The difference between ESG factor integration and SRI
BY Staff | June 5, 2019
There are certain legal differences between socially responsible investing and the integration of environmental, social and governance factors and it’s important to know the difference, according to a recent paper.
Authored by Randy Baslaugh, partner at McCarthy Tétrault and Hendrik Garz, executive director of thematic research at Sustainalytics, the paper stated that the lines between SRI and ESG have been blurred in the investment industry.
“The purpose of ESG factor integration from the perspective of a pension fund should not be to stop climate change, improve workplace diversity or end child labour,” the paper read. “That is more of what is referred to as SRI investing in this paper. Such results may flow from integrating ESG factors into investment policy, but the purpose of employing ESG factor integration should be to improve financial performance or mitigate financial risk. From a legal perspective, other non-economic goals or aspirations are at best distractions, and at worst departures from proper fiduciary behaviour.”
Language surrounding ESG hasn’t done a clear job of distinguishing the boundary between taking ESG factors into account in the investment process when relevant and promoting ethical or social action for its own sake, the paper said. Such confusing language appears in regulatory notes, legislation and guidance from stakeholders.
For example, Manitoba’s provincial legislation refers to ESG issues an “non-financial” factors, which implies that considering them cannot be directly related to the primary purpose of a pension plan, it said, noting that if an ESG factor can inform performance assessment, sustainability or risk within pension investments, they are financial factors.
However, for Canada overall, the law is quite clear on ESG, the paper said. “In the context of a defined benefit pension fund or fiduciary-directed defined contribution plan, if ESG factors relate to financial performance or risk mitigation, taking them into account is not only allowable, but may be legally required.” Notably, it continued, pensions plans should probably avoid including language in their investment statements that says they never take ESG factors into account.
When it comes to what should be described as SRI, the law is quite different, the paper said. “The general legal rule is that fiduciaries cannot exercise a discretionary investment power in a manner that does not relate to carrying out the purposes of the trust.”
There are, however, certain circumstances where opening up the discretionary power of an investor, on an ethical or moral basis, can be acceptable, noted the paper.
For example, the paper suggested it could be acceptable for fiduciaries to establish some kind of socially responsible investment policy which they could then follow, as long as the financial interests and benefits of those whom they represent remains paramount and the investment policy is consistent with legal standards of care and prudence.
“The bottom line is that unlike the law which clearly permits, and arguably requires ESG integration as a part of the economic analysis to achieve financial goals, investing to achieve SRI goals is more complicated and uncertain,” the paper read. “The main problem is how, in legal and practical terms, the decisions of fiduciaries to consider non-economic goals can be compatible with their duty to maximize the plan’s investment returns for the benefit of its active and retired members without undue risk of loss. As a consequence, fiduciary decisions to pursue SRI should be rare, and when made, should be well-documented.”
The paper then outlined some dos and don’ts of ESG disclosure, including having it reviewed by a lawyer, keeping it short and to the point and never saying never.