Institutional investors must be careful when navigating the legal issues relating to environmental, social, and governance (ESG) factor integration, or they may risk running afoul of their fiduciary duties, according to a white paper from Randy Bauslaugh, a partner in the Canadian law firm McCarthy Tétrault, and Hendrik Garz of Sustainalytics, a provider of ESG research.
Bauslaugh and Garz write that ESG is often confused with socially responsible investing (SRI) by institutional investors. They said the purpose of ESG factor integration is to improve financial performance or mitigate financial risk, not stop climate change, improve workplace diversity, or end child labor.
“This confusion has professional and reputational implications for actuarial and other firms that advise pension funds,” they wrote, “since actuaries are often the primary point of contact for many pension funds.”
The paper said that from a legal perspective, other non-economic goals or aspirations are at best distractions, and at worst are departures from proper fiduciary behavior.
“If ESG factors are not financial factors, then they cannot be advancing the primary purpose of a pension plan, which in most jurisdictions will be to provide financial benefits in the form of lifetime retirement income,” said the paper. “If the ‘non-financial’ factors are not relevant to providing financial benefits, they shouldn’t be considered, except in extremely well-defined and exceptional situations.”
The paper highlighted the main legal issues relating to ESG factor integration, and provided some insight into the current state of ESG analytics in order to provide some practical guidance for actuaries.
“The starting point for investment management in many jurisdictions is developing a written investment policy to guide prudent management,” said the paper. “Increasingly, that written policy must expressly disclose whether ESG factors are considered, and if so how.”
The paper attempts to distinguish ESG from SRI, and said that legislation, regulatory guidance, and statements from agencies such as the United Nations blur the distinctions between the two. It said a major barrier to understanding the legal obligation of plan fiduciaries relating to ESG factor integration is the confusing language that “shades the boundary between taking into account financially relevant ESG factors on the one hand and promoting ethical or social behavior for its own sake on the other.”
Bauslaugh and Garz write that the purpose of ESG integration from a fiduciary perspective should be to take into account any and all financially material risks and opportunities that arise out of environmental, social, and governance information. They said it is not about achieving particular environmental, social, or governance goals—that is the purpose of SRI, and may not be consistent with fiduciary duties.
“A bit of understanding can help actuaries better assist fiduciaries (trustees) to avoid making statements or disclosures about ESG investment practices that could provide proof they don’t understand their fiduciary duty or, worse, that they are in breach of it,” said the paper. “After all, written investment policies and other disclosures are evidence.”