Issue: December 2012 / February 2013
RESPONSIBLE INVESTMENT 1
The hard issues
Proper integration of environmental, social and governance (ESG) criteria into mainstream investment decision-making is taking place slowly. It had better speed up.
At its annual 'Trustee Day', the JSE provided a platform for a variety of discussions pertinent to retirement funds. One, where the panellists were Adrian Bertrand (manager of ESG at the Government Employees Pension Fund) and Tracey Want (head of strategic marketing at Investment Solutions), focused on ESG implementation.
Let's first be clear on who the “owners” of equities actually are i.e. the registered owners (usually asset managers) or the beneficial owners (such as pension funds represented by trustees). Does it make any difference in the sense that asset managers are signatories to CRISA whereas pension-fund trustees have ESG obligations under Regulation 28 as well as their investment policy statements under PF 130?
AB: Both Reg 28 and CRISA operate from the same premise. It's that the institutional investor, who is the asset owner, has fiduciary duties towards its ultimate beneficiaries and is held accountable. Reg 28 and PF 130 apply to pension funds falling under the Pension Funds Act. CRISA, a voluntary code, applies to both the institutional investor (e.g. pension funds and insurance companies) and its service providers (e.g. asset managers and consultants).
TW: Reg 28 and CRISA complement each other. The statutory Reg 28 requires trustees to consider ESG issues when making investment decisions. The voluntary CRISA gives clearer guidelines, particularly regarding disclosure and ownership responsibilities. The key here is who the “influencers” are. Given that trustees have the power to drive change at assetmanager level, they can influence asset managers into adopting CRISA. By doing so they promote sustainable investment, thus fulfilling their legal obligation imposed by Reg 28.
How do these respective owners ensure that they comply with these respective obligations? In other words, are there objective ESG criteria or are they subjectively interpreted and then subjectively applied?
AB: Reg 28 requires that pension-fund trustees follow a prudent investment approach, giving “appropriate consideration to any factor which may materially affect the sustainable long-term performance of a fund's assets, including factors of (an ESG) character”. It's up to individual funds to decide on which ESG factors are of particular importance and to develop policies addressing them e.g. on proxy voting.
Implementation would be at fund or serviceprovider level, monitored and allowing the fund to report on it. There'll always be elements of subjectivity. But as responsible investment (RI) develops globally, generally accepted best practices are sure to evolve.
TW: Right now, the RI concept is vague and subjective. The Association for Savings & Investment SA has defined what it should entail, but the industry is calling for more descriptive guidelines.
Want... power of influence
Who then monitors compliance? Are there penalties, on asset managers and/or trustees, for non-compliance?
AB: Asset owners should monitor service-provider compliance in the same way as any outsourced task. ESG responsibilities should be set out within the mandate between an institutional investor and its service providers. Noncompliance by pension funds against the principles of Reg 28 could see FSB action taken against them.
CRISA, given its 'apply or explain' reporting mechanism, requires that institutional investors and/or their service providers describe where the principles of CRISA were not applied and to give good reason for such non-compliance. It's expected that such disclosure will be publicly reported. Multi-managers have been surveying asset-manager capability in this area and pension funds will increasingly rely on these assessments when making manager selections.
TW: Because retirement funds are legally bound by Reg 28, under the Pension Funds Act, trustees would be held liable by the FSB. I'd think there's a broad spectrum of possible FSB actions e.g. inspections, time periods for rectification, and fines. The FSB has indicated that it will haul out the big stick in 2014, but how it intends to monitor compliance remains uncertain. Trustees would also be able to sue third parties – asset managers, administrators and consultants – who breach agreements providing for compliance with Reg 28.
Asset owners commonly say that they “engage” with companies on their ESG policies. What should the owners do when they're unhappy with the outcomes of such engagements? A few examples would be helpful.
AB: Asset owners dissatisfied with the response or performance of an investee company on specific ESG issues have various options. Increasingly, we're seeing investor collaborations in seeking to highlight certain ESG issues within the investee company and requesting change. Should a company not respond appropriately, investors may make their standpoints public.
They may choose, for example, to raise questions at the company's shareholder meetings. A last resort is to divest. This approach is popular internationally, where the investor has a large and diversified global portfolio, but it is not an attractive option for most pension funds in the SA context.
TW: Asset managers that hold a significant portion of a company's share capital are in a strong position to influence its directors. At times, however, more drastic measures are required. One example is where a large global asset-management house, after months of trying to engage the directors on a particular issue and essentially being ignored, threatened to vote against the upcoming directors' remuneration proposals unless due consideration was given to its views. The matter was duly raised at a board meeting and a decision taken very much in line with what the asset manager wanted.
To engage individually, year by year, with dozens of investee companies must come at considerable cost in research, expertise and time. Who pays?
AB: It will come at a cost. The cost for asset owners will vary based upon each pension fund's chosen approach to how it will engage investee companies on ESG issues. This approach should be decided by the trustees of every pension fund in response to Reg 28 and CRISA. Most pension funds will include it in their agreements with service providers. Good equity analysts already understand ESG issues relevant to their sector or company focus, and already have existing relationships with the companies.
ESG issues should also be raised, for example, at companies' investor presentations. There is still a need for more ESG data covering SA listed companies beyond the JSE Top 40. Engaging collaboratively as pension funds can reduce research and engagement costs. What is the long-term cost to a fund that does not engage on ESG, given such recent examples as BP and Lonmin at the company level or platinum and gold mining at the sector level?
TW: It depends on how the asset manager views RI. If it sees RI as integral to its investment process, engagement forms an important part of how risk is managed within its portfolio. In these instances, the cost of engagement can't be stripped out, just as the cost of quantitative analysis or risk assessment can't be separated.
What would you say to a pension fund that, for its equities portfolio, simply buys the JSE SRI index? Would you consider that the fund has complied with its ESG obligations?
AB: Investing a portion of a pension fund's portfolio in a specific index, such as the JSE SRI or similar 'green' branded products, is insufficient to meet the requirements of Reg 28 and CRISA. Some funds may choose to invest in these products as a sub-element within their RI strategy, but ESG issues and an active-ownership approach must be followed across the entire portfolio for all assets both before investing and while invested.
TW: RI should be integrated into every investment decision whether it is to buy, hold and engage, or sell. By buying an index, an investor would still need to engage to fulfil its ownership duties.
Should asset managers disclose to the world how and why they voted at shareholder meetings, or should they tell their clients only?
AB: CRISA requires institutional investors and their service providers to disclose all proxy votes and give reasons where an institutional investor chose to vote against or abstain from any resolution. It also requires institutional investors and their service providers to provide good reason should proxy votes not be publicly disclosed.
Non-disclosure precludes the investee company the opportunity to engage with the investor. Before agreeing to a proxy or other instruction to keep voting records confidential, institutional investors and service providers should carefully consider the arguments to justify such confidentiality.
TW: As a client or potential client, I would need meaningful reporting if I'm to understand whether the voting records validated the investment process being followed. Voting records must be made available to clients. I have no view on whether they should be made available to the public as well.
Bertrand... regulated and sensible
What should trustees insist that their fund's asset managers tell them, or consultants find out from asset managers for them?
AB: Trustees should require asset managers and fund consultants to report on any material ESG factors within investee companies or across the portfolio that may affect both the short-term and long-term returns on their investments. These service providers should also report regularly on how they've incorporated ESG when making investment decisions and on how they've exercised active ownership e.g. through proxy voting and engaging with investee companies.
TB: Trustees should told how the asset manager incorporates RI into its investment process; what systems it uses; how it reports on RI, and whether the voting records support these statements.
Are there obstacles to ESG implementation? If so, would you rate short-term performance pressures importantly amongst them?
AB: Yes. There is the perception that taking ESG factors into consideration when making investments will lead to additional costs and therefore erode shortterm performance returns. Pension funds will have to think critically about the performance incentives provided to asset managers. As long-term investors, the funds cannot work against themselves by pushing short-term performance.
TW: Most definitely. Short-term performance measures are part of a vicious cycle throughout the investment value chain. It starts with shareowners expecting strong gains in the short term, then measuring and remunerating directors based on annual results alone.
What would happen when say an oil-exploration company has rejected a costly maintenance programme, so boosting its profitability and hence directors' remuneration in that year, only to suffer an oil-spill later? Other notable barriers include a lack of reliable and accurate ESG information for assessment, as well as a lack of standardisation and an unclear definition of RI.
When it comes to actual benefits for fund members, why should trustees and asset managers bother with ESG at all?
AB: ESG is about understanding long-term sustainability and managing risks facing the company or sector. It's about how these investment risks can be mitigated, even converted into opportunity.
Also, fund members live in the same society where businesses operate. They must care about whether the companies are irreparably damaging the environment or paying exorbitant remuneration for sub-optimal investment returns. Pension funds, as ultimate owners, have the right and responsibility to hold the companies to account.
TW: Good companies with compelling businesses that are managed sustainably are likely to present fewer nasty surprises. Better-informed asset managers are likely to make better decisions. RI is an investment technique that creates an awareness of the risk and opportunity set found when assessing ESG factors.
Has the investment landscape actually changed, in any material way, through attempts at ESG integration? Or is it just a feel-good exercise in ticking of boxes?
AB: ESG integration is now a requirement within a trustee's fiduciary duty. How pension funds incorporate ESG is for each board of trustees to decide given that Reg 28 and CRISA are both principlesbased. Unfortunately, there'll always be funds that see ESG as a compliance exercise with a few extra boxes added to service-provider surveys.
However, given regulatory and industry endorsement of ESG, there is the opportunity for trustees to display leadership and to reclaim their responsibilities i.e. to hold service providers and investee companies to account within SA's broader governance framework. Trustees must move from being absentee landlords to being active stewards of funds' assets.
ESG implementation will take time. Funds' boards will need to decide how ESG should be factored into their particular fund's investment approach. Only when more asset owners require such capabilities from service providers will the investment landscape truly change.
TW: At this stage, the SA asset-manager landscape has a long way to go. There are some excellent asset managers that formally integrate ESG factors into their investment analysis, decision-making and engagements. It seems, however, that many still need to be totally convinced of the financial benefits of fullintegration strategies. Alternatively, the “influencers” need to nudge them in the right direction.
Can we say that ESG, sustainability of investee companies and stakeholder activism are different cogs in the same machine? If so, are you satisfied that activism – predominantly by or on behalf of trustees, often from trade-union ranks – has properly taken hold in SA? If not, what behavioural changes are required?
AB: We welcome the work of the Sustainable Returns for Pensions & Society project and particularly the Asset Owners' Guide to Responsible Investment, shortly to be released, that will assist trustees understand the importance of ESG and active ownership. It will assist them in their strategic goal setting in response to Reg 28 and CRISA.
To a limited extent, we are seeing some stakeholder activism. Once more pension funds align their policies and service-provider mandates with Reg 28 and CRISA – and understand why integration of ESG is important to long-term returns – we should see trustees increasingly empowered to hold companies and service providers to account on these issues.
TW: Full integration implies that RI is practised at every stage of an investment cycle. So far, there's little evidence that trustees and unions actively engage. I'd suggest that the primary reason is lack of skills and resources. Until these groups are educated and apply their minds on the topic, change won't happen.