Fiduciary duties are foundational for institutional investors. The interpretation of these duties frames investment time-horizons, strategies and objectives, and defines those features of the investment landscape considered appropriate subjects of analysis.
Some institutional investors, whether asset owners or investment managers, have defined their fiduciary duties in narrow terms, arguing that they preclude consideration of Environmental, Social and Governance (‘ESG’) factors in investment processes. This approach has often been informed by the mischaracterization of sustainability concepts in legal advice and short-term investment strategies. These misunderstand the position in law and regulation in the UK, fail to reflect the investment approach of major asset owners and data on the relevance of ESG methodologies to risk and return analysis.
The fiduciary duty project, undertaken by PRI, UNEP FI and The Generation Foundation, is part of a three-year project to create an enabling environment for ESG integration across asset classes. This involves removing barriers in regulation, organizational process and market norms. Our work represents an extension of work first begun by Freshfields through their report on ESG and Fiduciary Duty.
ESG integration and the law
Fiduciary duty is not a barrier to ESG integration. The UK Law Commission, in its report The Fiduciary Duties of Investment Intermediaries, stated that ‘there is no impediment to trustees taking account of environmental, social or governance factors where they are, or may be, financially material’. The relevance of an investment factor is determined by its financial materiality rather than its origin or the label applied to it.
The assessment of materiality is critical to prudent investment analysis. The relevance of ESG issues is not symmetrical across sectors and the range of issues available to be considered will vary by sector. The material ESG issues for a bank (cyber security, risk management, payment systems) will not be those for an extractives firm (GHG emissions, access to raw materials, social license to operate). Within sectors, the intensity of particular ESG issues will vary between companies, enabling assessments of risk and investment opportunity.
It is also important to note that ESG issues are not new, having been part of investment analysis without the use of the ESG label (whether through assessments of management quality, business-model resilience or board competence). The PRI defines ESG integration as:
‘the systematic and explicit inclusion of material ESG factors into investment analysis and investment decisions’.
It is worth clarifying that, in our view, ESG integration does not necessarily involve a narrowing of the available investment universe (unlike negative screening). Neither does it involve subordinating the pursuit of a financial return to unrelated objectives (social or ethical).
Fiduciaries may seek to achieve social or ethical objectives through their investment decisions. However, such intention is subject to an additional two-part test, requiring a fiduciary to consider in relation to the proposed investment:
- if the intended ethical outcome was supported by their beneficiaries; and
- whether it would result in significant financial detriment (when judged against equivalent investments).
That additional test essentially marks the legal boundary between ESG integration (which uses ESG factors systematically in investment analysis) and Social Responsible and Impact (‘SRI’) investing (which explicitly seeks to achieve collateral social and ethical outcomes through investment decisions). These approaches are conceptually different and subject to different legal tests, though they may employ some of the same tools of investment analysis. Unfortunately, these distinct concepts are often conflated.
As illustrated, the critical distinction between ESG integration and SRI may be intent. Obiter comments in the case of Cowan v Scargill illustrate this well, in the context of considering investing in apartheid South Africa (current at the time the case was heard). A fiduciary refusing to invest in South Africa out of ethical disfavor for the South African regime is not acceptable. Deciding not to invest in South Africa following an assessment of the material economic risks of apartheid South Africa is acceptable. One is driven by ethics, the other by financial considerations (which have significant ethical underpinnings). This distinction is in essence a function of the purpose for which a fiduciary arrangement (such as a pension trust) is constructed, namely, the delivery of a financial return.
There is though a danger of over-simplification and rigidity in the application of the law to the nuanced sources of investment value. Ethical considerations often have significant financial value. Poor labour practices often lower operational efficiency. Stories of mistreated workers or factory collapses impair brand reputation and consequently corporate valuation (in addition to being an ethical affront). The Shared Value paradigm also indicates that there may be untapped corporate value through emphasizing pro-social objectives in corporate strategy.
Also underlying this analysis is the organic nature of fiduciary duty, which displays the flexibility of the common law responding to social norms and market expectations. The trend data indicates that ESG integration is increasingly becoming part of mainstream investment practice. A recent PRI report also illustrates, across 40 case studies, that investors can treat ESG factors in the same way as any other financial factors using existing quantitative methodologies.
Stakeholder feedback and recommendations for policy and organizational process
Our report was developed through over 30 interviews with key stakeholders across the UK capital market. Informed by this work, our report makes recommendations in the following areas to enable and accelerate ESG integration in the UK capital market:
- Revision of the Investment Regulations (applicable to occupational pension schemes): to adequately reflect the conceptual distinction between ESG and SRI, reflect guidance issued by The Pensions Regulator, and remove the implication that ESG integration is an optional aspect of fiduciary practice
- Engagement and Stewardship: to embed in regulation that proxy votes and shareholder rights are fiduciary assets to be used in the best interests of beneficiaries (as stated in US and Canadian securities regulation).
- Investment Consultants: to ensure that investment consultant advice provided to institutional investors is subject to adequate review and is overseen by the FCA (as also proposed in the FCA interim Asset Management Market Study).
- Scheme Governance: DC pension schemes lack fiduciary governance structures and are often too small to be well governed. This exposes the dominant growth area of the UK pensions market to poor oversight, over-charging and unresponsive investment strategies. Pension scheme pooling and stiffened oversight would improve investment rationale and beneficiary protection.
This post is an adapted version of the UK Roadmap for Fiduciary Duties published by The Principles for Responsible Investment (PRI), UNEP FI and The Generation Foundation.
Brian Tomlinson is Associate Director, Fiduciary Duties, at PRI and UNEP FI.