Europe’s pension funds are neglecting their duty to ensure that the sustainability preferences of their beneficiaries are “proactively sought and incorporated” in their investment decision-making, the High-Level Expert Group (HLEG) on Sustainable Finance states in its 2018 final report, Financing a Sustainable European Economy.
As an indication of this dereliction of duty, the report states that only 5 per cent of European Union (EU) pension funds have considered the investment challenges climate risks pose for their portfolios.
A central theme running through the report is the need for financial institutions to engage with clients and beneficiaries on sustainability, to re-establish trust in the financial sector. This would also result in better directing of capital towards the real long-term needs of the economy and its citizens, the authors state.
The report’s recommendations, hailed as “a manifesto for far-reaching change”, follow on from an interim report published in July last year. They will inform EU policy on sustainable finance in the years ahead, with important implications for long-term investors.
The financial industry is a key to the EU meeting the ambitious sustainability targets it has set by pledging to cut greenhouse gas emissions by 40 per cent by 2030. That commitment will require an estimated €180 billion ($224 billion) of committed, stable financing annually.
Duty first
Investors’ duties to their beneficiaries are already enshrined in key EU financial services directives and regulations but they do not factor in sustainability to the level required, the report states.
“Pension funds should ensure that they have a sound understanding of the broad range of interests and preferences of their members and beneficiaries, including ESG factors,” it reads.
Although pension providers must publicly disclose whether and how they include ESG factors in their risk-management systems, they do not have to integrate ESG factors into their investment policies.
The report also highlights the need for Europe’s pension funds to improve their governance around sustainability. It recommends ‘fit and proper’ tests to include an assessment of the individual and collective ability of the members of governing bodies to address sustainability risks and understand the broader stakeholder context.
Governance should also include improved monitoring and assessment of investment portfolios from a sustainability perspective, the report asserts. It states that Investors should “continuously” analyse portfolio holdings with respect to sustainability risks, particularly in investments where they have significant influence. It recommends corporate engagement and investor collaboration and urges investors to avoid “extracting short-term profits at the expense of long-term value creation”.
New tools
Combating short-termism is a recurring theme throughout the report, which recommends new tools for investors. One recommendation is reform of key market instruments, like performance benchmarks and indices, to encourage sustainability. This way, investors will be more able to understand the sustainability characteristics and exposures of the different investments they hold.
“Indices and benchmarks have an indirect but important impact on the orientation of capital but are not necessarily aligned with sustainability objectives,” the report states. “Greater transparency and guidance on benchmarks is needed, to ensure investors use and select benchmarks in a manner that is consistent with long-term investment strategies, that does not impede on sustainability and that helps to drive allocation of capital towards green and sustainable investments.”
The HLEG also calls for improved disclosure from financial institutions and companies on how they are factoring sustainability into their decision-making. It recommends EU implementation of the Task Force on Climate Related Financial Disclosure framework at an EU-wide level. The task force has provided the first industry-led framework with the potential to become a ‘new normal’ of climate disclosure, the report states. Momentum behind the framework has grown; more than 230 companies, representing a combined market capitalisation of over €5.1 trillion, have voiced their support for the task force’s recommendations.
The report also calls for accounting rules to better incorporate sustainability issues, so investors can make clearer decisions on the companies in which they invest.
“The ultimate ambition has to be convergence or integration of financial and sustainability information, which should be subject to the same assurance rigour as audit requirements for financial information,” the report states.
Pressure on managers, consultants
Asset owners do more to incorporate their sustainability priorities in the awarding of mandates, the HLEG recommends. In turn, asset managers need to ensure owners understand the potential risks, and benefits, of incorporating sustainability, “leading to a two-way consideration and integration of ESG factors”, the report states.
Asset managers should have a clear understanding of their clients’ preferences on sustainability, governance and any broader ethical issues. They should also promote their own internal awareness, embedding ESG in internal training and professional development of staff, including management leadership and the board. Sustainability should also be reflected in incentive structures, the report states.
“Asset managers should establish greater consistency and alignment with their institutional clients’ sustainability preferences – and, through that, the interests of their clients’ beneficiaries.”
Investment consultants also have a role in helping deploy capital towards sustainability goals. The report recommends that investment consultants proactively raise sustainability issues to their clients and offer related advice.
Wider recommendations in the report include calls for a definition of sustainability to establish market clarity on the term, and a classification system, or taxonomy, that would give investors more confidence and ease when choosing to invest. This would also help measure financial flows into sustainable development priorities.
The report advises making it easier for investors to invest in green bonds as well. This could be achieved by setting up a European standard for green bonds and an EU-wide label for green investment funds.
Key recommendations from Financing a Sustainable European Economy
Introduce a common sustainable finance taxonomy to ensure market consistency
and clarity, starting with climate change.
Clarify investor duties to extend time horizons and bring greater focus on ESG factors.
Upgrade Europe’s disclosure rules to make climate-change risks and opportunities
fully transparent.
Develop official European sustainable finance standards, starting with one on green
Establish a ‘Sustainable Infrastructure Europe’ facility to expand the size and quality
of the EU pipeline of sustainable assets.
Reform governance and leadership of companies to build sustainable finance
Enlarge the role and capabilities of European supervisory authorities to promote sustainable finance as part of their mandates.
