ESG: Coming to a SIPP near you

Environmental, social and governance (ESG) factors were always around, but now they’re here to stay.

Under the new Ontario Pension Benefits Act (PBA), effective Jan. 1, 2016, a plan sponsor’s statement of investment policies and procedures (SIPP) must include information about whether ESG factors are incorporated and, if so, how.

And, by the beginning of July, members must be made aware (through their statements) that the SIPP will contain information about ESG factors, said Stephanie J. Kalinowski, partner with Hicks Morley, speaking yesterday at the Association of Canadian Pension Management’s ABCs of ESG event in Toronto.

This in itself can pose a problem. In DC plans, when members see their statements, the keen ones will ask to see a copy of the SIPP and how you are using those factors. Then it becomes a factor of member education, she said.

“It’s difficult for plan members to understand the basics of investing and now we’re asking them to understand something a room full of experts are struggling with.”

What are ESG factors?
There is no definition of ESG in the PBA, she said, adding that it goes beyond a purely financial analysis.

“This is a topic that has had as much confusion that I’ve ever seen in my life,” said Andrew Sweeney, vice-president with Phillips, Hager & North. “It’s an alphabet soup of jargon.”

So it’s not ethical investing, socially responsible investing, negative screening, fossil free, he said.

ESG refers to the environmental (climate change, sustainability), social (human rights, child and forced labour, employee relations) and governance (board independence, executive compensation, shareholder rights and voting) factors relevant to an investment that may have a financial impact on that investment, he said.

“[ESG] is about enhanced analysis,” he explained. “Enhanced analysis of company and a better understanding of the overall risk—both financial and non-financial. It’ about proxy voting and company engagement, and working with other managers and owners to address ESG issues.”

The starting point for ESG is the fiduciary standard of care that’s codified in the PBS, said Kalinowski, noting that person of ordinary prudence would exercise in dealing with the property of another

And that prudence is not about the outcome. “It’s about the decision-making process that led to the selection of that investment,” she said.

But could a plan sponsor breach its fiduciary duties by taking ESG factors into account? Cowan v. Scargill in the U.K. indicates yes. In this case, “ the court emphasized as a starting point that the company needed to look at financial factors, that trustees must set aside own personal interests and views and can’t ignore the financial interests of the beneficiaries.

Is ESG good for your portfolio?
Academic research shows that ESG factors can improve returns and lower risk.

In a report for Deutsche Bank, which looked at a number of ESG studies, 100% of the studies found that ESG standards correlated with a lower cost of capital, and 89% showed that strong ESG standards correlated with stock price outperformance, said Sweeney.

Magna International is a good example. The company had historically poor governance, a multi-voting share structure, excessive exec comp and its founder invested in personal projects (one of which was U.S. racetracks), explained Sweeney.

After shareholders devised a plan to solve Magna’s governance structure, the stock is now performed tremendously. “It’s stock no longer trading at a discount.”

But ESG does not just apply to equity investments. It also applies to corporate debt, sovereign debt, infrastructure, private equity and real estate, he added.

What should a plan administrator do?
First, you need understand your fiduciary duties as they apply to investing.

Look at what you’re already doing, said Kalinowski, and ask investment managers how they define and measure ESG factors.

Make sure you develop a definition of ESG for your SIPP. “There is no statutory or clear industry definition,” she said.

Review your decision-making process, understanding the financial impact of your decisions and asking if the plan itself contains any restrictions.

And document your decisions.

“This new requirement can’t be ignored and can’t be left to the last minute.”

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