THE GROWING ESG AND DC FOR ESG IN DC PLANS Funds that consider environmental, social and governance factors can help members mitigate emerging risks and capture new drivers of long-term growth. BY ALISTAIR BYRNE, HEAD OF EUROPEAN DC INVESTMENT STRATEGY, AND CHRISTOPHER MCKNETT, HEAD ESG STRATEGIST Investors with long time horizons need to consider how the world may look tomorrow, not just what it looks like today. That can mean adopting new criteria to assess an investment s potential performance especially as our globalised, interconnected economy is increasingly affected by environmental, social and governance (ESG) issues that don t readily show up on a company s balance sheet. In fact, the World Economic Forum predicts that seven of the ten greatest risks facing people, institutions and economies over the next decade come from threats outside of purely financial categories, such as extreme weather events, water and food crises, and the impact of climate change. 1 These risks also create opportunities for companies that can adapt to the changing economic landscape. Yet traditional investment analysis by itself may not adequately examine these non-traditional drivers of long-term performance. That s why more investors are considering the impact of environmental, social and governance factors on a company s long-term growth potential. 4 Contribute Autumn 2017 State Street Global Advisors
CASE At its core, ESG investing is based on the idea that environmentally efficient, socially responsible and well-governed firms are better positioned to withstand emerging risks and capitalise on new opportunities. The approach is not just for investors who follow a mission- or values-driven investment philosophy, but for anyone seeking a broader view of the issues that affect long-term value creation. As stewards of their members assets, scheme sponsors and trustees have the responsibility to consider all the risks and opportunities that can affect long-term investment outcomes. Incorporating ESG into the scheme s investment strategy can help balance risk and potential returns. Why ESG Matters ESG is Material to Financial Outcomes Because a company s environmental actions can signal: Operational efficiency and lower costs Reduced environmental liability Opportunities for low-carbon revenue sources Because a company s social behaviours can signal: Effective management of human capital Reduced risks (e.g. physical, financial, reputational) related to product/service safety Opportunities for an expanded customer base Because a company s governance practices can signal: Financial and operational decisions that best serve shareholders Reduced risk from reputational damage or weak financial controls Well-managed operations and costs in the face of regulatory changes Source: SSGA 2017. For illustrative purposes only. ssga.com/ukdc 5
The Evolution of ESG Investing Although ESG strategies have roots in earlier generations of socially responsible investing, today s ESG investors may be less motivated by values than they are by the ability to use ESG factors to mitigate risk, and to capture opportunities for innovation and growth. For example, environmentally efficient firms may consume fewer resources and produce less waste than competitors, helping them generate lower costs and higher returns on capital. Social factors have emerged as important proxies for management quality, for example with studies showing that management teams with greater gender diversity provide superior corporate performance. 2 The value of good governance is clear as well, especially in light of recent corporate scandals related to auto emissions, food safety and labour issues. Effective, independent boards of directors and strong internal controls can reduce the likelihood of corporate malfeasance, fraud and other ethical breaches that damage shareholder value. These trends suggest that ESG factors will only become more important to corporate health and by extension, to shareholder returns over time. That makes ESG investing especially relevant for long-term investors such as DC scheme members. More investors are considering the impact of ESG factors on long-term growth potential. How ESG Can Fit into a DC Scheme It has been common for DC schemes to offer an ethical fund for scheme members who wish to choose an investment fund consistent with their personal values. Typically, this would be a fund that screens out certain companies with business activities counter to those principles, for example involvement in the arms trade or tobacco. But the debate is moving on to the default strategy, given that relatively few scheme members make active investment choices and reflecting the fact that the ESG debate now focuses more on long-term financial risks than on simply values themselves. Equities form the majority of the growth phase of most default strategies, and most DC plans will have significant exposure to index funds benchmarked to marketcapitalisation weighted equities. We expect to see these approaches evolve to reflect ESG principles; excluding some companies for example those producing controversial weapons and tilting towards those that have better ESG credentials. Some early approaches have focused on climate change and tilting towards less carbon-intensive companies, but this can be extended to cover wider environmental issues (such as water and waste) and social issues (such as labour relations and diversity). This approach can still be executed by a systematic index-based strategy, using ESG ratings and analysis from established research providers. Some schemes may also look to include a Smart Beta factorbased investment approach alongside these ESG tilts. Schemes have an obligation to offer members appropriate and well-governed default investment strategies that deliver long-term value and we believe that ESG has a key role to play in that effort. 1 The Global Risks Report 2017, World Economic Forum. 2 Women on Boards: Global Trends in Gender Diversity on Corporate Boards, MSCI, November 2015. 6 Contribute Autumn 2017 State Street Global Advisors
FROM AMBITION TO ACTION Three key questions for scheme sponsors and trustees to address when contemplating ESG in DC. 1 WHAT ESG APPROACH DOES THE ASSET MANAGER USE? There are a number of different ESG approaches available, for example some funds screen out certain poor ESG stocks or sectors, and others focus on companies that are better than their peers or improving their ESG performance. In addition, ESG analysis and ratings come from a number of different research providers. Furthermore, it is a relatively new and evolving sector with new options becoming available. Trustees and scheme sponsors need to be comfortable with their manager s chosen approach. 2 WOULD AN ESG STRATEGY INTRODUCE ADDITIONAL COSTS AND RISKS? Any move away from an indexed strategy can introduce new challenges, such as increased portfolio turnover, complexity and tracking error. Changing the ESG profile of a portfolio also might lead to concentration or liquidity risk. These potential costs and risks must be monitored to ensure they are justifiable in terms of the improvements in performance and ESG ratings that the strategy delivers. THE POWER OF ACTIVE STEWARDSHIP At SSGA, we use our voice and our vote to engage with companies on issues that promote sustainable value. Our asset stewardship programme continues to be foundational to our mission of investing responsibly to enable economic prosperity and social progress on behalf of our clients. We adopt a systematic, risk-based approach to overseeing ESG issues in our investment portfolios. Each year we prioritise our engagement efforts around themes and sectors we believe to be especially relevant. 3 HOW WILL YOU EDUCATE MEMBERS ABOUT ESG? Trustees and scheme sponsors must be able to explain clearly the purpose of and extra steps associated with ESG investing, to ensure that all stakeholders understand the process and any changes in performance it might create. By engaging in these questions about ESG investing, scheme sponsors and trustees can help to mitigate potential risks and seize new opportunities to help members build meaningful savings over their careers. QUESTIONS ABOUT ESG? Visit ssga.com/esg to read about the crucial role of asset stewardship in ESG and our Fearless Girl campaign to enhance corporate board diversity. ssga.com/ukdc 7
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State Street Global Advisors Limited, Milan Branch (Sede Secondaria di Milano) is a branch office of State Street Global Advisors Limited. Street Global Advisors Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom. Netherlands: State Street Global Advisors Netherlands, Apollo Building, 7th floor, Herikerbergweg 29, 1101 CN Amsterdam, Netherlands. T: +31 (0) 20 718 17 01. SSGA Netherlands is a branch office of State Street Global Advisors Limited. State Street Global Advisors Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom. Switzerland: State Street Global Advisors AG, Beethovenstr. 19, CH-8027 Zurich. T: +41 (0) 44 245 7000. Authorised and regulated by the Eidgenössische Finanzmarktaufsicht ( FINMA ). Registered with the Register of Commerce Zurich CHE-105.078.458. United Kingdom: State Street Global Advisors Limited, 20 Churchill Place, Canary Wharf, London, E14 5HJ. T: +44 (0) 20 3395 6000. 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