On January 1, 2016, an amendment to Ontario’s Pension Benefits Act requiring pension plans to disclose whether they incorporate environmental, social and governance (ESG) factors in their Statement of Investment Policies and Procedures (SIPP) came into effect. Although such requirements are recent in Canada, they have long existed in Europe. UK and Swedish pension funds imposed similar ESG disclosure back in 2000, Norwegian, Austrian and Belgian ones in 2004 and Italian in 2005, among others. France recently required all institutional investors not only to report on their integration of ESG criteria but also to account for all means they employ to help the transition of the country towards green energy. Following the debt crisis, Europe’s pressing challenge is to channel savings to long-term and sustainable needs. ESG criteria has lead the way.
Is Canada following the same trend? Probably.
The 2015 Canadian Responsible Investment Trends Report reveals that assets in Canada being managed with ESG criteria increased from $600 billion to more than $1 trillion in just two years. While signing the Paris agreement on climate change last April, Prime Minister Justin Trudeau explained: “That’s a trend that will continue to grow, and it’s one that represents a tremendous opportunity for Canada. One that we cannot – and will not – ignore.” Surveys confirm: millennials prioritize ESG values more than financial rewards.[i] Pushed by the profession and students, finance curriculum is consequently changing.[ii] In the top business schools of the world, sustainable finance, impact investing or social and environmental performance are now taught together with portfolio management, derivatives and private equity courses.
The goal is clear: giving today’s students the tools they will need to become the leaders of tomorrow.
The question is less about whether Canadian pension funds will have to factor ESG into their management – rather it’s about how they could convert these additional requests into opportunities. As their European counterparts, Canadian pension funds are likely to face new challenges, whether at the level of the portfolio, the profession or the society.
The changes they might expect are outlined below.
Impacts of ESG criteria on portfolio management
ESG disclosure often precludes a transformation of investment practices. It is extremely difficult for pension funds to explain to their beneficiaries that they do not care about the environmental and social impacts of their investments. An ESG disclosure law hence usually leads in the following years to an increase of ESG integration in investment practices. Accounting research has shown it for a long time: What you measure is what you get. This trend is reinforced by the fact that arguments according to which ESG criteria negatively impact financial performance are (almost) no longer topical in European pension funds. The conclusion of twenty years of research and hundreds of meta-analyses is clear: there is no negative impact, probably even a small positive one. By helping portfolio managers to identify companies more likely to succeed in the future, ESG criteria would indeed compensate for the reduction of the investment universe they imply.[iii]
Consequently, Canadian pension funds will probably leap-frog the performance debate – which was so central in Europe in the beginning of the 2000s – to directly land into the world of the most advanced ESG investment practices across all the asset classes. Carbon footprint, ESG ratings, green bonds, certified real estate and impact investing could rapidly expand in the country.
Sensing the opportunity, European asset management companies are now launching their ESG products overseas. When faced with this new offering, Canadian investors will certainly have to rapidly increase their ESG competencies to grow in autonomy and adapt their management to the national features of their funds – the very needs business schools try to anticipate. But contrary to what one could expect from such a transformation, understanding the ESG techniques is often not the most difficult part of the process.
ESG criteria indeed bear strong resemblance to financial ones. The main challenge is elsewhere: in the assessment of the impacts of ESG demands on pension funds’ duties, particularly the fiduciary one.
Impacts of ESG criteria on fiduciary duty
Underlying the adoption of ESG disclosure laws is the belief that pension funds are accountable to society. As the French example illustrates it, institutional investors are increasingly expected to participate in the transformation of the economy towards green energy. Several pension funds opposed fiduciary arguments to these new ESG requests. According to the ESG opponents, the duty of pension schemes is to generate financial performance for their beneficiaries, not to act in the best interests of society. Weary of addressing such arguments, the signatories of the Principles for Responsible Investing (PRI) asked the best lawyers of each country to prepare a report on the question, published in 2015.[iv] The conclusion was clear: “far from being a barrier, there are positive duties on investors to integrate ESG issues” (p.9). Along the same lines, the 2014 UK Law Commission’s Report on the fiduciary duties of investment intermediaries has explained that the consideration of ESG factors by pension fund trustees is entirely consistent with their fiduciary duty to beneficiaries.
Although the fiduciary duty debate has not attracted as much interest in Canada as in the U.S. or the UK, the new ESG disclosure requirements will certainly trigger some discussion. As for the performance debate, however, Canadian pension funds will certainly have to evolve in a field that has already been paved in a certain direction. Not only has ESG been proven not to contradict fiduciary duty, fiduciary duty is now expanding towards ESG. The last example of such evolution is a legal case against a UK pension fund sued in 2015 for breaching its fiduciary duty by not considering the potential impacts of climate change on its investments.
Such lawsuits are not without consequence for pension funds’ trustees who are now increasingly juggling potential contradictory demands, notably due to the different time horizons of ESG and financial criteria: A challenge that certainly knocks at Canadian doors.
Impacts of ESG criteria on the relationships between pension funds and the public
The legal case against the UK pension fund was not initiated by its beneficiaries but led by lawyers, NGOs, climate specialists and public relations firms. By making pension funds disclose their ESG integration, governments increased the accountability of pension funds vis-à-vis the society at large, which consequently strengthened public scrutiny. In the aftermath of the European disclosure laws, Friends of the Earth, one of the most influential environmental NGOs worldwide, launched a campaign targeting institutional investors. The fossil fuel divestment movement that is now unfolding in Europe and the U.S. is a significant social movement in the industry since the Anti-Apartheid Movement. A sign of its importance is the commitment of some of the most prestigious universities worldwide to divest – a student-led initiative that social movement scholars have identified as a key success factor for triggering change.
Faced with an increase of societal critics vis-à-vis the investment industry, several European governments had to regulate the content of Socially Responsible Investing (SRI) funds to avoid the presence of controversial issuers in the portfolios.
Canadian investors seem to have not yet been impacted. The dependence of the national economy on the extractive sector and the consensus-based model of democracy certainly explain such difference. But the Canadian investment industry is not isolated. Statistics Canada says foreign capital accounts for about half of all direct investment in the country, a percentage that keeps increasing.
Given the scope and speed of the citizens’ involvement in the investment industry that followed the financial crisis, Canadian pension funds could be hit by the societal wave before they realize it. In such a situation, Canadian investors might need to strengthen their communication, not only to their beneficiaries but also to the public – an exercise that requires forethought.
Call to action
The disclosure amendment in Ontario might not be an isolated event but instead the departure point of an ESG race that Canadian pension funds will soon have to run. Based on what happened in Europe, three challenges are likely to emerge in coming years. Firstly, pension funds will have to work on ESG investment solutions across asset classes that are aligned with the Canadian features of the investment industry. Secondly, they will need to discuss what ESG integration means in terms of fiduciary duty and associated disclosure requirements; a debate which will probably involve the whole profession and public authorities. Last but not least, Canadian pension funds will have to communicate their choices to their beneficiaries and the general public. If there are no black or white answers, there are undoubtedly questions that will have to be addressed.
Diane-Laure Arjaliès is assistant professor at the Ivey Business School, Western University (London, Canada). Before moving to Canada, Diane-Laure spent ten years examining the integration of ESG criteria by the European investment industry. She is now studying the impacts of such requirements on Canadian trustees.
[i] Nielsen Study 2015. The sustainability imperative.
[ii] Fabozzi, F. J., Focardi, S. M., & Jonas, C. 2014. Investment Management: A Science to Teach or an Art to Learn? CFA Institute Research Foundation.
[iii] Clark, G. L., Feiner, A., & Viehs, M. 2015. From the stockholder to the stakeholder: How sustainability can drive financial outperformance. Report Published by the University of Oxford and Arabesque Partners.
[iv] Principles for Responsible Investment. 2015. Fiduciary Duty in the 21st Century.