Since July 3 last year UK pension funds have been required to state their policy on ethical investment. Three years ago, when this policy initiative was first announced by the then pensions minister, John Denham, there were very low expectations for change. Industry figures were predicting that the vast majority of pension funds were going to adopt policies of not taking account of social, environmental or ethical issues in investment. This is not how things are turning out. A number of the largest pension funds – including USS and BT – announced initiatives. A recent study of the top 25 UK pension funds, by the consultancy ERM, has found that 21 of them are going to implement some kind of positive socially responsible investment (SRI) policy.
Why has the industry response been so much more positive than the pessimists were expecting? One reason is the growing public attention that is being paid to these issues. Surveys show that the vast majority of the public would like their pension fund to have a policy, as long as this can be done without undermining financial performance. A number of articles have appeared in the press, drawing attention to the controversial companies in which some pension funds have invested. Two large pressure groups have mounted postcard campaigns to encourage their members to urge their pension funds to adopt a positive SRI policy. One of them, Friends of the Earth, has gone further by announcing that it will be scrutinising large pension funds to see whether their SRI policies match the employer company’s own policies on corporate social responsibility.
These demand-side factors have certainly affected the thinking of many trustees, but they do not account for the changes in attitude that we are seeing in the industry. If the options available to trustees as far as socially responsible investment are concerned were the same as they were two or three years ago, I suspect we would have made little progress. Three years ago, socially responsible investment was defined by retail ethical investment funds that used ethical screening criteria to exclude a substantial proportion of the stockmarket from investment. Some of these funds take a more positive approach, but the net effect is often sector and size-biased investment portfolios, driven by highly unorthodox investment processes. This makes such funds legally tricky for trustees who are commanded by trust law to give overriding priority to the financial interests of members.
One of the biggest factors in the change of mind in the pensions industry on these issues is the emergence of ‘engagement’ as a means of addressing social responsibility issues in investment. Pension funds are large shareholders and they have a legitimate influence on the way companies are governed. Pension funds like USS, Friends Provident, Lothian and PGGM, which have adopted this approach, have committed themselves to engaging with companies to seek to support and encourage their efforts to improve their management of social and environmental issues.
An important common feature of the approach taken by these funds is that it is financially driven. Their engagement activity is focused on seeking to encourage companies to improve their management of ethical and environmental issues when there is a business case for doing so. This approach is based on the belief that good management of social, environmental and ethical issues can improve the financial performance of the companies in which shareholders invest.
What does this policy mean in practice? Engagement requires shareholders to establish an ongoing constructive dialogue with senior managers of companies. This requires considerable expertise in corporate social responsibility and environmental management – expertise of a kind not typically found within investment companies. Friends Provident makes use of the dedicated SRI unit operated by Friends Ivory & Sime – a pioneer of the engagement approach with the well known Responsible Engagement Overlay (REO) programme. This REO team comprises 11 full-time staff with qualifications and experience relating to social, environmental and ethical aspects of business. USS has said that it will create two similar posts within its organisation.
The new engagement agenda is much easier for trustees to swallow because it does not require any changes to the management of the investment portfolio. Unlike traditional ethical funds, companies are not excluded on ethical grounds. This, and the business-focussed approach of engagement objectives, removes the traditional legal objections to SRI. A number of leading investment consultants have satisfied themselves that engagement is ‘safe’ for pension funds.
There are now several hundred pension funds signed up to engagement-type approaches in the UK and many more are now following throughout Europe. Engagement could go far to satisfy the demands of scheme members for SRI and, as long as it is done seriously and effectively, it should even satisfy the demands of pressure groups like Friends of the Earth. But, and this is an important ‘but’, woe betide those pension funds which claim that they will be engaging with companies but then do not follow it up with credible action. Pressure groups are surprisingly good at detecting empty promises.
Craig Mackenzie is director of the socially responsible investment unit at Friends Ivory & Sime in London