The Pensions Pod S5:E6 – ESG issues for Pension Schemes

James Fisher, Pensions Actuary – Willis Towers Watson
Morning Chris, I’m great thanks, thanks for having me on.
Chris
Pleasure, really good to have you on with us. James, just before I introduce our second speaker, could you just tell our listeners a bit about who you are and what you do please?
James
Yes, my role in relation to ESG is to do with the ‘E’ so that’s environmental sustainability including things like climate change. My background is that I’ve been a Pensions Actuary for 20 years and for the last four of those I’ve been on a team that thinks about how we, from the scheme actuary side, help pension schemes and trustees think about this stuff.
 
And a big focus has been on education and awareness about climate change sustainability and one of the things we’ve been doing is running a WCW climate course for pension scheme trustees and that includes looking at the key fundamentals of the topic which are important to know about but we think often get missed, they don’t often get discussed around the pension scheme table. So that course is going well and it’s getting really good feedback.
Chris
That sounds really interesting and as we’ll discuss today there’s a very large education piece for trustees and employers and advisers, and all really about ESG and as you say we’re going to be focusing today on the environment and sustainability aspects of that ‘E’ in in ESG.
 
And I’m also delighted to be joined by our very own Kate Granville Smith who is a director in our Pensions team. Kate, hi, great to have you with us. Do you want to say hello and who you are and what you do and some of the great things that you’ve led our team to do in the ESG space in pensions?
Kate Granville Smith, Director – Burges Salmon
Thanks Chris. Thanks for having me on. Well I’m obviously a pensions lawyer but I’m also our ESG lead which means I have a particular responsibility for developing products and resources which help pension trustees understand their duties in this area. And in particular we’ve developed the award-winning Burges Salmon pension schemes ESG tool which helps trustees navigate this area. So if any of our listeners want to access that, they can access that free via our website.
Chris
Yeah, thanks Kate, and that is a fantastic tool that you and the team have created and it has been recognized in the industry. So if anybody would like access to that then do find it on our website. [Music]
 
So, James, Kate, we’ll kick off. Kate, I’ll come to you first I think, just to ask you what is ESG? But just before I do that, I suppose both just wanted to reflect that ESG is a large and complex area, isn’t it? And I suppose because it’s large it’s rather extensive in scope, you could see trustees, perhaps late trustees sitting around the table the whole discussion around ESG being quite intimidating perhaps. You know, there’s there’s lots to discuss, but it’s become an increasingly prominent as a theme for pension trustees. So let’s start, you know, thinking about why it matters for pension schemes. So Kate, what is ESG?
Kate
Well ESG stands for environmental, social and governance and is used as a framework to assess how an organization manages risks and opportunities relating to environment, social and governance criteria. It is wider than than just climate change, although that is an important component of ESG and the ‘E’ element, and that is one of the elements that that attracts most attention.
 
The social element looks at how an organization manages relationships with the wider community, and governance looks at organizations, leadership and shareholder rights. So as you say, it is a really wide reaching definition and this is why it does cause trustees some challenges I think.
Chris
Yeah absolutely, wide reaching, covers a whole range of different things that trustees need to be thinking about, you know in that social and governance limbs of it. But we’re going to be focusing today on the ‘E’ aspect of ESG and sustainability with that. So James, coming to you. Sort of, the climate crisis attracts a lot of attention but why does ESG and sustainability, thinking about that ‘E’, why does it matter for pension schemes?
James
Well but very simply it means that big change is coming. And if I can just unpack that using climate change as an example. We all know that the climate impacts are here and they’re already bad. We see it on the news all the time, you’ve got extreme weather events, you’ve got you know floods in Europe, wildfires we’ve recently seen in the States, bigger hurricanes, you know more droughts in places like Africa. And the reason for that, we’re putting more carbon pollution into the atmosphere, that’s causing the planet to overheat and the climate to destabilize.
 
But I wonder if we’re all falling into the trap of thinking that, this is it this is as bad as it gets. And I don’t know if you’ve both heard the phrase ‘the new normal’?
Chris
Yes you see it in the press a lot don’t you, sort of you know climate crisis we need to get used to environmental impacts and this is the new normal, yes.
James
Yeah exactly, but I think this phrase is a bit dangerous because it reinforces the idea that this is it, we’ve moved from A to B, we’re now in a a new stable state. Whereas, if you stop to think about it, that doesn’t make any sense. Because if we keep putting more and more carbon pollution into the atmosphere it will heat even further and the impacts will get worse, and scientists are worried it could become unmanageable.
 
So if you want a key takeaway, don’t use the phrase ‘the new normal’ replace it with the phrase ‘the end of normal’. Moving into an era of more volatility, less certainty. So we can’t assume that things will be the same as the past and that’s not a comfortable thought for anyone but it’s useful to be aware of it.
Chris
I think it’s a really interesting point because, you know, the climate crisis is a developing risk, things are continuing to change as you say, so when trustees sit around a trustee meeting table and think okay we need to think about ESG, we need to think about the ‘E’ in ESG, is this a new risk we are dealing with? Well actually it’s a developing risk isn’t it? The risk is changing, the risk is you know potentially getting more volatile and less certain. So yeah I think it’s a really good point.
James
Yeah and that might change how we do risk management. Exactly, exactly. Those things I talked about before are called in the jargon ‘the physical risks’ you know the climate impacts that we’re seeing.
 
There’s another aspect which is that if we as a species decide we want to avoid the worst of those physical impacts and change course we could transition to a low carbon economy. But everything we do generates emissions. So that transition would involve us moving to a kind of- changing everything we do as a society over the coming decades. So that would bring a different kind of change, but it’s changed nonetheless. We call that transition risk. So the takeaway here is that, whether we leave things as they are and things continue on the physical risk side or we make a big change as a society. Change is coming either way and that brings risks and opportunities.
 
And if we bring it back to the question of why does it matter specifically for pension schemes?
Chris
Yes.
James
Three areas I’d highlight. Firstly investments, this is going to change your risk and return profile for investments. So it might impact what what you invest in. It might also impact how you invest, so for example does stewardship get a bigger focus than it has done in the past? And then secondly I’d think about your funding strategy, so is it resilient to shocks? Is it going to affect things like inflation in the future? How long your members live.
Chris
Longevity, yeah.
James
So we need to be think about those, yeah yeah, when we make predictions about the future. And finally, you’re sponsoring employer. You know, how is climate change and a potential transition going to affect your sponsor and the sponsor covenant?
Chris
Yeah.
James
And Kate, I don’t know if you want to come in on the legal aspects?
Kate
Yes, thanks James. So as well as the reasons that you’ve outlined, what we concentrate on as lawyers as are the legal obligations on pension trustees and there are obligations on trustees to make sure that they understand climate ESG and wider sustainability issues. The Pensions Regulator has said that ignoring ESG is no longer an option for trustees and there are various legal obligations which apply to trustees in relation to statements of investment principles, implementation statements, there are various obligations under the general code, and also reporting obligations under The Pension Schemes Act 2021, for schemes with assets of over a billion pounds.
 
And there’s real regulatory emphasis on trustees improving the quality of their policies and disclosures and moving away from boilerplate wording and ensuring that action follows intent. The Regulator observed that for too long too few trustees focused on climate ESG and wider sustainability issues in any significant detail, but trustees can no longer ignore what The Regulator calls ‘the elephant in the room’. So I think we’re really moving away from ESG disclosures being seen as a tick box exercise and rather that decisions, reports rather, should be decision useful and drive action.
 
And I think another important thing to remember is, although that the trustees will have advisors to support them, they do retain overall responsibility for their disclosures and understanding it themselves.
Chris
Yeah I think they’re really good points. So it’s clear that there are good reasons, sort of, in practice, in reality, just thinking about the world we live in, why trustees want to think about environmental factors ESG, also good reasons under industry guidance, under regulation, and under law for trustees to be really engaging in this area I suppose. Kate, I suppose one thought is, how do trustees’ duties around thinking about ESG factors, how does that match up with their fiduciary duties? So I suppose, say trustees are thinking about an investment decision to what extent does complying with, or making the right choice from an ESG perspective, whatever that might be, is that consistent with applying a trustees fiduciary duties? So Kate, can you start by telling us what a trustees fiduciary duties actually are?
Kate
The first challenge Chris, is that defining fiduciary duties is actually quite difficult. They’re quite difficult to distil. They’ve evolved from case law over the years so they can be defined differently depending on what source you go to. If we go back to basics a fiduciary duty arises as soon as a person is entrusted to manage another person’s property and to make discretionary decisions on that other person’s behalf. So such decisions can include investment decisions and that’s the case for pension scheme trustees.
 
In a pension schemes context, a key aspect of being a fiduciary are said to be a duty to be loyal to members, that is to act in their interest, to avoid conflicts of interest and not to profit without authority. Now an analysis of the case law is beyond the scope of this podcast, I think it would take a long time, but in summary we do have a couple of important industry papers that do help us. The first is the law commission’s 2014 report on the fiduciary duties of investment intermediaries. Which concludes, that in pensions the purpose of the investment power is usually to provide a pension, therefore the primary aim of the investment strategy is to secure the best realistic return over the long term, but given the need to control for risks.
 
So the report draws a distinction between financial and non-financial factors that can be taken into account by trustees. And financial factors are any factors which are relevant to a trustees primary investment duty of balancing returns against risks, and these can include ESG factors.
Chris
So what you’ve got then is useful guidance there that is telling trustees that risks matter as much as returns in investment decisions. Okay, and has there been more recent guidance too Kate?
Kate
Well yes, it’s actually a year on now since we had the report by the financial markets law committee and this report has been widely praised in the industry as being a helpful explanation of the position when it comes to pension trustees fiduciary duties. And what the report does is recognise that financial factors can be very broad and that many ESG factors will, when they’re properly understood, be financial and indeed can be systemic risks, such as climate risks.
 
With regards to systemic risks, it’s unlikely the diversification of a portfolio would be enough on its own to avoid all the risks in the way that it would mitigate against non-systemic risks. And furthermore financial factors need to be considered at a number of levels, so at the level of a specific asset or investment at portfolio level and at the level of whole economies material to the pension fund. Given the global context of most schemes investment portfolios issues of sustainability, governance, and climate change will undoubtedly have financial implications for beneficiary.
 
So in other words, properly construed ESG factors are often financial factors and as such may need to be considered by trustees as a matter of course. Now I’d really encourage our listeners to read the whole report which is very accessible for full details as this is really very much a summary of some of the points.
Chris
Yeah thanks Kate, that’s really super helpful. James, wonder if we could put a similar question to you please? So how are you seeing that trustees are making decisions in light of their fiduciary duties?
James
Yeah thanks Kate, that’s really super helpful. James, wonder if we could put a similar question to you please? So how are you seeing that trustees are making decisions in light of their fiduciary duties? If you are doing training on it, make sure they cover things like carbon budgets and tipping points because they’re central to this but you very rarely hear about them, the media does not cover them well. So if you don’t know about things like tipping points, you may underestimate the problem.
 
Step two is action, what actions are right for your scheme? And a useful tip here is to distinguish between the risk to you and your scheme on the one hand, and on the other the impact your scheme has on the world. So if we take those two in turn. Risk is the effect that ESG and things like climate have on your scheme, so for example if you own a factory somewhere and there’s a wildfire it burns down your asset goes to zero. Pension schemes are used to weighing up risk and return, right, when making investment decisions so there’s no barrier there but it is just a good prompt to remember the message that you were saying a minute ago Kate that risks matter as well as returns, it’s not just about maximizing returns. So all schemes should be thinking about the risk here.
 
The other aspect is the impact your scheme can have on the world. You hear about the question of, can you invest in a way that aims to improve environmental and social issues? And then it becomes more interesting, that brings the fiduciary duty question into much sharper focus.
Chris
Yeah.
James
So a good place to start here is for each trustee board, agree what your mission is, what are you aiming for? So are you just focused on paying the benefits as they fall due, you know which is obviously central to running a pension scheme. But does your scope go beyond that and would you consider wider considerations, such as how long your members live, and the quality of the world that they live in? So they’re interesting conversations to have around the table and the answers we’re finding are unique to each scheme because you got different people in the room, different scheme rules, different scheme circumstances.
Chris
And this is- I think Kate said earlier, rightly, that we haven’t got enough time on this podcast to do a summary of all the case law around trustees duties. Yeah. But if I just jump in with one, this makes me think that the sorts of things that you’re suggesting there that trustees think about, are sort of almost a moral obligation to think about, what’s morally right for beneficiaries of a scheme and it reminds me of that case from the 1880s re Whiteley.
 
So we’re talking about ESG environment in the context of investment, of course it’s much wider than that, but in terms of investment duties, re Whiteley, an old case, says that trustees should exercise their investment powers prudently. Not as prudently as an ordinary, you know, person of business would invest, you know sort of an ordinarily prudent person of business, how prudent they would invest. But more prudent than that, as if they were morally bound to provide for beneficiaries and I just mention that because I think the wider considerations you’re mentioning there, you know, they make me think of that moral duty that trustees have.
James
Yeah, and it’s an interesting question. Are you- do you have that moral duty within scope? And investing for impact doesn’t have to only be, there might be a number of reasons why trustees are investing for impact because this thing how the whole system copes and where it goes affects, you know, beta in terms of returns and there’s a systemic risk here. So yeah, it’s you know moral duty potentially from a risk and return angle and this concept of universal owners. So I think just, for each trustee board just have these conversations about what you’re aiming for and why. Make sure the legal advisors are in the room and that you’re making decisions in the right way, you know, proper purpose of the trust.
Chris
Yeah.
James
But yeah, if you can have these conversations and work out what you’re aiming for, it then will guide you as to what actions are right for your scheme. And obviously Chris, in practice some decisions might be expected to improve risk and return and have a positive impact on the world so that’s a win-win.
Chris
Yeah, yeah.
James
That’s an easy one. Where it gets more fun is where there’s potentially a trade off, but like I said even then it’s not black and white. You know, you’ve got to think about-
Chris
and scheme circumstances come into it don’t they?
James
Yeah, yeah. So for example, funding levels have improved recently so some very well funded schemes may feel they’ve got more license.
Chris
Yeah more latitude.
James
Yeah, for impact. There was a really good meeting with a client last week and they talked about kind of concentric circles. Firstly we want to pay benefits as they fall due, and then we would like to kind of improve member outcomes, like how long people live and then the quality of the world they live in. So yeah, it’s not black and white. But we know that some schemes are investing for impact and they’ve gone on record saying that, so fiduciary duty isn’t a barrier here necessarily you just need to make sure you’re making decisions in the right way. Yeah.
Kate
And I agree with you that you can have this win-win situation as well and the paper, the FMLC paper, did touch on this too. It said that financial factors may at the same time be factors that go to a beneficiary’s quality of life. So I would agree with you on that, and also the point you made that is all going to be very scheme specific as well and there’s not just a one answer and that schemes have to look at their particular circumstances and take advice and keep that audit trail that you mentioned as well James.
James
Yeah, no you’re right Kate, this is unique to each scheme. And the final point I’d make on this is that as well as the FMLC paper last February, February 2024, there was the Work and Pensions Committee hearings, where they take evidence on this and is a change to the law needed? So we are expecting and hoping for more guidance from DWP and/or The Regulator to help pension scheme trustees in this space. So yeah, more to come on that and watch this space.
Chris
Yeah, so lots for trustees to be thinking about now but there’s more to come. Both, Kate, I’ll come to you first if that’s okay? What are final thoughts from you both and thinking about, you know, what do trustees need to be thinking about here?
Kate
Well I would agree with what James has said and that trustees need to make sure they’re conversant with their requirements in this area.
Chris
That education piece.
Kate
That education piece is really important, don’t be intimidated by ESG, but yeah get the training that you need. We can provide a general code checklist which summarizes the requirements of the general code in this area and of course our tool could help as well. Again just going back to the fact that ESG shouldn’t be a tick box exercise, but ensure that trustees are producing quality disclosures which become embedded in their scheme governments. An area to watch could be green washing. This is something that isn’t just affecting pension schemes, but organizations and corporates generally. So trustees need to consider how accurate is the information that they are receiving and the information that they are publishing as well.
James
That education piece is really important, don’t be intimidated by ESG, but yeah get the training that you need. We can provide a general code checklist which summarizes the requirements of the general code in this area and of course our tool could help as well. Again just going back to the fact that ESG shouldn’t be a tick box exercise, but ensure that trustees are producing quality disclosures which become embedded in their scheme governments. An area to watch could be green washing. This is something that isn’t just affecting pension schemes, but organizations and corporates generally. So trustees need to consider how accurate is the information that they are receiving and the information that they are publishing as well.
Chris
Yeah thanks James, real sobering point there.
 
James it’s been a pleasure to have you on with us I think we’ll finish the podcast with you please. Could you give our listeners three key takeaways when thinking about the ‘E’ in ESG?
James
Yeah, thanks so much Chris. Three key takeaways. Number one, understand the fundamentals of ESG topics like climate change, often the devil is in the detail here. Number two, distinguish between risk to your scheme on the one hand and impact your scheme has on the world, and decide what you’re aiming for, what is your mission? And then finally, on the fiduciary duty point, I’d echo Kate’s points. The FMLC paper is really good, so print and read a copy of that. There’s lots of good nuance points in there and it’s only around 10 pages so it is an accessible reference point, you know, you can read it on the train on the way to the trustee meeting. So yeah, they’re my three takeaways, that’s all from me.
Chris
Thanks James, and Kate, that’s really helpful. I think some- I mean we’ve only really scratched the surface haven’t we of a discussion that we could be having just on the ‘E’ of ESG, let alone the whole area. But I think that’s really helpful and nice to finish there, James, on a practical step that trustees can do in the short term. Print the 10-page paper and read it on the train. So thanks ever so much to the both of you for coming on. [Music]
 
Well, that’s the end of season five of The Burges Salmon Pensions Pod, been delighted to have completed our fifth season so thank you to everyone for listening. If you’d like to know more about our Pensions and Lifetime Savings team and how our experts can work with you then you can contact myself, Chris Brown, or any of our team via our website. And as we say every week, all of our previous episodes are available on Apple, Spotify, our website, or wherever you listen to your podcasts. Don’t forget to subscribe and thanks for listening. [Music]