into account.

Asset managers and consultants are rising to the challenge. They are getting much better at making the formerly esoteric subject of ESG tangible and relevant to pension schemes.

Why have pension schemes struggled to engage with ESG to date?

There is a perception problem here. ESG is a multi-faceted issue and the way the industry has talked about related issues historically has not always brought clarity. Plus, the term itself has been used interchangeably with other terminology, when SRI, sustainable investment, impact investing and ESG all mean subtly different things.

Another element of ESG’s perception problem is that some investors wrongly believe it is a moralistic movement which, if followed, will lead to poorer returns. In reality, ESG is not defined by excluding certain assets from portfolios on ethical grounds; it is instead about developing a clear and holistic picture of investment risk, and so is more likely to improve outcomes.

Pension schemes have also struggled to integrate ESG risk factors into their investment process and risk management because there is no single, straightforward way to do it. Every scheme will have a different way of interpreting ESG risk factors and a distinct set of concerns. Plus, as schemes have unique portfolios, each will have different risk factors.

Finally, behavioural biases could be hindering trustee boards. People behave differently in groups, and groupthink can reinforce the notion that it is acceptable to delay action on ESG issues. It would be very easy for a trustee board to avoid a difficult debate about their ESG beliefs and where these may differ. Present bias, or myopia, can also impede trustees from engaging with far-off-seeming risk factors like climate change.

How to engage in more meaningful change

It is vital to address the behavioural biases associated with ESG. The pensions industry frequently succumbs to the so-called “curse of knowledge”, assuming everyone understands the nuanced set of issues which make up ESG and talking in a highly technical shorthand. It’s time to drop the acronyms and speak plain English. Thankfully, the industry is already making great improvements in this regard.

Not only does regulation demand it, but consultants and asset managers have a duty to emphasise the risks associated with ignoring ESG issues.

If trustees fail to engage, they are not managing the full spectrum of risks associated with their asset portfolios. Scheme advisers can also help trustee boards to overcome present bias by using statistics to drive home the urgency of acting to mitigate issues like climate risk.

With their access to top-quality advice and generous governance budgets, large schemes have been the frontrunners in adopting coherent ESG policies and responsible investment frameworks. Smaller schemes could examine these to get inspiration on how they can, in turn, take a more well-rounded approach.

The good news is that ESG is dominating the conversation across Europe’s trustee and corporate boardrooms. There are encouraging signs that the actions outlined above are being taken. This, combined with politicians’ growing focus on the key issues and the increasingly hefty weight of regulation, means that 2020 is set to be a seismic year for ESG.