UK - Pension fund managers may be able to meet their fiduciary duty and engage with companies on environmental, social and corporate governance (ESG) issues if they opt for sustainable investment strategies, suggests Watson Wyatt.

According to a report published today by the consulting firm, UK pension schemes are currently precluded from pursuing a route of social responsible investment (SRI) or ethical investments because this requires them to eliminate companies - through negative screening - as potential investments based on factors other than on purely financial grounds.

Adopting such a strategy might be seen to be contrary to the trustees' fiduciary responsibilities to deliver the best possible investment return for their members.

But in the paper entitled "Sustainable Investment", Watson Wyatt argues firms could now engage in sustainable investment, and might see improved long-term investment potential as a result, because it may be possible to ascertain whether the ethical activities of a company will affect their long-term investment performance.

Watson Wyatt believes whereas the concept of ethical investment negatively screen companies as potential investments because they do not fit certain criteria and SRI tends to opt for positive selection, sustainable investment combines the two aspects by asking active fund managers to look at the "ESG risks and opportunities…with the aim of improving financial performance".

"We believe that a sustainable investment approach, taking account of a wide range of environmental, social and governance issues alongside more traditional financial factors in the investment process, can help active managers to gain a better understanding of the risks and opportunities within their investment universe, which in turn could enable them to construct portfolios with superior long-term risk and reward profiles," the Watson Wyatt report states.

The consultancy notes "some trustees have expressed a concern that legal precedents exist which might prohibit them from appointing [investment] managers with a clear mandate to consider ESG issues".

However, quoting a United Nations Environment Report produced by international law firm Freshfields Bruckhaus Deringer in 2005, Watson suggests "the links between ESG and financial performance are increasingly being recognised" and integrating ESG as a mandate requirement might be possible because investors are likely to be better informed about a company's performance potential if they understand the economic drivers which might affect their returns.

Examples presented which could be beneficial investments might, for example, include car, lorry and bus manufacturing firms with hybrid engines which might have an advantage if oil prices remain high or knowledge of retail companies which might see their brand damaged if they have links to the use of child labour or animal testing.

At the same time, Watson Wyatt highlights a study of US-listed companies conducted by specialist research firm Innovest which suggests it is possible to show how "the application of environmental factors added value to a range of different styles, cap-sizes and even geographic regions" over a three-year period.

At this stage, not all asset managers have some form of framework upon which companies' risks and opportunities can be assessed, according to the firm.

That said, Watson Wyatt is suggesting it may be possible to increase fund managers' need to consider sustainable investment by perhaps including a portfolio manager with a sustainable investment approach alongside mainstream managers when compiling shortlists of potential mandate managers.

"The approach adopted by trustees will depend on their scheme's governance capacity and their personal views of sustainable investment but we believe that this area could become an increasingly importance competitive element of the investment strategy of long-term investors," concluded Watson Wyatt.