The Volkswagen emissions scandal looks set to bolster environmental, social and governance (ESG) investing, but pension funds adopting this approach face potential conflicts of interest, cautions the latest issue of The Cerulli Edge – Global Edition.
“The possible legal implications of looking beyond pure financial returns when making investment decisions need to be weighed up,” says Barbara Wall, Europe research director at Cerulli Associates, a global analytics firm. The UK’s Law Commission, for example, says that trustees should not proceed on a decision motivated by non-financial factors if it risks significant financial detriment to the fund. However, as Cerulli notes, this can come down to a question of degree: in one case a court ruled that “church commissioners had acted within the law by deciding that excluding 13% of the market would be acceptable, while excluding 37% would not be.”
Affecting millions of vehicles globally, Volkswagen‘s fraudulent action may even threaten the German automaker’s existence. Cerulli says that pension fund shareholders of Volkswagen are entitled to feel aggrieved; not only over the loss to their portfolio valuations, but also because of the health and environmental damage inflicted on society at large.
“Would a focus on ESG have avoided investing in Volkswagen? Probably not, because no fund manager could have anticipated fraud in a company such as Volkswagen,” says Wall. “But, by probing companies’ governance structures and having a full understanding of their management incentives, investors should be better placed to identify those vulnerable to shock events.”
Over the past 10 years the United Nations’ Principles for Responsible Investment (UNPRI) initiative has grown from about 100 signatories with US$4 trillion (€3.7 trillion) in assets under management to 1,260 signatories with US$45 trillion in AUM. Cerulli believes that this trend will continue, with ESP investing playing a more prominent role.
Many investors have long had specific exclusions within their investment guidelines; faith-based entities, for example, often will not invest in weapons and tobacco. ESG investing, however, has moved well beyond passive exclusion to an activist approach that encompasses key issues, of which the most visible and controversial today is carbon dioxide-induced climate change, says Cerulli.
Dutch pension fund ABP announced in October that it will be asking every company in its investment portfolio to “reapply” as part of its new socially responsible investment policy. Companies will need to detail how responsibly they operated and how much attention they paid to sustainability.
“We expect more pension funds to start considering ESG investing, but cultural backgrounds and the level of investor sophistication will be factors in determining any commitment. For example, pension funds in the Netherlands and Denmark will be far more inclined to do so than say those in Germany,” says Justina Deveikyte, an international analyst at Cerulli.