Environmental, Social and Corporate Governance

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This document is for investment professionals only. It is not to be viewed by or used with retail clients.

Environmental, Social and Corporate Governance (ESG) Foundation

Presented by Iain Richards, Regional Head of Corporate Governance

Iain Richards: Hello and welcome to this module of Investment Tutor. In these sessions we’re going to have an introduction to responsible investment, and environmental, social and governance issues, and the place they have within the investment process, and the relevance of that to pension fund trustees. The issues we’re going to cover in these three sessions are covered in more detail in the main course (classroom module and following videos), but these will give you a flavour and an idea of what’s involved. I’m going to go first of all into first principles, and the starting point and sort of philosophy that underpins all of this.

First principles Jonathan Charkham, a well-known governance expert and a member of the Cadbury Committee that established the UK framework, set out very clearly the importance of companies and the way we invest in them, not only to ourselves and the beneficiaries of pension funds but to the wider community and other stakeholders in businesses. It’s important from an investment perspective to recognise that companies that are well governed and that operate in a sustainable and responsible way will have the frameworks in place to support the long-term health of a business and shareholder value, and this is where ESG comes into play and is relevant in the context of investment. So what we’re going to do very briefly is touch on the position of trustees and how their responsibilities, in particular their fiduciary responsibility, relates to ESG issues.

Trustees and ESG: The powers and duties of Trustees and their agents Now, clearly, in the UK there is a very common misconception that ESG issues are irrelevant to trustees and, indeed, that trustees cannot take account of them because they have a profit maximisation duty that overrides everything. The common case that’s cited to support this is Cowan-v-Scargill. But what a lot of people don’t know is the judge was so incensed by the misinterpretation of his judgement that he actually came back five years later and clarified the judgement to make clear that the profit maximisation objective doesn’t override all the other considerations that exist. Indeed, this has been tested subsequently in a case involving the church commissioners that upheld pension fund trustees’ rights to take account of broader issues, and in the case of the church commissioners that was social, ethical and environmental issues, in their investment mandate and approach. So I’m going to touch a little bit on some of these aspects and what they mean to pension fund trustees, but very clearly these things will be discussed in more detail during the course itself, and these are just to give you a highlight and a flavour for what’s covered.

Now, in terms of pension fund trustees, the headlines are three to take away from this. The first one is that trustees should not fetter their discretion in the way they approach investments. Secondly, it is very clear that trustees can take account of socially responsible investment within their array of investment approaches and strategies.

ESG framework Now, clearly, the framework in which this sits, set out under the Pensions Act and associated regulations and guidance that comes from the Pension Regulators, pension fund trustees are not required to involve this and include this within their investment approach. But they are expected to be clear about the extent to which they do and to be transparent about that, and to the extent that they do, to have a proper understanding of how they approach this and to take proper advice in making their decisions in this area.

Myners principles - generally-accepted industry best practice Clearly, behind the regulatory framework that exists, we also have the Myners principles that the Treasury updated and published again in 2008, and these set out a very clear framework and basis on which pension fund trustees can approach this area. Now, on the next slide you’re going to see a table that just tries to sort [out the] structure it and present it in a format to make the headlines very clear, and we’ll talk a little bit more about that. Now the framework and basis in which a lot of this operates is set out in generally-accepted industry best practice, the Institutional Shareholder Committee Statement of Principles. That has very recently been updated into a complier-explained code. Now, within the investment industry, this is considered best practice. The frameworks and standards, therefore, support trustees incorporating ESG issues and a more responsible engaged approach to investment within their mandates is in place, and trustees can rely on the basis of this framework to establish an appropriate format for delegation to their investment managers, and to expect clear and transparent reporting on those responsibilities to trustees.

ESG – does it matter? So we’re left with a question, does it really matter? And I think, in the current context, that’s a relatively easy question to answer. Clearly, the financial crisis has outlined very clearly the importance and issues that exist around whether investment managers and pension funds do engage actively and act as responsible owners or not. It also highlights some of the deficiencies in particularly the governance arena around risk management, around misaligned

incentives, and these are all issues that are relevant and can have potentially material effects to the investment environments to which we’re all exposed.

Executive remuneration Turning to a more popular aspect of corporate governance, obviously the bête noire of governance is the question of executive remuneration, and many people debate about whether it’s appropriate to get involved in this. But there is a clear association between this as an area and the interests of pension funds and their underlying beneficiaries. The slides that I’m showing up now just highlights very clearly the disconnect that existed between the explosion of executive remuneration and the performance. This is at an aggregate level but it clearly highlights the difference in trend between the yellow line at the bottom, which is the FTSE 100 index performance over time, and the inflation within elements of executive remuneration for directors. Clearly this doesn’t solely look at chief executives which would show an even more extreme dispersion between sort of executive remuneration elements and performance but it clearly highlights an issue that exists around alignment of interest and rewards for value creation that are so important to pension funds and their beneficiaries.

Now, at the same time as we have this deviation between performance and pay, what we see is as the executive pay goes up, the level of engagement and pushback from the investment community has gone down over time, and if we were to show the level of actual voting against share schemes, remuneration reports, you’d actually see it getting less and less strong as pay inflation increases. This is just a very small illustration of the types of disconnect that do need to be looked at and addressed to ensure there’s clear alignment of interest between all the parties in the value chain of investment to protect and look after the long-term interests of the beneficiaries of pension funds. These are all issues that are going to be discussed in more detail in the Investment Tutor programme itself, and I’ve talked a little bit about some of the governance aspects, and in the following sessions we’re going to touch on the other aspects of ESG in more detail and their relevance to the investment process.

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