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As an industry, we’re responsible for looking after our members’ assets and helping them grow safely.
Investment decisions need to reflect environmental, social, and governance (ESG) considerations. And this is important to us because it helps deliver capital and income sustainably to our membership. It aligns our investment approach with the wants of our members, and simply, it is the right thing to do.
We believe that investing in companies with good ESG practices can help us achieve these goals. When we think about how best to achieve this across our investment portfolios, it can be tempting to think in binary terms.
For example: Do we work with the companies we invest in (directly and through our asset managers), using engagement to ensure they effectively manage all material ESG risks and then use our voting rights to reinforce this?
Or do we disinvest from companies with poor ESG practices? By disinvesting the risks from our portfolio, we could in theory drive down their share prices and increase their costs of capital, thereby incentivising them to up their game in ESG.
Realistically, both approaches need to be embraced. It’s not either/or but, rather, carrot and stick. Both approaches complement and enhance each other. Engagement can be more successful if accompanied by the threat of disinvestment, which should only be pursued if engagement has not or will not yield a positive outcome.
Engagement is to be favoured when:
Divestment could impair risk-adjusted returns (unless values matter more than returns, which is challenging given that the fiduciary responsibilities of trustees prioritise good returns over other considerations).
There is scope to work with other asset owners to meaningfully change corporate behaviour.
The issue is related to ‘how’ a firm goes about its activities rather than ‘what’ it does.
Divestment is to be favoured when:
Engagement has hitherto been unsuccessful, and there is likely to be a limited impact on portfolio risk-adjusted returns if the relevant assets are removed from the portfolio.
There is limited scope for the business model to become more sustainable.
The core activities of a company don’t align with the values of investors (eg, controversial weapons).
However, there are those who oppose divestment. For example, the main argument against selling off assets that have an adverse effect on the climate is that the acquirer may be a hedge fund or private equity firm solely focused on extracting as much value from them as possible without any regard for mainstream ESG metrics. Also, transferred assets from publicly listed to private firms can disappear from the radar of the public disclosure of sustainability, with the result being emissions could even rise. The analogy that has been made is that it’s akin to throwing rubbish over the fence, hoping your neighbour will clean it up.
The academic evidence also indicates that if your goal is to change the behaviour of a company, engagement is often the better route to achieve this compared to immediate disinvestment.(1)
So, while not quite a last resort, the bar for full disinvestment needs to be quite high. Last year, we decided to disinvest £226m from companies that failed to meet our ESG standards. The Trustee of The People’s Pension removed companies involved in the production of controversial weapons, severe ESG controversies involving human rights, labour, the environment, and corruption from our portfolios due to the risk they posed to the value of our members’ assets.
In addition, portfolio construction techniques also offer us a further route to integrate ESG into our portfolios. Across our core fund range, including the default option, we use ESG factors to decide on the weight of each company held in our portfolio. We do this by allocating to strategies that hold greater weightings to companies with good ESG metrics, targeting a 20% improvement in the MSCI ESG scores along with a 50% reduction in potential carbon emissions and a 50% reduction in carbon intensity relative to the MSCI World Index. By integrating ESG in this way, we can improve the ESG profile of our portfolio, reduce the risks our members face, as well as incentivise companies that perform poorly on ESG metrics to improve their practices without fully disinvesting and losing our voice.
(1) https://scholar.harvard.edu/files/hart/files/exit_vs_voice_1230.pdf