A look at the latest legal issues around ESG investing

Read: UPP climate action plan establishes 2040 net-zero portfolio target

In July 2022, the UPP unveiled a new climate strategy that aims to make its portfolio carbon neutral by 2040. The plan also established two interim targets, with the UPP aiming to reduce its total portfolio emissions by 16.5 per cent of its 2021 baseline by 2025 and by 60 per cent by 2030. However, while ESG factors such as sustainability have risen to the forefront of the pension fund’s investment strategy, the outcomes expected by plan members remains the key focus.

“We’re trying to make sure we can earn the returns to pay that pension over the long term,” says Minns. “From a bottom-up perspective, we look at incorporating financial material and ESG information into how we manage our investments, while the top-down view is ensuring we have the environmental, social and financial systems in place to deliver on those investment returns over the very long term.”

It’s this focus on plan members that shapes much of a pension fund’s fiduciary duty regarding ESG factors.

Fiduciary duty

When considering an investment, the UPP closely evaluates the approach investment managers are taking when it comes to integrating ESG factors into their investment decisions. “We’re always looking for evidence of action,” says Minns. “If an investment manager states they’ll engage companies in their portfolios in a dialogue around material ESG risks, we’re looking for evidence that they’ve actually engaged in those dialogues. In particular, we’re looking for evidence they’ve identified a gap where they’ve advocated for better disclosure or practices around sustainability issues.”

Read: Report urges pension plan fiduciaries to focus on finance when considering ESG factors

From a legal perspective, Jordan Fremont, a partner in the pensions and benefits team at Bennett Jones LLP, says the law around ESG considerations is clear. “The primary purpose of pension plans is to provide retirement income — that’s a fundamental principle that guides the duties and responsibilities of the pension plan administrator. A plan administrator is a fiduciary and has a duty to identify relevant risks and opportunities as they relate to the plan generally.”

For some plan sponsors, ESG may translate to avoiding investments in certain industries, such as tobacco or weapons. However, this process isn’t as simple as pulling money out of investments based on moral or ethical reasons, says Kathy Bush, a partner at Blake, Cassels & Graydon LLP, noting any such change must consider the financial impact on the plan and its members.

“Where some plans struggle is when they don’t want to invest in X, Y or Z. They can’t really do that. The short answer is they need an economic case for not doing that. They can’t just say ‘I don’t like guns’ or ‘I don’t like nuclear [power].’ The case law isn’t any different in Canada, the U.K. or the U.S. The lawyers get to say the easy thing — ‘just do it in the best financial interest of the plan members’ — but it’s harder for the plan sponsor to actually do.”

Provincial and federal legislation

The federal government’s 2022 budget introduced a new requirement for federally regulated pension plans to disclose ESG considerations, including climate-related risks. And in May, the Office of the Superintendent of Financial Institutions published a draft climate risk management guideline for federally regulated financial institutions. The final version of the guideline is expected in early 2023.

Read: ACPM advises CAPSA against one-size-fits-all approach to ESG, cybersecurity risk management

At the provincial level, only Manitoba and Ontario have regulations around pension plan sponsors’ ESG considerations and disclosures. However, by blurring the distinction between material ESG factors and ethical behaviours, the language around ESG in both provinces’ rules has proven confusing to pension plan administrators, says Christine Girvan, head of distribution in Canada for MFS Investment Management.

“[The Ontario ESG legislation] basically said, ‘If you don’t like ESG, just say it.’ But the problem is that ESG factors are material to the investment return of your plan, so you should probably ensure they’re integrated in your approach.”

The CAPSA’s ESG guidelines

Last summer, the Canadian Association of Pension Supervisory Authorities released a draft guideline on risk management and ESG considerations.

The guideline aims to help clarify the current provincial and incoming federal legislation around ESG, particularly the issue of financial materiality, says Girvan. “[The guideline] spells out the fact that ESG factors that are material to the risk/return profile of pension assets should be considered by plan administrators. It’s anchoring ESG into that fiduciary duty and financial materiality. It does a good job of telling investors what they should consider, so it’s a good step in the right direction.”

Read: CAPSA’s risk management guideline committee seeking members for industry working group

However, in an open letter to the CAPSA, the Association of Canadian Pension Management suggested the guideline should take a less prescriptive method, noting a one-size-fits-all approach to ESG regulation could potentially place a significant burden on the administrators of small pension plans, defined contribution pensions or plans with a limited ability to control or influence their asset manager’s implementation of a desired ESG approach.

And while the proposed ESG guideline addresses the concept of pension plan proportionality, the ACPM said it should specify multiple factors, including complexity, governance structure, plan administrators’ corporate sustainability strategy, plan size and resources.

Greenwashing concerns

Under current Canadian securities legislation, public companies aren’t required to disclose ESG practices.

However, earlier this year, the Canadian Securities Administrators issued a guideline for ESG disclosure practices for investment funds, in part to address concerns around greenwashing. With a plethora of investment options to choose from, plan sponsors face the challenge of distinguishing funds that truly embody ESG from those that merely bear the label.

Read: CFA’s ESG standards could facilitate greenwashing, warns IFIC

“Greenwashing is a real concern for investors and it’s really about knowing what you want in your portfolio,” says Girvan. “If you think about a product in the supermarket, if you want to know what’s in there, you don’t just look at the label: you turn it around and look at the ingredients. That’s the challenge investors face with some of these products — it’s just a label. As we look at investments, there’s a lot of securities making ESG claims and it’s our job to ask questions.”

While regulators are trying to be helpful by issuing guidance, it can sometimes come across as heavy handed when it comes to implementation by pension plan sponsors, says Fremont. “Two reasonable people can come up with different views on these issues. It’s about a plan administrator determining for itself its philosophy on ESG, as well as how other factors can impact performance and risk.”

Requirements for increased ESG reporting can be helpful to pension plan sponsors investing in these funds, says Bush, but she notes data collection remains a challenge. “For example, if we look at governance, bad governance — whether at the political level, the corporate level or the individual fund level — may result in bad returns and something may be said for that. But you need the analysis, the underlying data to prove that the ‘G’ caused that. It’s similar for the ‘S.’ When there’s more reporting — and more granular reporting — it will be easier to figure out whether it’s a bad economic investment or not. Right now, it’s really difficult.”

Read: CIA advising CAPSA to consider pension plan liabilities, climate disclosure in ESG risk management guideline

She adds smaller pension plans face several challenges in reporting ESG disclosures, due to fewer resources and the nature of their investments. “[The big DB plans] have the ability to be activists or engaged investors, but many [DB] plans in Canada are buying funds and aren’t all that different from DC plans — they don’t have much control and they only get certain information. In direct investment, pensions have more ability to dig down to get more information than in a fund. The nature of funds is that they have multiple investments and you’re relying on the reporting of each of those underlying investments.”

Canada vs the world

Similar to Canada, the U.S. has seen an increased focus on ESG legislation. In May 2022, the U.S. Securities and Exchange Commission proposed amendments to enhance regulations around investment funds’ ESG disclosures.

Whitney Sweeney, investment director for sustainability at Schroders, says while the CAPSA’s guideline provides pension plan administrators with some clarity regarding the integration and consideration of ESG factors, the SEC’s proposed amendments aren’t as clear.

“What’s interesting about CAPSA is there’s a piece in there that states you might not be performing your fiduciary duty if you don’t consider the financial and material ESG factors. In the U.S., there’s still a lot of ambiguity from the Department of Labor and the Employee Retirement Income Security Act as to what you can and can’t consider [from an ESG standpoint].”

Read: Survey finds fewer U.S. institutional investors incorporating ESG into investment decisions

North America is still catching up to the European Union, which, over the last decade, has tackled ESG disclosure from the perspective of moving towards a sustainable economy, she adds, noting there are lessons to be learned from the E.U.’s approach.

“It’s very black and white in the E.U. — companies are either good or bad [from an ESG perspective] — but it’s important to consider that transition phase because that’s the only way we get to a sustainable economy. There’s also the order of disclosure — right now, companies aren’t disclosing, but funds are having to disclose on the companies they own.

“There’s a real need to understand, articulate and report what’s being done in funds and strategies. Anything we can see from a reporting or disclosure standpoint that provides additional transparency to investors, so they know and understand what they’re buying, would go a long way.”

Blake Wolfe is the managing editor of Benefits Canada.