By Paul Davies and Michael Green

The Organisation for Economic Co-operation and Development (OECD) published a report (OECD Report) on investment governance and integration of environmental, social and governance (ESG) factors on 2 May 2017. The OECD Report develops work already carried out by the organisation on the regulation of investment companies and pension fund investments. It is also linked to certain OECD instruments, including (i) the OECD principles of private pension regulation (adopted in 2016) and (ii) the G20/OECD high level principles of long term financing by institutional investors (last published in September 2013).

The OECD Report looks into how pension funds, insurance companies and asset managers approach ESG risks and opportunities in portfolio investments. Specifically, it presents the findings of an international “stock taking exercise” of the legal and regulatory frameworks that applies to institutional investment in different jurisdictions. It focuses on how these are interpreted by institutional investors in terms of their ability and/or responsibility to integrate ESG factors into their governance processes. The interesting point here is whether these existing frameworks encourage or discourage the integration of ESG factors into decision making processes.

The key findings of the OECD Report were as follows:

• Regulatory frameworks enable institutional investors to integrate ESG factors into their investment governance where this is consistent with financial obligations. However, a lack of regulatory clarity, practical complexity and behavioural issues may discourage effective ESG integration.
• ESG factors may influence investment returns through their impact on the financial performance of companies and through the risks they may pose to broader economic growth and financial market stability.
• There are certain technical and operational difficulties in measuring and understanding ESG related portfolio risks. An increasing number of tools are available that would enable institutional investors to integrate ESG factors to different extents.

Common barriers to effective integration of ESG factors are flagged: for example, practical constraints (the cost and complexity of putting in place an ESG investment strategy) or behavioural barriers (investors believing ESG factors are “non-financial”). A key example is the concept of climate change being considered a “material financial risk”. The growing shift towards low-carbon and non-fossil fuel pathways will have a substantive impact on businesses that emit large volumes of carbon and investment in fossil fuel extraction will carry greater risk. Such considerations must be factored into investment decisions at the board level itself and not through separate environment committees. Although this aspect is usually dealt with in a more sophisticated way in the private equity space, clearer regulations are required to level the playing field in the pensions sector.

The OECD Report concludes that these issues are starting to be addressed by policy makers. Institutional investors are now required to provide more transparent ESG investment policies and to increase engagement with portfolio companies. The OECD Report also flags that policymakers should support proposals to develop standardised investment terminology and consistent corporate ESG reporting. Part of this process would involve a detailed analysis of ESG investment models used in the industry and how they affect the prudential and behavioural standards of institutional investors. Perhaps addressing such issues at a policy level will drive the cultural shift required and enable investors to adopt a proactive stance on ESG issues, as they increasingly coincide with investment interests.

This post was prepared with the assistance of Ei Nge Htut in the London office of Latham & Watkins.