Article November 17, 2020

Integrating ESG risks: Looking beyond the headline number

COVID-19 pushed Environmental, Social and Governance (ESG) risks to the backburner for many trustee boards. However, recent regulatory changes have put ESG firmly back on the agenda.

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COVID-19 pushed Environmental, Social and Governance (ESG) risks to the backburner for many trustee boards. However, recent regulatory changes have put ESG firmly back on the agenda. This is a positive step forward for the industry as it raises the bar for all participants. But there’s so much more we can do. Integrating ESG needs to go much further than statements of compliance with policies and mission statements. Ultimately it requires a holistic approach across a scheme’s portfolio, prefaced in two key aspects: looking deeper and looking forward.

Looking deeper

Despite the industry clamour, most UK pension schemes are still only at the early stages of their ESG journey. So far, most trustees have focused on setting policies, understanding how their investment managers are taking account of ESG factors and exercising stewardship. Some will be drafting their first implementation statement as you read this article.

Many consultants and fiduciary managers assist trustees by providing an ESG risk assessment for their investment managers alongside the usual buy/hold/sell recommendation. But a highly rated manager with a poor ESG rating surely presents a governance dilemma for trustees?  The circumstances underpinning the poor ESG rating may directly impact the overall performance and rating of the manager or strategy in the future. And I’m not just talking about performance of the underlying assets here. Weak ESG credentials at the level of the investment manager shouldn’t be ignored. Perhaps if the industry had been more ESG aware some twenty years ago fraudsters like Bernie Madoff wouldn’t have enjoyed such a good run.

ESG risk assessment shouldn’t be a separate assessment or result in an independent ‘rating’. For our fiduciary clients we apply an integrated approach combining both qualitative and quantitative assessment at a portfolio level. Using detailed portfolio analytics and ESG metrics we can look deeper than the face value of manager reports.

Viewing the ESG risks for ourselves allows us to effectively interrogate manager decision making. This forms a crucial part of our engagement process with managers both at the outset and during ongoing due diligence. Where inconsistencies between their policies and portfolio positioning are identified, our researchers will engage in challenge. This is the best way to affect positive change and will ultimately influence their behavior, and our rating. This does not stop at investment due diligence. We ensure ESG risks are considered operationally as well. This represents an area of continued engagement, particularly in firm and fund level governance to ensure best practice.

To deliver better outcomes for schemes, looking deeper is key. Not only at a manager research level, but also at a governance level. They say, ‘information is power’, but in the case of governance, ‘information empowers’. Deeper analysis of portfolio ESG and climate risks can be translated to clear, transparent reporting: boiling up the detail into the metrics which really matter to trustees. As schemes develop their implementation statements, this will provide invaluable disclosure to support their ongoing governance.

“As part of our partnership with clients we evaluate the key risks that may blow them off course or present challenges further down the line.”

Looking forward

As part of our partnership with clients we evaluate the key risks that may blow them off course or present challenges further down the line. ESG risks are very real and should not be ignored. The next phase of the ESG journey for the pensions industry is quantifying climate risk, and the impact of global temperature increases on assets and liabilities. In some respects, we can liken climate risk to progressive improvements in mortality on pension scheme funding. In effect, it may create a funding hole further down the line which requires action today.

So what is a pension scheme to do? One could purchase the best rated ESG companies today (and potentially pay a good ESG premium), but who is to say these companies won’t deteriorate in the future? Alternatively, one could screen out the weakest ESG companies today, but these may actually be on a positive ESG trajectory. Whilst these techniques may paint a favourable picture today, they are backward-looking by design and they rely on available data and subjective interpretations. The resulting portfolio can depend heavily on your screening criteria and data vendor, given the industry still struggles with consistent ESG definitions.

We have conducted significant research into the virtue of ‘ESG momentum’ as a forward-looking portfolio construction technique. ESG momentum seeks to favour those sectors and companies on a positive ESG trajectory. In doing so, such companies may have a weaker ESG assessment today, but are moving in the right direction, this could unleash positive financial benefit alongside a more favourable ESG score. When implementing this approach for our fiduciary clients we also steer away from those on a negative trajectory whose ESG scores are deteriorating. Rather than looking backward, ESG momentum is forever looking forward, steering away from risk and into opportunity.

Increasing ESG obligations could feel an unwelcome burden for trustees given their already overloaded plate and adjustment to a mid-COVID world. Using a fiduciary manager can significantly ease the reporting and governance strain but also add real value through integrating ESG into everything they do. Adapting to changing requirements requires innovation. In 2019 we used our scale to create a single investment vehicle for all our equity index-tracking exposure in our fiduciary client growth portfolios. In doing so, we can directly implement our ESG views for all clients irrespective of size. To our mind, this aptly shows how fiduciary managers should take a more integrated approach to ESG, driving funding success for clients whilst effecting positive change.

This article constitutes a financial promotion and has been issued and approved by River and Mercantile Solutions, a division of River and Mercantile Investments Limited which is authorised and regulated in the United Kingdom by the Financial Conduct Authority and is a subsidiary of River and Mercantile Group Plc (registered in England and Wales No. 04035248).
Please note that this communication is directed at, and intended for, the consideration of Professional clients only.
The value of investments and any income generated may go down as well as up and is not guaranteed. An investor may not get back the amount originally invested. Past performance is not a guide to future performance. Changes in exchange rates may have an adverse effect on the value, price or income of investments.

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