A Spoke in the Wheel of ESG Consideration in the U.S. Private Pensions Management: lessons from other climes and history (Part 2)

Over the last decade, many efforts have been made within the European Union to advance the cause of sustainable finance. Some of these include the EU Action Plan for Sustainable Finance, the development of a taxonomy of sustainable economic activities, and the adoption of the Sustainable Finance Disclosure Regulation (SFRD). Either at the country level or under the auspices of the commission, the clear message coming from the bloc through these initiatives is its pivot to a financial system that is simultaneously resilient to environmental, social, and governance risks and is supportive of a transition to a more sustainable world. Concerning ESG assessment in pensions administration, a 2016 revision of the Institutional and Occupational Retirement Provision (IORP II Directive) required pension funds to include ESG factors in their governance and risk management frameworks.

In contrast with the DOL’s aggressive stance towards ESG risk analysis in pension plan management, the European Insurance and Occupational Pensions Authority (EIOPA), which is the supervisory body with oversight over insurance and occupational pensions in the EU, has thrown its weight behind ESG assessment and its proper implementation. A member of the Network for Greening the Financial System (NGFS) and the Sustainable Insurance Forum (SIF), EIOPA is currently working on a roadmap that will enable “[I]nsurers and pension funds adopt a sustainable approach in their investments based on principles of stewardship."

Responding to the EU’s recent consultation on a renewed sustainable finance strategy, it affirmed that “[T]aking into account ESG factors to reduce the risk exposure of IORPs toward ESG risks can also help IORPs in the pursuit of sustainability goals." It also believes that "... considering the long-term impact of investment decisions on ESG factors can contribute to mitigating IORPs’ exposures to ESG risks." Together with the other two European Supervisory Authorities, the European Banking Authority, and the European Securities and Markets Authorities, EIOPA has been tasked with the responsibility of developing a set of Regulatory Standards (RTS) for the content, methodologies, and relevant sustainability disclosures in line with the 2019 Sustainable Finance Disclosure Regulation of the EU.

An established risk management practice for pensions management in Europe

Even before the latest move by the European Commission, several pension plan administrators had been incorporating ESG assessments in their risk management framework and investment strategies. As early as 2011, the French agency that manages pensions of public workers, Retraite Additionnelle de la Fonction Publique (RAFP), emerged a two-time winner?of the award for best European ESG investor in recognition for its pragmatic use of extra-financial criteria to inform portfolio management. The following year it formally adopted guidelines to track the carbon intensity of its investments because of the risks posed by climate change to the long-term valuation of its assets. By 2016 almost 90% of its assets were within the radar of its carbon footprint.

There is no doubt that RAFP's early moves in this regard adequately prepared it for the implementation of article 173 of the French Law on Energy Transition which, as of 2016, mandates carbon disclosure for listed companies and carbon reporting for institutional investors.

Fig. 1 Common ESG Integration Approaches (source: MSCIA 2011 ESG Research)

A similar perception of the relevance of ESG factors in pension plan management can also be found among plan managers in the UK. When the National Employment Savings Trust (NEST) updated its statement of investment principles in 2014, it clearly stated the belief that “… incorporating environmental, social and governance (ESG) factors is integral to the investment management process.” This thesis informs why it automatically enrolls about 99.8% of plan participants (as of 2017) in its default investment option that considers ESG; convinced this gives better protection to participants by enhancing risk-adjusted returns. It is crucial to juxtapose NEST’s choice of offering ESG investment as the default option for plan participants with the DOL’s decision that prohibits ERISA plan managers and fiduciaries from doing the same.

Regulation underway in Australia to promote ESG integration

Over in the Pacific, the appetite for ESG as a risk assessment tool and investment criteria is rapidly growing among pension plan managers. In 2018, 47% of pension fund members surveyed by State Street Global Advisors expressed their interest in ESG investment options. The proportion had risen to about 61% by 2019. Several of the superannuation funds in the country use a wide array of strategies including integration, stewardship/active ownership, and divestment. Cognizant of the varying needs of plan participants when it comes to values/ethical investing (see fig. 2 below), some pension plans like?AustralianSuper?even offer specific options to cater to this universe of participants.?

So far, industry groups and plan participants have been largely behind the drive for ESG adoption while regulators continue to support the voluntary adoption of ESG disclosure standards and climate risk assessment frameworks. Back in February this year, the Australian Prudential Regulation Authority (APRA) issued a letter encouraging entities to “… be proactive in taking steps to assess and mitigate climate change financial risks now….” APRA also mentioned that it will launch a consultation for an update to the Prudential Practice Guide SPG 530 which should “ … assist a registrable superannuation entity licensee in complying with requirements in relation to the formulation and implementation of an investment strategy, including in relation to environmental, social and governance (ESG) considerations.”

DOL’s misjudgment of ESG and proposed rule actively expose plan participants to risks

When the DOL cites issues such as unreliable ESG data, harm to pecuniary returns on investment, or even the advancement of political goals by fiduciaries as part of its reasons for restricting the integration of ESG factors in the management of ERISA plans, it is clearly missing the wood for the trees or deliberately politicizing pensions management itself. This quick review of ESG practices and pensions management in Europe and Australia, which is quite similar to other jurisdictions, stands in stark contrast to the DOL’s approach of ignoring the fact that ESG consideration helps in addressing systemic risks, particularly over the long term.

Fig. 2 Integrating ESG into the Investment Process (MSCI, 2011)

Why would the DOL seek to constrain plan managers from assessing companies they invest in for potential exposure to penalties under the Modern Slavery Act enacted in the UK and Australia; or even in the US which recently sanctioned 11 Chinese firms that are part of the supply chains of Apple and Tommy Hilfiger? What could explain the decision to prohibit the systematic assessment of climate and environmental risks which the NGFS, a group of central bankers and financial institution supervisors, have overwhelmingly agreed to be material to the global economy?

Even if pecuniary gains would be traded for other objectives like ending the production of weapons of mass destruction, the DOL should be able to work with fiduciaries to see that those plan participants who wouldn’t mind can still have the options available to them. It’s hard to imagine why in this dispensation there’ll be opinions against measures being advanced to proactively dry financing flows for businesses whose supply chains rely on child labour and/or are super catalysts of climate change.

Whatever the DOL does to detract ESG investing in the US vis a vis its proposed rule, there is no going back globally. This wind of change did not just start blowing today, and with time it would surely sweep the US as well.

Even when the US government withheld from taking drastic action against the white-minority apartheid government in South Africa, many businesses and institutional investors had to bow to pressure as anti-apartheid activists succeeded in their divestment campaigns against businesses operating in the country around the time. There is no want of examples if we even go further down memory lane. As it was with the Quakers who began campaigning for the end of the slave trade in 1688 and prohibited their members from participating in the slave trade by 1758, today, there is an emerging voice among investors clamoring for the need to rightly channel investment flows.

Although some would still make whatever profit there is from the system, as long as there is state support for the status quo, they would have failed to put their names on the good side of history. The excuse that they were only “products of their time” would not suffice because it is clear that they created the times and actively sought to maintain them.