Greening Finance: embedding sustainability in financial decision making Contents

2Pension saving & environmental risk

15.Considering climate change risk from the perspective of pension regulation is especially important given the long time-scales involved in pension saving and the huge sums of money controlled by pension funds. There are many hundreds of billions of pounds in UK pension schemes and these ‘asset owners’ sit at the top of the investment chain. The UK Sustainable Investment and Finance Association (UKSIF) argued that these ‘sleeping giants’ often ‘do not realise the financial power they wield’.24 Ensuring that these funds manage environmental risks effectively could assist in the transition to a low carbon economy and reduce the UK’s overall exposure to climate risk. However, only 5% of 1,241 European Pensions schemes have considered the investment risk posed by climate change, according to the consultancy firm Mercer’s 2017 European Asset Allocation Report.25

Influence of asset owners

16.As part of this inquiry we looked at two core issues affecting how pension funds manage environmental risks like climate change:

The interpretation of fiduciary duty
How pension funds could be engaging with their beneficiaries on sustainability

We also wrote to the 25 largest UK pension funds, responsible for some £550bn of long term investments, to seek evidence as to how climate change risk was—or was not—incorporated into these investors’ long-term investment decision-making.26 We will discuss the responses in the context of recommendations on climate-related financial disclosures in Chapter Three.

Pension saving in the UK

17.More people are saving for retirement through workplace pension schemes than ever before.27 Since the Pensions Act 2008, employers have been required to auto-enrol all employees aged between 22 and the state pension age and who earn over £10,000 a year into a work pension scheme.28 By 2016, 78% of eligible employees (16.2 million people) were participating in a workplace pension, up from 55% of eligible employees (10.7 million) in 2012.29

18.There are two main types of workplace pension:

Defined benefit (DB) scheme: In DB schemes, the employer guarantees scheme members a certain income on retirement, often expressed as a percentage of their final or average salary.
Defined contribution (DC) scheme: In DC schemes, the saver’s income on retirement depends on the performance of the pension fund investments. The saver, rather than the employer, takes the risk that the investments may not perform well.30

19.As well as the distinction between DB and DC schemes, pension arrangements can be further categorised as either being set up through a trust structure or based on a contract. DB schemes are set up as trust-based schemes. DC schemes can be set up either as trust-based or as contract-based schemes run by personal pension providers. This further distinction is a matter of legal form and does not impact the pension saver’s return. However, the different types of scheme have distinct governance structures and are subject to different legal and regulatory regimes:

Trust based schemes. The Department for Work and Pensions (DWP) sets the rules for trust-based schemes, which are overseen by a board of trustees and regulated by the Pensions Regulator (tPR).
Contract-based schemes. The Financial Conduct Authority (FCA) regulates contract-based schemes because they are typically provided by insurance companies.31

Trust-based and contract-based schemes are governed by different sources of law and there are differences in relation to how investment decisions are made and reviewed.32 In a contract-based pension scheme there are no trustees, but FCA rules require each provider to establish and maintain an independent governance committee which carries out an oversight role over workplace schemes operated by that provider, assessing value for money and how the provider has considered the policyholders’ interests.

The Pensions Regulator (tPR) is the public body that protects workplace pensions in the UK. It is responsible for outlining what employers and trustees governing schemes need to do. It also has a role in driving up standards of trusteeship across all schemes, particularly for chairs and professional trustees.

Financial Conduct Authority (FCA) is the conduct regulator for 56,000 financial services firms and financial markets in the UK and the prudential regulator for over 18,000 of those firms. It has three operational objectives: consumer protection; protecting & enhancing the integrity of the UK financial system, and; promoting effective competition in the markets for regulated financial services.

20.Since auto-enrolment was introduced the number of people saving in a contract-based defined contribution (DC) pension scheme through their workplace has overtaken the number saving in trust-based DC schemes. Meanwhile active membership of private sector DB pension schemes is in decline.33 The DWP described the changing pension market in its submission:

‘the two halves of the pensions market are converging, with personal pension schemes being used as workplace pensions for automatic enrolment, and multi-employer occupational pension schemes being established and run by traditional personal pension providers. Since the provider of a workplace pension might equally well be a personal pension provider regulated by the FCA or an occupational scheme regulated by The Pensions Regulator, there is an argument for continued harmonisation of legislation, and increased collaboration between these bodies.’34

Interpretation of fiduciary duty

Fiduciary duty refers to the responsibility that company directors or pension fund trustees have to exercise their responsibilities in the best interests of their company or ‘beneficiaries’. In law, a ‘fiduciary’ owes a duty of loyalty to others arising from the role the fiduciary holds, and the context in which they hold it. That role may give rise to other legal duties which sit alongside the fiduciary duty. For pension fund trustees, these duties will generally be to the pension savers who are members of the scheme. For UK companies, directors’ duties—including fiduciary duties—are owed to the company (primarily to shareholders, but having regard to a range of other factors including employees’ interests).

21.Evidence we considered during the inquiry suggested that fiduciary duty is often misinterpreted as a duty to maximise short-term returns and that this could be particularly problematic when it came to the management of long term pension funds.35 The UK Sustainable Investment and Finance Association (UKSIF) said that ‘lingering confusion’ meant some parts of the investment chain interpreted fiduciary duty ‘very narrowly’ as a requirement for ‘investors to maximise short-term returns over consideration of factors which may be material over the longer-term’.36 UKSIF says that:

‘Fiduciary duty means acting in the best interests of beneficiaries, who will have, given the nature of pensions, long-term investment horizons. The integration of financially material environmental, social and governance (ESG) issues into investment decisions and robust stewardship policies can help reduce investment risk and enhance returns, yet misconceptions remain around the legality of consideration of these factors.’37

22.We asked the National Employment Savings Trust (NEST), which is the body set up by the Government to provide a default pension service for employers, about this. Its Head of Responsible Investment, Diandra Soobiah told us:

‘ … all the evidence points to climate change being a big economic risk in the future, but when I have made presentations on our climate-aware fund I still have questions from members of the audience asking, “How do you square this with your fiduciary duty?” and numerous times throughout that presentation I have said, “This is about managing material financial risk for our members in the long-term” and I cannot emphasise that point any more than I already have. I have given them examples of how we are moving more into these companies that are instrumental in the transitioning to a low carbon economy and generating renewable energy. These are the companies that are going to be generating value in the long-term and members are going to be benefiting from that in the long-term so this is about financial value.’38

Short-term vs long-term returns

23.Evidence to the inquiry suggested that the misunderstanding of fiduciary duty was compounded by the structure of short-term incentives noted in Chapter One. As Aviva explained:

‘Pension funds often rely on the advice of investment consultants when allocating capital. This gives investment consultants considerable influence over capital allocation. However, their fee and incentive structures too often drive a short-term outlook that overlooks long term sustainability considerations.’39

24.ShareAction outlined how the pursuit of short-term returns by the fund managers and consultants could undermine long-term value creation for pension savers:

‘Misalignment of interests across the investment chain is particularly problematic in the pensions system, where the majority of pension savers have a long-term perspective, but their agents (pension funds and their investment managers) operate on shorter time horizons driven by market practice. For example, a 25 year old saving for their pension has an investment horizon of 40 years, but pension fund investors say they stay invested on average for a little more than four and a half years. 22% of funds say they have a time horizon of five to 10 years, but 51% of funds have a time frame of five years or less, with 8% of these having a time horizon of just six to 12 months. 20% of funds say they have no specific timeframe for holding investments. To put this in context, a timeframe of five years is usually suggested as the minimum for equity market investment, on the basis this allows investors to experience the ups and downs of a normal market cycle.’40

Law Commission findings on fiduciary duty

25.In 2014, the Law Commission published a report on The Fiduciary Duties of Investment Intermediaries which found that, under the existing law, pension trustees are legally required to take into account factors which are financially material to risks or returns when making investment decisions, regardless of whether or not those factors might sometimes be considered to be environmental, social and governance (ESG) factors.41 On 23 June 2017, the Law Commission published a further report on Pension Funds and Social Investment.42 It found there are no substantive regulatory barriers to making social impact investment by pensions funds. Most of the barriers are in fact structural and behavioural, including the need for clearer legislation and guidance. The Law Commission argued that the conflation of ‘social, environmental or ethical considerations’ is confusing. It says that environmental, social and governance factors can in some cases be considered material risks and as such are financial factors. ‘This is very different from specifically “ethical” considerations, such as a decision not to invest in or withdraw investment from an industry to show ethical disapproval.’43

Disparity on guidance for trust & contract-based pension schemes

26.Following the Law Commission recommendations, the Pension Regulator (tPR) published updated guidance in July 2016 on investment by Defined Contribution (DC) schemes and in March 2017 on Defined Benefit (DB) schemes. This clarified that trustees are required to take into account factors that are financially material to investment performance, including environmental, social and governance factors. However, the FCA did not publish similar clarifying guidance for personal pension providers governing the contract-based pension schemes, which it regulates. We heard concerns that this has left a disparity in the guidance to trust-based DB and DC schemes (regulated by the Pensions Regulator) and contract-based DC schemes (overseen by the Financial Conduct Authority) when it comes to their duty to consider longer-term environmental risks as a financial factor.44 It was argued that the FCA should issue guidance for contract-based schemes in line with the Law Commission’s recommendations, as the Pensions Regulator has already done for trust based DB and DC schemes.45

27.The UK Sustainable Investment and Finance Association (UKSIF) criticised the ‘reticent’ approach of the FCA on sustainable investment issues. Its evidence highlighted that the Law Commission had recommended ‘for the second time in 3 years’ that the Government clarify fiduciary duties for trustees by making it clear that consideration of ESG factors is compatible with trustees’ fiduciary duty and, where financially material, to ignore such factors would breach that duty.46 UKSIF says:

‘the Law Commission also recommended the FCA introduce equivalent rules on the contract side of the market, which has seen rapid growth since the introduction of automatic enrolment. We strongly welcome the recent DWP announcement that it is “minded” to make such changes and will consider how to implement the recommendations in consultation with the sector. We are confident it will introduce appropriate new rules which will require trust-based pension schemes to take account of, for instance, the financial risks associated with climate change. […] DWP and the FCA have said in the past they want outcomes for pension scheme members in trust-based and contract-based schemes to be the same, and it is difficult to see how this would be the case should the FCA fail to introduce equivalent measures.’47

28.ClientEarth said it was concerned by the delayed response from the Financial Conduct Authority to the Law Commission’s recommendations for contract-based pension schemes. It says the FCA should urgently address the recommendations drawn to its attention. In its submission, the DWP notes the disparity between the guidance for trust and contract-based pension funds on managing environmental risks and says:

‘as the FCA is an independent regulator and not sponsored by the DWP it therefore would not be appropriate for us to comment on whether or when the FCA should accept the Law Commission’s recommendations and harmonise its own rules.’48

29.In January 2018, the Pensions Regulator and the Financial Conduct Authority published a joint statement announcing that they will working together on ‘a pensions regulatory strategy, which will set out how we will work together to tackle the key risks facing the pensions sector in the next five to ten years’.49 The regulators say this work will also be informed by the FCA’s research and tPR’s ongoing ‘TPR Future’ programme, and the Department for Work and Pensions’ review of automatic enrolment.

Clarifying the law on fiduciary duty

30.In response to the Law Commission’s 2017 report on ‘Pension Funds and Social Investment’, the Department for Work and Pensions (DWP) announced that it was ‘minded’ to accept some of the recommendations.50 It has committed to consult on changes to policy and regulations during 2018 and bring forward legislation—subject to the outcome of the consultation—that clarifies trustee duties in respect of financially material environmental risks as well as the ability of schemes to give weight to members’ non-financial and ethical concerns.51 This consultation is expected to be announced in June.

31.We heard multiple calls for the scope of fiduciary duty to be clarified in law by the Government.52 The Principles for Responsible Investment (PRI), an international NGO working to promote sustainable investment practices, said that the Department for Work and Pensions should amend the Investment Regulations to clarify that fiduciary duty requires pension trustees to pay attention to long-term factors—such as climate change—in their decision making and the decision making of their agents.53

32.In its submission, the Department for Work and Pensions acknowledged that recent research showed that misunderstanding of fiduciary duty remains ‘widespread’, although it noted that there is ‘relatively little robust research’ on the interpretation of fiduciary duty. It said:

‘We hoped that the publication of guidance on this point by The Pensions Regulator would address trustee confusion about their duties. However, recent research has suggested that a lack of attention and outright misunderstanding remain widespread among Trustees.’ […] ‘Whilst there are clearly trustees who understand the issues, are actively engaging with them and are reviewing and where necessary amending their investment strategies accordingly, good practice appears to be far from universal.’54

The DWP added that:

‘Given that there is a broad scientific and public policy consensus that climate change is [a material] risk, then trustees already have a duty to take account of it.’55

33.On 8 March 2018, the European Commission published its action plan on sustainable finance intended to reorient capital flows towards sustainable investment, manage financial risks from climate change and foster transparency and long-termism in financial and economic activity. As part of this strategy, the Commission has pledged to table a legislative proposal to clarify institutional investors’ and asset managers’ duties in relation to sustainability considerations by mid 2018, subject to an impact assessment. The proposal will aim to (i) explicitly require institutional investors and asset managers to integrate sustainability considerations in the investment decision-making process and (ii) increase transparency towards end-investors on how they integrate such sustainability factors in their investment decisions, in particular as concerns their exposure to sustainability risks.56

34.Considering climate change risk from the perspective of pension regulation is especially important given the long timescales involved and the many hundreds of billions of pounds in UK pension schemes. Pension fund trustees have a fiduciary duty to act in the best interests of their beneficiaries. This include taking account of long-term risks, such as those arising from climate change. Although we heard examples of good practice during the inquiry, the Government also admitted in its evidence that there is widespread misunderstanding amongst trustees on the scope of their fiduciary duty in relation to environmental risks.

35.We were deeply concerned to hear how structural incentives also promote the pursuit of short term returns by investment managers acting on behalf of pension funds, often leading to the neglect of longer-term considerations—including environmental sustainability and climate change-related risks and opportunities. The Government should clarify in law that pension schemes and company directors have a duty to protect long-term value and should be considering environmental risks in light of this.

36.A worrying disparity currently exists in the guidance to trust-based pension schemes (regulated by the Pensions Regulator) and contract-based schemes (overseen by the Financial Conduct Authority) when it comes to considering environmental risk as a financial factor. This is the result of the FCA’s apparent reluctance to act on the Law Commission’s recommendations on clarifying the duty of contract-based schemes in relation to environmental, social and governance factors. The FCA should rectify this by the end of the year.

Giving pension savers a say on sustainability

37.There is evidence that demand for sustainable investment is growing, with young people driving this trend. In 2017 40% of those surveyed in an annual YouGov poll for ‘Good Money Week’ wanted a ‘fossil fuel free’ pension option, up from 35% in 2016 and 32% in 2015. In the 2017 poll, over half of 18 to 34-years-olds (54%) said they would like to be offered fossil free investments as standard, compared to the national average of 40%, and only 34% of those over 55. Overall, 57% of the UK public with a pension believe investment managers have a responsibility to ensure holdings are managed in a way that is positive for society and the environment, according to the survey.57

38.According to the Law Commission, pension trustees are legally able to take environmental or social impacts of an investment into account in certain circumstances even if they are not considered a financial risk. It points out that trustees of a scheme may favour investments with a positive environmental or social impact or avoid investments deemed to have a negative impact if they pass two tests taken from case law:58 Trustees or governance committees must:

Have good reason to think that scheme members would share their concerns; and
The decision should not involve a risk of significant financial detriment to the fund.

39.According to the Law Commission, having ‘good reason’ to think that scheme members hold a concern does not necessarily require survey evidence. In some cases trustees may be able to make assumptions. The Law Commission gives the example of the manufacture of cluster bombs, which was banned by the 2008 Convention on Cluster Munitions. Trustees may reasonably assume that most people would consider investing in their manufacture to be wrong. In other cases, the Law Commission says it may be necessary to consult members more formally.59

Statement of Investment Principles

40.Trust-based pension schemes are required under the Pensions Act 1995 and Investment Regulations to produce a ‘statement of investment principles’ (SIP) setting out their investment policies. Among other things, the SIP must include a statement of the trustees’ policy on the extent to which social, environmental or ethical considerations are taken into account in the selection and retention of investments.

41.Trustees of occupational schemes have a duty to consult the sponsoring employer on their SIP60 and must provide a copy of the SIP if beneficiaries request it. However, we were surprised to discover during the inquiry that there is no requirement for pension fund trustees to engage with beneficiaries when devising their Statement of Investment Principles (SIP), or for other governance bodies to act similarly. Nor is there even a requirement to communicate the SIP to beneficiaries once it is completed. In its submission, Aviva recommends that the UK Government should require fiduciaries to actively seek the views of their beneficiaries so that these can be reflected in investment decisions.

42.The Department for Work and Pensions said in its submission that it wants pension savers ‘to have their say on where their money is invested’.61 It will be launching a consultation in June 2018 on how pension savers could be given more of a say over how their money is invested and set out in its letter to us some of the options it is considering including in the consultation:

requiring trustees to evaluate not just how they intend to take account of financially material risks but, when they revisit their Statement of Investment Principles, to review how they ensured those considerations were taken into account;
specifically highlighting particular considerations, such as climate change or corporate governance, for which trustees are required to have a particular policy;
requiring trustees to publish the statement of investment principles, or make it available to all on request, and to tell members that the Statement of Investment Principles is available.62

43.The Government says it support the Law Commission’s view that trustees should consider members’ ethical concerns and act on them where they have good reason to think that members share the concern and it does not involve a risk of significant financial detriment. However, the DWP raised concerns about ‘ethical’ investment decisions being made solely on the basis of self-selecting surveys:

‘The Department is actively considering how best to achieve this in practice. For example, it is noteworthy that trustees of occupational schemes have a duty to consult the sponsoring employer on their Statement of Investment Principles, but there is no equivalent duty to consult with scheme beneficiaries. Nevertheless, we are mindful that trustees’ duties are to their whole membership. The Pensions Regulator’s DC guidance makes clear that it is appropriate for trustees to carry out beneficiary surveys where the sample group self-selects. However, a decision, on purely ethical grounds, to invest or divest in an asset on the basis of a low-response self-selecting member survey alone, would rarely be justified.’63

44.The European Commission’s action plan on sustainable finance proposes that institutional investors and investment managers should consult their beneficiaries on their sustainability preferences and reflect those in their investment decision-making—regardless of whether or not they are financially material.64 The plan states that:

‘institutional investors and asset managers do not sufficiently disclose to their clients if and how they consider these sustainability factors in their decision-making. End-investors may, therefore, not receive the full information they need, should they want to take into account sustainability-related issues in their investment decisions. As a result, investors do not sufficiently take into account the impact of sustainability risks when assessing the performance of their investments over time.’65

45.Pension savers should be given greater opportunities to engage with decisions about where their money is invested. There is evidence that younger generations would often prefer to see their money invested in a fossil fuel-free manner. They should be given the opportunity to express this preference.

46.In its forthcoming consultation the Department for Work and Pensions should propose a change in the law to require pension fund fiduciaries to actively seek the views of their beneficiaries when producing their Statement of Investment Principles or Investment Strategy Statements. The DWP must set out guidance on how to ensure that evidence of members’ views is gathered robustly.

24 UKSIF (GFI0002)

25 https://www.uk.mercer.com/newsroom/european-asset-allocation-report-2017-climate-change-risk.html

26 Letters to Pension Trustees on climate change risks (February 2018)

27 https://www.autoenrolment.co.uk/news/more-people-have-workplace-pensions

28 Law Commission, Pension Funds and Social Investment Summary (June 2017)

29 Department for Work and Pensions, Automatic enrolment review 2017 (December 2018)

30 Law Commission, Pension Funds and Social Investment Summary (June 2017)

31 https://www.fca.org.uk/firms/independent-governance-committees

32 Law Commission, Pension Funds and Social Investment Summary (June 2017)

33 Law Commission, Pension Funds and Social Investment Summary (June 2017)

34 Department for Work and Pensions (GFI0037)

35 Aviva (GFI002), ClientEarth (GFI0012), UKSIF (GFI0002), Q236