The ESG elephant is now in the room

Louise Davey, Director of Regulatory Policy, Analysis and Advice at The Pensions Regulator explains why ignoring environmental, social and governance factors is no longer an option for trustees.

Just a few years ago it would have been rare for pension trustees to consider climate, environmental, social and governance (ESG) factors and wider sustainability issues in significant detail.

That has changed — driven by developments in government policy, increased regulations, industry initiatives and greater awareness of the potentially profound implications for life as we know it if action is not taken on global climate change and biodiversity loss.

One challenge raised by trustees is addressing the climate and biodiversity crisis is a matter for government and policymakers, not for trustees and how they invest and manage their assets.

There have been concerns around availability and quality of data, effective modelling of outcomes and impacts, the implementation risks of greenwashing and the potential for green hushing – where firms keep quiet about their emissions reduction targets to avoid scrutiny.

These are legitimate concerns, but they shouldn’t be a barrier to trustees meeting their legal duties or an excuse to put things in the too-difficult-to-do box.

Trustees should be mindful that these climate, environmental, social and governance concerns, and more, have been acknowledged by policymakers, regulators, and wider industry.

Indeed, the pace and scale of change in relation to data improvements, policy development, guidance and regulations to help drive change and reduce some of these industry challenges has been phenomenal in recent years.

Regulatory initiative

Around 3,900 pension schemes must produce and publish a statement of investment principles (SIP). Trustees of schemes in scope also have to publish an implementation statement (IS), which shows how certain principles in the SIP have been implemented.

We will be carrying out a regulatory initiative (RI) in relation to SIPs and ISs, as we indicated we would in our climate change strategy 2021. The RI will have two phases.

Two phases

The first involves checking all trustees have published their SIPs and ISs (where they need to).

These documents should be publicly available. Where schemes have not published correctly, we will contact the trustees to ensure they do.

The second phase involves a review of a cross-section of SIPs and ISs. This will be a qualitative review and only in relation to the climate, ESG and wider sustainability related provisions included in these documents.

We intend to start our review in the autumn, as the ISs prepared and published for scheme years ending on or after 1 October 2022 should reflect the guidance published by Department for Work and Pensions (DWP) in June 2022.

This guidance was intended to address weakness in existing SIPs and ISs in relation to stewardship and to a lesser extent, consideration of financially material ESG factors and non-financial factors.

Over the coming months, we will finalise the details for this second phase and the schemes we intend to include in our analysis. The outcome of this review will be shared with industry to highlight good practice.

Vague and generic

While the content of SIPs and ISs will vary from scheme to scheme, depending on investment strategy and implementation, we are aware some schemes produce disclosures where the wording is relatively vague and generic.

We want to see a change to that practice. When we carry out our review, we expect to focus on the extent to which the DWP guidance has been adopted by the trustees.

We will also look to identify and publish examples of good practice to help other schemes to improve their future disclosures. Where we believe schemes have not made a reasonable effort to define their policies in the SIP and report on how those policies have been implemented in the IS, we can take enforcement action.

Risks and opportunities

Science indicates the climate consequences of global warming are not linear. Some scientists believe we need to limit the increase to 1.5C above pre-industrial levels. Some suggest every fraction of a degree above 1.5C increases the risk of a tipping point – a critical threshold once crossed could lead to potentially irreversible, catastrophic impacts, including more warming.

However, while there are significant risks, there is the potential for significant opportunities, as the global economy transitions and local economy policymakers align behind a ‘carrot’ approach to incentivise decarbonisation, emissions reductions and transition.

As the DWP guidance highlights, stakeholder engagement can be a key stewardship tool and trustees need to understand and consider:

  • financially material ESG factors (including, but not limited to climate change)
  • stewardship

in their investment decision making.

Trustees need to improve their understanding of climate, ESG and wider sustainability issues.

Trustees also need to improve the quality of their policies and disclosure, move away from boilerplate wording and ensure action follows intent.

For too long, too few trustees focused on climate, ESG and wider sustainability issues in any significant detail, however, trustees can no longer ignore the elephant in the room.

By Louise Davey, Director of Regulatory Policy, Analysis and Advice