The Pensions Act 1995 requires pension funds to set out their investment policies in a statement of investment principles (SIP). In July, amendments to the legislation extended this to require trustees to state "the extent (if at all) to which social, environmental or ethical considerations are taken into account in the selection, retention and realisation of investments" (ENDS Report 305, p 40 ).
While the new rules do not require funds to take on board social or environmental concerns, there is some evidence that funds are beginning to do so.
Environment in investment decisions
According to a recent survey by the UK Social Investment Forum (UKSIF), most funds now claim that they take account of environmental, social and ethical issues. 1 Following the changes to the legislation, the forum asked to see the SIPs of the 500 largest UK pension funds; 171 funds, with assets totalling £302 billion, responded.
Some 59% of the funds said they incorporate environmental and social concerns into their investment processes. These tended to be the larger funds, worth 78% of the assets surveyed. Some engage directly with the companies in their portfolio to enact the commitments in their SIPs, while others have instructed their investment managers to be guided by these concerns.
A further 27% of the funds said they leave it to their fund manager to decide whether to take environmental or social concerns on board. Only 14% said they do not take account of these concerns, but these tended to be the smaller funds worth just 4% of the assets surveyed.
"Given that the SIP regulation is relatively new, what is encouraging is that a lot of funds have something on paper," said Stuart Bell of Pensions and Investments Research Consultants (PIRC). But he has seen little evidence that these commitments are having an impact on the ground. "Clearly, the next step is checking the impact on performance," he said.
Engagement or screening
The UKSIF survey uncovered a difference in approach between local authority pension funds and company funds. Local authority funds tend to retain ownership of their social and environmental policies, while company funds delegate responsibility for implementing the statements to their fund managers.
Furthermore, local authority funds prefer to work with the companies in their portfolios to achieve their social and environmental goals - 71% mentioned engagement compared with just 23% of company pension funds.
Taking funds and fund managers as a whole, engagement is proving the most popular approach. Fund managers meet with companies regularly and seem happy to bring up social and environmental concerns as part of this process.
"It's all just part and parcel of normal good due diligence," thinks Jim Tennant of investment managers Schroders. In response to requests from its pension fund clients, Schroders drew up an environmental and social investment policy which it sent to the chairmen of the top 350 FTSE companies earlier this year. It has also teamed up with Innovest - a firm which specialises in providing environmental profiles of companies - to help it operate this policy.
Engagement is just one of many options open to funds. Another approach is to invest in companies which comply with a set of pre-determined criteria. Under this approach, funds either screen out companies which are environmentally or ethically questionable - the most likely candidates for this approach are tobacco and armaments firms - or they invest in firms with environmental or social strengths, such as renewable energy or "fair trade" companies.
The problem with screening is that it limits funds' market coverage and some feel this constrains their ability to spread risk across a broad portfolio. As a result, funds are reluctant to go down this road, though a significant minority are using the approach for at least part of their assets.
A third option is to invest in "best of class" companies - firms which are seen to be ahead of others in their sectors in managing social and environmental impacts. However, deciding which firms are best of class is tricky and funds and their managers are increasingly turning to ranking schemes such as Business in the Environment's index of corporate environmental engagement (ENDS Report 302, p 5 ) or to specialist firms like Innovest.
The fiduciary duty
Simon Brown of Innovest - one of the leading firms providing environmental and social profiles - thinks that opting for firms with good environmental management records is a smart financial move. He points out that environmental funds consistently outperform the market average. He thinks that funds are waking up to the idea that firms which manage their environmental risks well tend to be good at managing - full stop.
This view is echoed by Eric Borremans of environmental consultants ERM: "There is an increasing awareness that environment and shareholder value are linked," he says. "Good environmental management can be a proxy for good management and is therefore linked to shareholder value."
Indeed, Mr Borremans thinks that socially responsible investment may well become the norm. He points out that environmental investment funds like the Dow Jones Sustainability Group Index (ENDS Report 296, pp 21-24 ) consistently outperform the market average.
"If it is proven that socially responsible companies or companies with more proactive policies actually outperform the rest, it may turn out that fund managers have to meet socially responsible investment [principles] if they want to meet their fiduciary responsibility," he says.
This may explain why funds have been willing to include socially responsible investment principles in their SIPs. The primary driver for pension funds remains shareholder return - they have a fiduciary duty to strive for the best return for their members and cannot adopt social or environmental policies which conflict with this. "Ultimately, it all has to be about shareholder value," says Michelle Etkins of Hermes Investment Managers.
Hermes manages the BT pension fund, the UK's largest, with assets of around £23 billion. It was one of the first to amend its SIP to include social and environmental concerns.
Michelle Etkins does not think there has to be a conflict between socially responsible investment and shareholder return. Funds are in it for the long term, she says, with investment horizons of 20 years and more. "We're more interested in sustainability than we're actually being given credit for."
Hermes has chosen to engage with companies in its portfolio and is now paying more attention to the way they manage their environmental and social risks. But Ms Etkins is adamant that fund managers should not be telling firms how to run their business.
"We have to be careful," she says. "We're not company managers, we're money managers. We can't tell a company what environmental or human rights strategy it should have."
But on the other hand, she says, funds bring companies up short if they are not happy with what they are doing. "We can tell them [management] when they have done things well, or when they have done things badly. Our job is to look at the disclosures to understand what the company is doing, and to sanction [changes] if we think they have got it wrong."
Perhaps most importantly, by simply displaying an interest the funds have put the issues on the boardroom agenda.
Risks to reputation
Another reason for investors' heightened interest in environmental and social policy is the effect that liabilities can have on financial performance.
"These are massive risks," says Michelle Etkins. The last thing fund managers want is for their investments "to be blasted all over Business Week or Panorama."
Yet many firms are not on top of these risks. A recent survey for environmental consultants Entec found that only half of firms have systems in place to deal with such risks (ENDS Report 307, p 8 ). This statistic is particularly worrying because non-financial concerns have been brought to the fore recently by the requirement for firms listed on the London Stock Exchange to demonstrate that they have systems in place to identify and control all risks.
The so-called Turnbull report provides guidance on a raft of corporate governance issues, but it is the sections on environmental and reputational risks that are causing directors sleepless nights - despite the fact that they run only to a sentence or two. Most directors are comfortable with what Turnbull has to say about financial and legal risks and indeed they all should have systems in place to manage them.
But reputational and environmental issues are beyond their ken. The Turnbull requirements, combined with the added interest from major investors, mean that ignoring these issues is no longer an option.
Management not performance
The demand for information on companies' social and environmental profiles has placed more pressure on firms to disclose their policies and performance in these areas and is encouraging interest in environmental and sustainability reporting (ENDS Report 308, pp 26-28 ). Increasingly, however, firms are having to tailor their reports to the needs of the financial community - and these are different from those of other stakeholders.
Traditional environmental reports tend to focus on data on emissions and consumption; they focus on absolute figures and present information on direct environmental impacts. But pension funds are more interested in environmental management than environmental performance. They want to see evidence that firms have a handle on environmental risks.
"The questions [that funds and their managers are asking] are all trying to capture the degree of sophistication of environmental management rather than impacts," explained Eric Borremans of ERM. "The focus is on policies and systems rather than hard data."
This interpretation is backed up by Michelle Etkins of Hermes. "We do look at environmental reports?but what we want to see is things like whether there is someone at board level responsible for environmental, social and ethical [concerns]; whether they have had training; whether directors' bonuses are linked to these issues," she said.
"A good report is discursive - where you get a sense of how well management has things under control. That sort of thing is more important than loads of stuff about CO2."
However, she warns firms against producing "greenwash" reports. Funds are not interested in seeing just a firm's good side. She went on to explain that funds want well balanced reports which highlight problems as well as achievements. They want to know that firms are addressing weaknesses and adapting to challenges, not ignoring them.
Simon Brown of Innovest also thinks that it is in companies' interests to be open. Firms which do not disclose information in these areas are sending out a signal that they are not able to deal with them, he says. This makes investors wary.
Impact on company performance
The big question is whether the new interest in environmental and social concerns will improve companies' performance in these areas. There is little doubt that companies will come under pressure to improve their systems and there is likely to be a flood of firms implementing environmental management systems (EMSs). But the jury is still out on whether EMSs actually improve environmental performance (ENDS Report 309, pp 19-22 ).
The emphasis on management rather than performance means that firms with poor records may be able to attract funds if they can persuade investors that they are managing the impacts and that they do not threaten their bottom line. Furthermore, the relationship between the company and the investor is one of trust: funds have to take what companies tell them at face value.
Access to EMS auditors' reports may go some way to giving a clearer view of the quality of management, but a fund may find out about a firm's environmental or social risks only when a problem occurs.
Even external verification of environmental reports is no guarantee of credibility. Earlier this year, a House of Commons committee heard evidence on the woeful state of current verification practices. Steve Rintoul of environmental consultants EnvirosAspinwall revealed that there is "considerable scope for abuse" (ENDS Report 305, pp 33-34 ). Some verifiers were saying "little more than: 'This is a sound report'," he complained, "with no indication of the level of detail, whether they looked at data, systems, commitments and so on and so forth, whether it sampled, 100% audited, or whatever."
Despite these obstacles, there is little doubt that the funds' demands will galvanise laggardly or unconcerned company directors into action: "There's nothing that focuses people's minds better than warnings about losing their jobs," thinks Michelle Etkins. Pension funds have considerable influence over the companies' management teams - but she believes it will be some time before a director is sacked for social or environmental reasons.
Jim Tennant of Schroders says that socially responsible investment is being taken seriously for the first time. "We've made enormous strides this year," he says - "but it will founder unless you can prove you are adding shareholder value."
Despite the promising signs, nearly two-thirds of funds refused to respond to the UKSIF survey and, of those that did, a significant minority still think that social and environmental issues do not affect their investments. There is still some way to go before socially responsible investment becomes mainstream.
"Our experience is that it has taken the best part of a decade to take on board corporate governance. Getting the financial world to take on board environmental or socially responsible investment will take time," said Stuart Bell of PIRC.