May 11, 2022
Enhancing Effective ESG and Climate Governance in Pension Fund Oversight
Remarks to the International Foundation of Employee Benefit Plans Canadian Legal & Legislative Conference by Dr. Janis Sarra, Professor of Law, University of British Columbia, and Principal Co-Investigator, Canada Climate Law Initiative
Imagine, for a moment, living in a region devastated by wildfires, a heat wave that kills hundreds, and atmospheric rivers hundreds of kilometres long and wide that flood entire regions. Well, it no longer takes imagination, because my home province of British Columbia has experienced all that in the past year. Ten months ago, the Lytton wildfire destroyed over 90% of the town in minutes the day after it reached temperatures of 49.6 °C (121.3°F), the highest temperature ever recorded in Canada. There were more than 1,600 fires in Canada in 2021, destroying 8,700 square kilometres. In June, a heat dome over Vancouver killed over 400 people in less than one week, according to the BC Coroner’s Office.1 A few months later, atmospheric rivers stretching 1,600 kilometres long and more than 640 kilometres wide, unleashed record-breaking rainfall, triggering devastating floods and mudslides, flooding a thousand farms, killing 640,000 livestock, and cutting off all land routes to Vancouver with significant disruption to supply chains.2
These events are occurring across Canada – even as we are meeting today, Manitoba is experiencing severe overland flooding, washing out roads and bridges.3 The Insurance Bureau of Canada reports that insured damage for severe weather events across Canada reached $2.1 billion last year.4 The United States (US) is faring even worse. The National Interagency Fire Center reported 58,985 wildfires in 2021, consuming 7.1 million acres – twice the size of Connecticut.5 The NOAA National Centers for Environmental Information reports that in 2021, the US experienced 20 separate billion-dollar weather climate disasters totalling approximately US$145 billion in damage.6 NASA predicts that by the mid-2030s, rising sea levels will cause coastal cities all around the US to experience dramatic increases in floods.7 Increasingly, worsening climate effects are leading a growing number of Americans to abandon homes and communities.8
The impacts of climate change are poignantly real – and they are not only being experienced in distant low-lying lands, they are core to our lives and our economies in North America. I start with this gloomy picture because environmental, social, and governance (ESG) issues and concerns can no longer be relegated to debates among pension fiduciaries about values investing or investment value (returns), but rather, need to be addressed holistically, given the place of pension funds in our society.
One of my first jobs during my university studies was as a pension clerk for the pension department of the Ontario public service – 51 years ago (I am really dating myself). While times were really different – it predates independent pension boards – two facts have stayed with me about that experience. First, pensions are critically important to employees as they represent financial security that allows them to grow old gracefully, a goal that has not changed, and if anything, has become even more important. Second, at that time, a staggering number of spouses of pensioners died within one year of the pensioner dying. A quick search reveals that these risks continue – a recent report found that older people who have lost a spouse have an increased risk of dying themselves shortly after, although it appears to have come down from 90% to 66% given better supports.9 For me, both facts point out the critical importance of the economic security and supports provided by pension funds.
As of June 2021, there are 6.5 million Canadians covered by more than 16,000 registered pension plans with over $2.18 trillion in assets.10 A mere 32 of those plans account for 50% of all plan membership.11 Given that there are many smaller pension funds, the vast majority of Canadian pension fund fiduciaries rely on a wide variety of service providers such as investment and asset managers, mutual fund and trust companies, and life insurance companies to establish and implement investment policies, which become important in thinking about how we approach ESG.
The Scope of Environmental, Social, and Governance Risks Considerations
ESG factors have become key to consumer and beneficiary preferences, investor expectations, and the ability to attract/retain a dynamic management team and workforce. Each of these factors are broad, and it does not mean pension funds or their portfolio companies need to address them all. That said, pension fiduciaries should be turn their minds to what aspects of E, S, and G may be important to their exercising their prudential duty to meet the pension promise.
A non-exhaustive list is:
ENVIRONMENT includes climate change mitigation and adaptation, energy management, air quality management, water management, toxic and hazardous materials management, and circular economy activity. Generally, it is how pension funds and their investments impact and are impacted by climate change and broader environmental issues such as protection of biodiversity. Global reporting standards are emerging, underpinned by international agreements on underlying climate policy and through initiatives like the Task Force on Nature-related Financial Disclosures (TNFD).
SOCIAL includes human capital management, equity, diversity and inclusion (EDI), health and safety, supply chain oversight, labour standards, human rights, community relations, and social acceptability. The easy issues are refusing to invest where child labour or slavery are used; but there are tough issues here at home, and there are few signs yet of inclusion and diversity in key roles. In 2021, only 5% of TSX-listed CEO are women, 22% of TSX-listed directors are women, 4% of TSX-listed directors are racialized, and less than 1% (0.3%) of TSX-listed directors are Indigenous.12 The systemic barriers are everywhere: the motherhood penalty, systemic biases, gender & racial devaluation, intersectionality. Inequities can be seen across core activities of companies and their supply and distribution chains.
GOVERNANCE is the effectiveness of risk management, strategic planning for long-term delivery of the pension promise, and accountability structures in place for pension fiduciaries, including trustees, administrators, and their service providers. It includes composition and effectiveness of the board of trustees and the boards of portfolio companies, accountability mechanisms, executive officer compensation, ethics and business practices, and cybersecurity risk management.
In my view, truth and reconciliation with Indigenous Peoples is an overriding factor that involves E, S, and G, and should be considered in exploring all these issues.
There are a wide range of approaches to considering ESG investments: negative or exclusionary investing based on ESG factors; ESG integration where the fund explicitly considers ESG-related factors that are material to the risk and return of the investment; best-in-class or inclusionary screening, aiming to invest in companies that perform better than their peers on one or more performance metrics related to ESG matters; thematic investing, investing in sectors expected to benefit from long-term macro or structural ESG-related trends; impact investing where the fund seeks to generate a positive, measurable social or environmental impact alongside a financial return; and then stewardship, proxy voting and engagement.13 Key is for pension funds to identify which of these strategies it is adopting, being clear about objectives, methods of assessing meeting objectives, and measuring and disclosing milestones achieved.
Accelerating trends in ESG
Transition Plans to Net-Zero Emissions – there is growing momentum globally for transition plans that focus company and pension fund efforts to decarbonize the business and investment portfolios, as recommended by the Taskforce on Climate-related Financial Disclosures (TCFD) and proposed under the new International Sustainability Standards Board (ISSB) exposure draft.
Diversity, Equity, and Inclusion – both intention and attention are required. For pension funds, it means dedicated-demonstrable inclusion practices in all aspects of employment and investment decisions and zero tolerance for discrimination.
Truth and Reconciliation – acquiring deep understanding, accepting responsibility, and creating new best practices in business and finance partnerships with Indigenous Peoples.
Picture a Venn diagram – each of E S and G interact to support future value – for example, diverse teams are more effective at problem solving and ensuring equitable outcomes, and thus climate risk and solutions teams should be diverse in experience, race, gender, and knowledge if we are to fashion a just transition that maximizes opportunities.
Pension Fiduciary Duties
So where are pension fiduciary duties in the context of these developments?
Pension fiduciaries have a duty to acquire an understanding of, and then balance their decisions in respect of, current and future intergenerational risk and return over periods that potentially exceed human lifetimes. Pension funds are large diversified institutional investors with long-term investment horizons, so they cannot diversify away from systemic risk such as climate change and income inequality, and that system-level investment lens needs to be keenly attuned to intergenerational responsibilities as part of their fiduciary duties.
The prudential obligation requires fiduciaries to act with the care, diligence, and skill in the administration and investment of the pension fund that a person of ordinary prudence would exercise in dealing with the property of another person. The duty of loyalty requires pension fiduciaries to act in the best interests of plan members, and to avoid conflicts of interest. Fiduciaries have a duty of even handedness as between different classes of beneficiaries.
Evaluating ESG-related risks and opportunities goes beyond passive receipt of information, and instead means establishing a robust process to oversee and verify the fund’s progress in relation to these risks and opportunities.
ESG has evolved from a matter of principle where investors aligned in the 1970s around key social concerns such as apartheid in South Africa;14 to the notion of an investment product the 1980s;15 to development of social indices to track ESG and socially responsible investing in the 1990s;16 to this current moment in time, where we see some global convergence on the importance of sustainable development and effective ESG governance. The Principles for Responsible Investing (PRI) now have more than 2,500 signatories investing $90 trillion.17
In 2019, the United Nations Environment Program Finance Initiative (UNEPFI) and PRI updated their landmark document Fiduciary Duty in the 21st Century, reporting that the fiduciary duties of pension funds require them to:
- incorporate ESG issues into investment analysis and decision-making processes, consistent with their investment time horizons;
- encourage high standards of ESG performance in the companies in which they invest;
- understand and incorporate beneficiaries’ sustainability-related preferences, whether or not these preferences are financially material;
- support the stability and resilience of the financial system; and
- report on how they have implemented these commitments.18
The report cites three primary reasons why the fiduciary duties of loyalty and prudence require the incorporation of ESG issues: ESG issues are financially material, a source of investment value, and a mark of prudent investment; ESG incorporation is now an investment norm globally; and regulatory frameworks are changing to require ESG incorporation, with over 730 hard and soft-law policies that encourage or require investors to consider ESG as a long-term value driver.
From Voluntary to Mandatory
The most notable trend globally in the past year is the shift from voluntary to mandatory standards. United Kingdom (UK) law has set a target of cutting emissions by 78% by 2035 compared to 1990 levels, the government adopting an entire economy approach.19 In 2021, the UK Department for Work and Pensions (DWP) proposed legislation requiring a variety of pension schemes to make TCFD-aligned disclosures and effectively manage climate-related risks and opportunities. New legal duties for UK’s £2 trillion investments pension funds require pension trustees to assess and publish the financial risks of climate change within their portfolios. Regulations in effect 1 October 2022 will require trustees to report on how their investments align with the goals of COP26 net-zero emissions, the government stating that “it will not be enough for schemes to just passively report on and tick-box their way through climate change risks and to net zero”.20
The UK government has announced new Sustainability Disclosure Requirements (SDR) whereby pension schemes and other asset owners must disclose how they take sustainability into account,21 including governance of sustainability-related risks, opportunities and impacts, and the implications for investment policies, strategies and outcomes; processes used to identify and manage sustainability-related risks, opportunities and impacts, and the implications for the scheme’s investment policies, strategies, and outcomes; and metrics and targets used to assess and manage relevant risks, opportunities and impacts and performance against targets.22 The SDR will require disclosures of transition plans that align with the government’s net-zero commitment, taking an objective and science-based approach or provide an explanation if they have not done so. As standards for transition plans emerge, the government has stated it will incorporate them into UK regulation and strengthen disclosure requirements.23 It has also announced a mechanism to adopt International Sustainability Standards Board issued standards in the UK and will also require disclosure against the UK’s Green Taxonomy, which requires sustainable investments to satisfy minimum safeguards relating to basic good business practice.24
I highlight the UK, because it often signals future direction for regulators in Canada. Yet these efforts can be seen globally; in Hong Kong, Singapore, etc. For example, the European Union (EU) has a Taxonomy for Sustainable Activities,25 the EU Guidelines on Reporting Climate-related Information,26 the EU Sustainable Finance Disclosure Regulation,27 aimed at discouraging greenwashing in the financial sector, and the proposal for an EU Corporate Sustainability Reporting Directive.28 The EU also introduced ‘double materiality’, asking managers to assess how sustainability issues affect the company’s business and how the company’s actions impact people and the planet.29
There are also supply chain developments. In November 2021, the European Commission tabled its plan to introduce mandatory due diligence in the supply chain.30 Effective 2021, companies need to collect information about the products they have placed on the EU market to confirm they are not linked to deforestation, including taking “adequate and proportionate mitigation measures, such as using satellite monitoring tools, field audits, capacity building of suppliers or isotope testing” to confirm the product’s origin.31 France has enacted a corporate duty of vigilance law that places a due diligence duty on large French companies and requires them to publish an annual vigilance plan.32 The plan must include reasonable measures to allow for risk identification and prevention of severe violations of human rights and environmental damage resulting directly or indirectly from the operations of the company, its subcontractors, and suppliers with whom it maintains an established commercial relationship. Measures include risk mapping and a system to monitor the effectiveness of measures implemented. A court can order the company to comply with its vigilance obligations, including ordering it to develop a vigilance plan, improve its vigilance measures, and/or impose a penalty for each day of non-compliance. Germany’s legislation follows suit and there are already lawsuits pending alleging violations. While there is not yet any such legislation in Canada, a private member’s bill tabled this year is aimed at these issues.33
The new ISSB has two new exposure documents, Exposure Draft IFRS S2 Climate-related Disclosures and Exposure Draft IFRS S1 General Requirements for Disclosure of Sustainability-related Financial Information, which will require an entity to disclose information about its significant sustainability-related risks and opportunities that is useful to the primary users of general purpose financial reporting, including governance processes, controls and procedures used to monitor and manage sustainability-related risks and opportunities.34
The International Organization of Securities Commissions (IOSCO) recently published a report setting out recommendations for securities and other regulators to improve sustainability-related policies, procedures, and disclosure in the asset management industry.35 A number of regulators have developed and implemented regulatory requirements on ESG or sustainability-related disclosure for investment funds.36 IOSCO’s Product Disclosure Recommendation covers ten areas relating to product disclosure, including naming, labelling, and classification; investment objectives and strategies disclosure; proxy voting and engagement disclosure; risk disclosure; marketing materials; and monitoring of compliance and sustainability-related performance. The CFA Institute in 2021 published the CFA Institute Global ESG Disclosure Standards for Investment Products to provide greater transparency and comparability to investors by enabling asset managers to clearly communicate the ESG-related features of their investment products.37
In contrast, regulation on ESG in Canada is at a nascent stage. We know that the Regulation under the Ontario Pension Benefits Act specifies that “The statement of investment policies and procedures shall include information as to whether environmental, social and governance factors are incorporated into the plan’s investment policies and procedures and, if so, how those factors are incorporated.” Federally, similar regulation is being considered, although not yet in place.
The Canadian Association of Pension Supervisory Authorities (CAPSA) is developing a principles-based guideline on the integration of ESG factors in pension fund investment and risk management,38 a consultation draft expected to be released within the next month. The Office of the Superintendent of Financial Institutions (OSFI) is collaborating with the CAPSA in its effort to develop this guidance.39
In terms of pension funds managing their Canadian portfolio companies, it is important to take note of Canadian Securities Administrators’ (CSA) proposed National Instrument 51-107 Disclosure of Climate-related Matters (NI 51-107) which will implement TCFD-aligned disclosure for governance and risk management irrespective of materiality and require disclosure of strategy, metrics and targets based on materiality. The current draft has emissions disclosure on a comply or explain basis. Publicly-held portfolio companies will also have to take note of the 2022 CSA Staff Notice 81-334 ESG-Related Investment Fund Disclosure, which provides guidance on the disclosure practices of investment funds as they relate to ESG considerations.40 It reports that the value of “sustainable funds” in Canada was $18 billion at the end of the first quarter 2021, representing a 160% in the past year. The CSA reports that in responding to investor demand to create ESG-related funds and incorporate ESG considerations into existing funds, there has been an increased potential for “greenwashing”, whereby a fund’s disclosure or marketing intentionally or inadvertently misleads investors about the ESG-related aspects of the fund.
The CSA’s review of 32 ESG-related funds managed by 23 different investment fund managers reveals some real concerns:
- More than half of those funds lacked detailed disclosure in their investment strategies about the specific ESG factors considered by the fund, including failing to identify or explain the ESG factors or how they are evaluated.
- Over a third of the funds held investments in industries that, according to their exclusionary investment strategies, should not have been permitted.
- Of the funds that use proxy voting as an ESG strategy, more than half of those funds did not disclose their ESG-specific proxy voting policies and procedures in their prospectuses or Annual Information Forms, as applicable.
- Three-quarters of the funds reviewed did not report on the changes in the composition of their investment portfolios due to the ESG objectives and investment strategies and the vast majority did not report on their progress or status with regard to meeting their ESG-related investment objectives.
- In CSA staff’s view, regulatory guidance is needed.
- The Staff Notice makes a number of suggestions that are relevant beyond the funds targeted:
- An investment fund is required to disclose, in its prospectus, the fundamental investment objectives of the fund, including information that describes the fundamental nature or fundamental features of the fund that distinguish it from other funds.
- To prevent greenwashing, it is important that the name and investment objectives of a fund accurately reflect the extent to which the fund is focused and its investment objectives accurately reflect the extent to which the fund is focused on ESG, where applicable, including the particular aspects of ESG.
- Where an ESG Fund intends to generate a measurable ESG outcome, such funds should clearly state the intended outcome as part of their investment objectives in order to allow investors to identify funds that match their own ESG-related goals.
- Full, true, and plain ESG-related investment strategies disclosure enables investors to understand the ways in which the fund will meet its ESG-related investment objectives and the types of investments that the fund may make.
- If a fund’s use of one or more ESG strategies includes the use of targets for specific ESG-related metrics, it should disclose those targets as part of its investment strategies and identify if those targets may evolve or change over time in response to changing circumstances.
- If a fund uses proxy voting or shareholder engagement as a principal investment strategy, the fund is required to disclose this engagement in its investment strategies reporting and how it is used.
- For funds that use ESG-related indices or benchmarks as part of their principal investment strategies or investment selection process, the fund should identify the index or benchmark used.
- For funds that use third-party, company-level ESG ratings or scores as part of their principal investment strategies or investment selection process, the fund should identify the provider of the ratings or scores and methodology used.
- A fund should not include statements in its sales communications that indicate that it is focused on ESG unless the fund references ESG in its investment objectives.
In March 2022, OSFI, which supervises federally-regulated pension plans for financial condition and soundness, released a consultation paper on pension investment risk management,41 observing that “Good pension plan governance includes elements such as robust processes to identify and manage more complex investment risks, independent oversight of risk-taking activities and appropriate risk controls”, noting that an independent risk oversight function provides objective oversight of the quality and adequacy of the plan’s risk management practices, including establishing a risk management framework and policies, ensuring they are aligned with the risk appetite of the plan administrator; risk identification and assessment, setting and reviewing risk limits; and risk monitoring and reporting requirements, quantifying material investment risks to which the pension plan is exposed, including market risks, credit risk, and liquidity risk.42
In the US, pension funds have been hit with the revolving door policies of the Department of Labor (DOL), which under the Trump administration held retirement-plan fiduciaries to a “pecuniary” standard when selecting plan investment options, questioning the appropriateness of social investing in defined-benefit plans covered by the Employee Retirement Income Security Act of 1974 (ERISA). The Biden administration has suspended enforcement of that policy43 and the DOL has now proposed a new rule “Prudence and Loyalty in Selecting Plan Investments and Exercising Shareholder Rights”, which states that when considering projected returns, a fiduciary’s duty of prudence may often require an evaluation of the economic effects of climate change and other ESG factors on the particular investment or investment course of action.44 The DOL received more than 900 submissions on the proposed rule and is moving to next steps. In the interim, it issued a request for information in February 2022 on in which the Employee Benefits Security Administration (EBSA) is asking for public input on its future work relating to retirement savings and climate-related financial risk and actions that can be taken under ERISA, the Federal Employees’ Retirement System Act of 1986 (FERSA), and any other relevant laws, to protect the life savings and pensions from the threats of climate-related financial risk.45
Climate Risk is Particularly Urgent
Foremost of ESG at this moment is addressing climate change. The Intergovernmental Panel on Climate Change (IPCC) , representing a broad consensus of more than 800 scientists representing 140 countries, is clear that immediate, rapid, and large-scale reductions in greenhouse gas (GHG) emissions are needed, which requires a significant shift of investment into sustainable projects and green technology. Focusing on climate risk as a particular urgent issue, as there is now broad-based acknowledgement that climate change is an existential threat. It poses business risks that extend to the long term. We know from the IPCC that the burning of fossil fuels is the main source of GHG emissions that have led to the current climate crisis.46 It cautions that the emissions from existing and planned fossil fuel infrastructure alone are higher than scenarios consistent with limiting warming to 1.5°C.47
The cumulative evidence from scientists, governments, and the courts suggests that pension fund trustees have a fiduciary obligation to pension beneficiaries to act prudently in their best interests in making climate-related investment decisions regarding fund portfolios.48 Pension funds and other institutional investors will potentially lose significant value of their investments if they do not act as prudent investors by recognizing climate change financial risk. In fulfilling their obligations to beneficiaries, pension trustees and their investment managers have an obligation to identify and address climate-related financial risks. Trustees can take climate change into account as a legitimate investment issue over the short, medium and long term. If trustees fail to act to address material climate-related risk, they may be personally liable for breach of their fiduciary obligation. Inaction is no longer acceptable, given all the evidence that climate change risk is material across the entire economy.
Trustees can also take climate change into account because they have duties as public fiduciaries additional to their financial duty to beneficiaries. Fiduciaries have a duty to act even where the potential costs and benefits of climate change cannot be fully quantified immediately. Fiduciary obligation also requires considering the benefits of investment in green adaption and mitigation technologies and other products and services that are likely to have upside financial potential for return on investment.
A legal opinion released by Randy Bauslaugh of McCarthy Tétrault in 2021 opines that pension fund fiduciaries have a duty to take into account financial risks and opportunities when managing plan assets.49 In view of widely accepted evidence of climate change and its financial implications, including evidence accepted by the Supreme Court of Canada, Bauslaugh suggests that pension fiduciaries ignore these matters at their peril. Duties include adequately assessing and managing climate-related financial risk, reporting to beneficiaries and other stakeholders on how these risks are being managed, and taking decisive action to mitigate these risks. Bauslaugh observes that in defined-benefit plans, positive financial performance results in greater financial security for plan participants and lower cost for employers, because the employer is directly responsible for funding shortfalls; and in defined-contribution plans, successful investment performance means greater retirement income for plan participants and less pressure on employers to improve contribution rates or top up pension accumulations to encourage a transition to retirement.50
Litigation risks: While there are not currently pending cases against Canadian pension funds, a couple of cases in jurisdictions similar to Canada are of note. In 2019, a member of an Australian pension plan brought a lawsuit against pension trustees for failure to identify, manage and disclose climate risks.51 It settled on the eve of the hearing, with the trustees acknowledging that climate change is a material, direct and current financial risk to the superannuation fund across many risk categories; committing to actively identifying and managing these issues, and to develop systems, policies and processes to ensure that the financial risks of climate change for assets and the fund’s portfolio as a whole are addressed; and ensuring that investment managers take active steps to consider, measure and manage financial risks posed by climate change and other relevant ESG risks.52
In the UK, a lawsuit is pending against trustees/directors of the University Superannuation Scheme, the UK’s largest private pension scheme, for alleged breach of fiduciary duties, conflicts of interest, and failure to create a credible plan for disinvestment from fossil fuel investments.53 In February 2022, the Court held that there was a prima facie case to answer, that the claimants were acting in good faith, and allowed their claim to go to an inter partes hearing seeking to bring a derivative claim against the directors.54 The lawsuit is pending.
In the Canadian Senate, Senator Galvez has introduced Bill S-243 An Act to enact the Climate-Aligned Finance Act (First reading was 22 March 2022) (2nd reading debate in progress as of 11 May 2022).55 Among its goals are: reduction of emissions on a pathway that respects the global carbon budget and is consistent with limiting global temperature increase to 1.5οC; elimination of dependence on and lock-in of emissions-intensive activities, including by avoiding new fossil fuel supply infrastructure and exploring for new fossil fuel reserves and instead planning for a fossil fuel–free future; preservation and restoration of natural carbon sinks, increasing climate resilience. It would require a climate commitments alignment report, including details on the entity’s progress on achieving targets and implementing its plans, measurable targets, emissions reductions within the value chain, and measures on operational and capital allocation for existing and new lines of business to ensure the achievement of targets. It calls for more stringent conflict of interest provisions. Senator Galvez’s Bill also seeks to clarify existing fiduciary duties by specifying:
When acting in their official capacities, directors, officers or administrators of reporting entities have a duty to exercise their powers and functions in a way that enables the entity for which they are officers, directors or administrators to be in alignment with climate commitments. (2) The duty must give precedence to that duty over all other duties and obligations of office, and, for that purpose, ensuring the entity is in alignment with climate commitments is deemed to be a superseding matter of public interest. However, this precedence does not supersede any requirement under the Income Tax Act or regulations made under that Act, nor does this precedence affect the eligibility of pension schemes under the Income Tax Act or its regulations.
The Bill would also amend Public Sector Pension Investment Board Act and Canada Pension Plan Investment Board Act. While not a government-sponsored bill, it is generating a lot of attention nationally about the need to legislate in order to make meaningful progress in the private sector on Canada’s climate commitments.
Equity, Diversity, and Inclusion
I understand that the topic for tomorrow’s conference sessions will be equity, diversity and inclusion, so I will make only brief remarks here. Fighting systemic racism in pension funds and their service providers requires both intention and attention. With respect to intention, unconscious bias is pervasive, and the challenge is taking individual ownership for systemic discrimination and questioning our assumptions. With respect to attention, it is not just policy statements (although they are helpful in building consensus on objectives and mechanisms to achieve them), it is intervening in a thousand different micro-moments to correct, reframe, create options, amplify and make ongoing and concerted efforts needed. So, as with all the “S” in ESG – we need to be clear about the objectives, however the trustees wish to set them; be transparent about these objectives; and then be transparent about the milestones and the unexpected barriers and challenges.
One visual I like to refer to is Dr Andrew Ibrahim’s “Becoming anti-racist” framework, which is a visual that talks about three zones of transition.56 The Fear Zone – not just those unaware of racism, but how we avoid the hard questions; the Learning Zone – recognizing that racism is a current and pervasive problem; understanding one’s own privilege in ignoring racism; and the Growth Zone – where we speak out when we see racism in action in all its forms and where we yield positions of power to those otherwise marginalized. There are many other questions posed in this framework, which helps us be mindful of the need to tackle racism at multiple levels simultaneously.
Tomorrow you will also hear from speakers on truth and reconciliation – I note here the changing legal framework that should inform views as fiduciaries – as pension fiduciaries we should consider Canada’s commitments under the United Nations Declaration on the Rights of Indigenous Peoples (UN DRIP) legislation federally and in British Columbia and what that means for our oversight for investment strategies – it means moving from a duty to consult and accommodate to inclusion and partnerships in sustainable investing.
What is the Direction of Travel for Pension Funds as Investment Fiduciaries?
Increasingly, we see alliances of pension funds in their commitments to ESG. In 2020, three of the largest pension funds globally: California State Teachers’ Retirement System (CalSTRS), the Japanese Government Pension Investment Fund (GPIF), and UK Universities Superannuation Scheme (USS) joined in a public statement that said: “if we were to focus purely on the short-term returns, we would be ignoring potentially catastrophic systemic risks to our portfolio” and that they will work with asset managers that integrate ESG factors throughout their entire investment process, vote according to the mandate to which they have pledged, and are transparent about their level of corporate engagement.57
The CEO of the eight largest Canadian pension funds “the Maple 8” made a pledge to create sustainable and inclusive growth by integrating ESG factors into their strategies and investment decisions as an integral part of their duty to contributors and beneficiaries, asking companies to measure and disclose their performance on material, industry-relevant ESG factors.
In terms of climate risk and opportunity, over US$40 trillion in global assets under management apply at least a partial restriction on investing in oil and gas.58 That includes than 180 pension funds that have divested globally.59 For example, pension fund ABP will stop investing in producers of fossil fuels and will divest from the fossil fuel producers in phases; the majority of which is expected to be sold by the first quarter of 2023, redirecting 15 billion euros in assets. The fund does not expect this decision to have a negative impact on long-term returns.60
In December 2021, the New York City Employees’ Retirement System (NYCERS) and the New York City Board of Education Retirement System (BERS) announced the successful divestment of securities related to fossil fuel companies, bringing the total divestment across all funds to an estimated US $3 billion.61 The New York City Teachers’ Retirement System’s divestment is underway with over $1 billion divested to date, expected to be complete divestment of the remaining $1 billion this year.62
In order to manage systemic risks, a pension fund needs a credible plan for transitioning its portfolio to net-zero emissions and annual reporting on achieving milestones to members and beneficiaries. Transition planning means assessing all high-carbon-emitting companies across all sectors of the economy. Direction of travel for investment is to reduce and then end financing new oil, gas, coal and pipeline projects, or any high-risk fossil fuel dependent infrastructure that would lock in new carbon pollution. This “lock-in” threshold is a key part of taxonomies for sustainable investment under development in the EU, UK , Singapore and other jurisdictions.
Ontario Teachers Pension Plan (OTPP), managing $241.6 billion, has demonstrated climate leadership by committing to achieve net-zero portfolio emissions by 2050 and reduce portfolio emissions intensity by two-thirds below a 2019 baseline by 2030.63 It states: “For the avoidance of doubt, any investment that increases the use of fossil fuels would not support a transition to a low carbon economy and would not be a green investment under our principles… Our expectation of significant reductions in emissions will consider sector decarbonization trajectories as outlined in the International Energy Agency’s Sustainable Development Scenario (SDS) and/or the EU Taxonomy.”
In September 2021, Caisse de dépôt et placement du Québec (CDPQ), with $420 billion in net assets, announced that it is divesting all of its oil production investments by end of 2022; aiming to achieve a 60% reduction in the carbon intensity of its total portfolio by 2030 compared to 2017; creating a $10-billion transition envelope to decarbonize the heaviest-emitting sectors; and it has grown its low-carbon investments to $39 billion in 2021, up 120% from 2017.64 It has reduced 49% of its portfolio’s carbon intensity compared to 2017.65 It has made equity, diversity and inclusion actions a priority. In 2021, it held discussions on ESG issues with 194 companies. It also voted on 57,008 proposals concerning these issues at 5,762 shareholder meetings.
However, a study released by ShiftAction in May 2022 notes that even as Canada’s public pension funds move to measure and manage the growing financial risks of climate change, their progress may be held back by their multi-layered connections to an incumbent fossil fuel industry. It found that Canada’s ten largest pension fund managers, together managing $2 trillion in assets, are deeply entangled with the oil, gas, coal, and pipeline industries through their boards of directors, executive teams, and senior staff.66 It identifies 80 individuals currently responsible for managing and overseeing Canada’s ten largest pension funds who currently hold or previously held 124 different roles with different fossil fuel companies.67 A key part of pension fiduciary duties is a duty of loyalty, which includes avoiding and properly managing conflicts of interest.68 The study reveals a lack of transparency to members and beneficiaries on how real or perceived conflicts of interest are being managed by these relationships and whether pension fund trustees/directors are recusing themselves from discussions on investment in the fossil fuel sector.69 It identifies some reputational and litigation risks, particularly where funds are, or are perceived to be, making decisions that may harm meeting the pension promise.
There are several issues here. In terms of fossil fuel executives sitting on pension boards – for years, this strategy made sense- they were attuned to investment risks and returns in a sector in which it made sense for pension funds to invest. But with the shift in capital flows and the changing regulatory environment, the question is whether board recruitment and retention needs to be refocused for new skills and expertise and greater diversity of views, including climate expertise, racial and gender diversity. At minimum, such trustees/directors need to be recusing themselves from discussions and decisions about fossil fuel investments.
Another way to look these interrelationships is that pension funds could use their positions on company boards to encourage those companies to adopt climate action plans that are transitioning to net-zero GHG emissions, but again, my caution would be that conflicts of interest need to be carefully managed, there should be transparency with beneficiaries as to the objectives, strategies and measurable progress in transitioning.70 There should be clear guidance on the role of the staff person on the board of a high-carbon-emitting portfolio company, and there should be action taken where progress in transition is not being made. Divestment is one of many strategies to be used, and while Canadians prefer engagement, that engagement must be deployed to generate action, and failure of portfolio companies to be responsive must have some consequences.
There are tremendous opportunities for companies to access new markets, new products and services that can report low-emissions, diversity and inclusion; and effective governance can improve competitive position. Design waste out at outset – circular economic activity can enhance productive output, minimize waste, and have positive reputational impacts. There are growing empirical studies out of Oxford University and Harvard University that have found that companies with strong ESG records are likely to be more resilient. There is a reason BlackRock is out in front on ESG.
Action Items for the Board of Trustees
You will be happy to know that I started out with 36 action items, but managed to focus it to the following 15 things to think about.
- Consider and decide the objectives for incorporating ESG into the pension fund’s risk management and sustainability framework, defining purpose and commitment to people and planet and drilling down to the most urgent concerns, risks, and opportunities.
- Integrate ESG factors at all stages of the investment process – focus on what is necessary, material and achievable over different time horizons.
- Do our portfolio and products reflect our purpose?
- Are we aligning recruiting and promotion decisions with our ESG objectives – are we setting milestones for enhancing diversity, equity and inclusion within the pension fund workforce, and create expectations for service providers and portfolio companies?
- Are we embedding our identified purpose into our supply chain and capital allocation?
- For new investments, what is the due diligence process for target companies and external fund managers; are we actively engaging with portfolio companies to advance ESG sustainability, particularly climate governance, including exercising proxy-voting and actively voting on election of directors based on their climate governance or other ESG record?
- Ensure processes are in place for executive to manage material ESG risks across investment portfolios, with clear accountability and reporting to the board.
- Review and approve annual objectives and milestones reached, including using to assess performance and determine annual compensation.
- Constructively query management on ESG matters when investment transactions come to the board for approval.
- Set interim targets as part of a net-zero objective to meaningfully reduce portfolio’s carbon emissions intensity over the short, medium and long term.
- Carefully examine the recommendations of the Truth and Reconciliation Commission and recent federal and BC legislation incorporating commitments under the UN Declaration on the Rights of Indigenous peoples to develop new partnerships with Indigenous Peoples.
- Clarify governance policies for preventing real or perceived conflicts of interest and regularly disclose conflict declarations from directors, including recusing selves from discussions on investments and strategies that impact the fund’s approach to climate risk and the fossil fuel sector.
- Disclose to beneficiaries how exactly the financial success of specific investment decisions aligns with the long-term interests of beneficiaries.
- Ensure all actuaries, consultants, and accountants hired to provide independent reviews of financial risks have adequate climate and ESG expertise.
- Provide guidance regarding climate-related and ESG expectations for portfolio companies and for directors and staff appointed to sit on the boards of held companies, including a robust, timebound, escalatory engagement policy that sets expectations for all held companies with respect to climate action.
In conclusion, ESG has moved into line of sight in respect of fiduciary duties to meet the pension promise. That is not to say that the fund needs to concern itself with every factor that could come under the umbrella of prudential oversight – but it does mean the trustees need to identify the most critically important issues as part of their duties of prudence, care, and loyalty. They need to ensure their investment managers and other service providers are acting in a manner that aligns with the fund’s objectives for investment. The Canada Climate Law Initiative offers pension boards and their portfolio companies free and confidential sessions on getting started and/or on moving to next steps in climate governance based on changing regulation and best practices – please consider reaching out. Thank you.
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