Issue: December 2011 / February 2012
Expert Opinion
ABSA

PRACTICAL APPLICATION OF ENVIRONMENTAL, SOCIAL AND GOVERNANCE (ESG) FACTORS

Cobus Strydom
Are you concerned about the impact on your retirement fund from poor corporate governance of companies in which its assets are invested? Do you want to ensure your fund does not invest in companies that harm the environment? Cobus Strydom, head of consulting at Absa Consultants & Actuaries, discusses questions faced by trustees following the revision of Regulation 28 in the Pension Funds Act.

Trustees will now need more than an average understanding of fund investments. Besides derivatives, hedge funds and private equity coming into play, the revised Reg 28 also states that trustees have a responsibility to invest members’ savings in a way that promotes the long-term sustainability of investments.

To do this, trustees must take into consideration environmental, social and governance (ESG) factors, ESG being a generic term to evaluate corporate behaviour and to assess the sustainability of companies. ESG factors are a subset of non-financial performance indicators, such as the company’s ethical practices and management of its carbon footprint. Potentially, ESG analysis allows insight into long-term prospects and can identify pricing inefficiencies.

Full compliance with the revised Reg 28 is expected by end-2011. For asset managers, incorporating ESG considerations into investment decision-making, will influence the way they determine the fair value of a company. For trustees, it would mean they would need to include:

  • An evaluation of asset managers’ ESG process as a criterion in selecting managers; and
  • The ESG process in their investment policy statements.

Another important development is the adoption of the Code for Responsible Investing in SA (CRISA). It is endorsed by the Principal Officers Association, the Institute of Directors and ASISA which represents most SA asset managers, collective investment scheme management companies, linked investment service providers, multi-managers and life insurance companies.

CRISA is a voluntary code that encourages institutional investors, including retirement funds, insurers and all their service providers, to adopt its principles and practise its recommendations on an ‘apply or explain’ basis, thus encouraging best-practice conduct by shareholders and companies.

Its key principles enshrine ESG, transparency and accountability (Today’s Trustee Sept-Nov 2011). The effective date for reporting on application of the code is 1 February 2012.

CRISA requires that, at least once a year, institutional investors publicly disclose to stakeholders the extent to which they have applied the code. Where they have not applied it, they must disclose the reasons therefor.

Practical application as part of manager selection and monitoring

ESG factors can be taken into account by trustees in the key areas of asset-manager selection and monitoring. As part of their evaluation of an asset manager's staff, philosophy, process and performance, trustees can ask these questions of each manager being considered:

  • Are you a signatory to and represented on CRISA? If not, do you have any intention of becoming a signatory?
  • How do you take into account ESG factors in considering the fair value of a company? In what way, if any, do you expect incorporation of ESG factors to impact your ability to enhance fund returns and reduce risk ? Do you consider ESG factors in non-equity asset classes allowed by your investment mandate e.g. property, corporate bonds, private equity and hedge funds?

Based on responses to these questions, trustees will be able to form a view on the quality of attention given to ESG factors. The trustees should decide what weight is given to this relative to other factors considered.

As part of an ongoing manager-monitoring programme, trustees can request that asset managers report back quarterly on:

  • Companies where ESG considerations materially affected their view on fair value;
  • Instances where ESG factors affected their proxy voting on your fund’s behalf;
  • Progress in development of their investment process regarding ESG considerations.

By adopting this approach, and importantly by recording the questions asked and responses received, trustees will be able to show fund members and regulators that they have complied with their duty to apply their minds in considering ESG factors.