en

    investment viewpoints

    Moving with the times? Fiduciary duty and climate change

    Moving with the times? Fiduciary duty and climate change
    Marek Siwicki - Head of Consultant Relations

    Marek Siwicki

    Head of Consultant Relations
    Sheena Shah - Consultant Relations

    Sheena Shah

    Consultant Relations

    It’s tempting to reach for a soundbite when aiming to describe a trustee’s fiduciary duty in the age of climate change.

    Something like: ‘I can invest responsibly if it enhances, or at least doesn’t harm, returns’.

    But it’s not so easy: sustainability can’t simply be bolted on to a return objective. During Race to net zero, an LOIM event held for UK investment consultants, the concept of fiduciary duty was explored – from its origins to present-day relevance as pension funds assess the impact of climate change on portfolios.

     

    Need to know:

    • Fiduciary duty is a concept in search of a definition. But legal precedents and industry consultations provide an understanding of what it involves
    • The net-zero transition can be seen as relevant to a fiduciary ‘bundle’ of duties given that its financial materiality calls for a prudent wielding of investment power
    • The ‘universal owner’ concept, which posits that externalities are inevitable internalised in a large, diversified portfolio, underscores the importance of climate risk

     

    In search of a definition

    Ralph McClelland, Partner at Sackers, a specialist law firm for pension scheme trustees, explained how fiduciary duty is rooted in ideas of purpose, prudence and financial materiality, and how it has evolved in a series of legal cases and industry consultations over decades.

    McClelland described the 1985 case of Cowan vs Scargill, in which a pension trustee sought to divest South African sovereign bonds due to the nation’s Apartheid policy. This early application of portfolio screening was judged to be outside of their “power of investment”. According to the case:

    Power of investment must be exercised so as to yield the best return for the beneficiaries, judged in relation to the risk of the investments in question.

    • Cowan vs Scargill (1985) Ch 270

    Even if we were to agree with the interpretation of the court in this case, this does not fully resolve the issue – as it may well be that the concern identified (whether it be apartheid, or misalignment to the climate transition) would in fact affect risk and return calculations. In this case, even under a narrow definition of fiduciary duty, it would then be relevant and even essential for trustees to consider such questions.

    More recently, in 2014, with the Principles for Responsible Investment established in the pensions industry and sustainability considerations progressing from the periphery to the core of investment debates, a Law Commission survey of the understanding of fiduciary duty yielded a range of views:

    • [Trustees] must invest the scheme assets in the best interests of scheme members and beneficiaries.
    • Trustees are not required to ‘maximise returns’. Trustees must weigh returns against risks, including long-term risks.
    • [Trustees] should take into account factors which are financially material to the performance of an investment.

    McClelland posed the question: can these perspectives be used to create a legal definition of fiduciary duty? If so, the industry hasn’t formulated one yet. But there is some consensus on an approach to fiduciary duty.

     

    The fiduciary bundle

    McClelland argued that trustees can fulfil something close to this elusive concept by exercising a bundle of fiduciary and trust law duties. These are:

    1. Exercising trustee investment power for its proper purpose
    2. Considering relevant factors – typically financially material risks and potential return
    3. Acting in accordance with the prudent person principle

    There is ample room for interpretation in this bundle, but it provides a framework for fiduciary decision making.

    First, how should a trustee define the ‘proper purpose’ of their investment power? This varies among schemes. At the most fundamental level, trustees of a defined benefit fund must target a specified income stream for beneficiaries. Those overseeing defined-contribution (DC) default funds should grow a pension ‘pot’ from accumulated contributions, whereas trustees of DC member-select funds must provide a range of suitable investment options.

    Second, relevant factors for investment evolve over time. Risks intensify and ease, market crises develop from different causes, and phenomena emerge that result in new return drivers – from globalisation to the rise of digital technology and the climate and nature crises.  

    Third, how should a prudent person act? They are not judged by the outcomes of their decisions, but in the steps taken to reach them. This distinction is crucial: a prudent trustee is not expected to be prescient but should exercise care, skill and diligence in the context of the economic and financial conditions of the time. They are defined by their behaviour, in the context of contemporary issues.

     

    Climate: a fiduciary concern?

    Climate change is a defining challenge of our time. At LOIM, we believe that as policy and consumer appetite increasingly favour mitigation and adaptation efforts, it is impacting asset valuations.  

    This is because many companies are implementing more sustainable business models to manage the physical, transitional and liability risks inherent in the decarbonisation of the global economy – and   to benefit from increasing demand for carbon-neutral goods and services. An imminent indication of the net-zero transition’s influence on asset valuations will be the repricing of European corporate bonds as the region’s biggest investor, the European Central Bank, tilts its €340 billion portfolio to climate-aligned firms.

    Is climate change an essential concern for trustees? In our view, the decarbonisation of the global economy is a strong enough influence on risk and return to be seen by a trustee, acting prudently, as a proper and material investment concern. The fiduciary bundle certainly applies:

    • Climate risk is a relevant factor among other financially material risks and sources of return
    • A prudent person would assess how the net-zero transition is impacting business models and asset valuations
    • Minimising exposure to the risks of the transition, and optimising access to its opportunities, is an exercise in using trustee investment power for its proper purpose

    Trustees do not hold an investment power to solve Earth’s problems, to protect a scheme’s reputation or meet a particular desire expressed by its members. But as economy-wide decarbonisation impacts asset valuations, it would be prudent to take action.

     

    An unavoidable risk? The ‘universal owner’ concept

    The ‘universal owner’ hypothesis provides another perspective on the investment materiality of climate change. It posits that there are clear links between the performance of large, diversified portfolios and the overall economy:

    “A portfolio investor benefiting from a company externalising costs might experience a reduction in overall returns due to these externalities adversely affecting other investments in the portfolio, and hence overall market return”.1

    A free-market economy delivers clear advantages, from competitiveness and innovation to adaptability. But one severe flaw has been the ability of companies to transfer costs – from environmental pollution to poor health and safety standards – to nature, other companies or social institutions.

    A universal owner can’t avoid these costs, the theory goes. A large asset owner, such as a pension fund, typically has a diversified portfolio relying on stable and productive economic, environmental and social systems to underpin the assets it invests in. Costs externalised by one company are likely to negatively impact other holdings, entering the portfolio as taxes, insurance premiums, inflated input prices, litigation on environmental concerns and the physical cost of disasters – including extreme weather caused by failing to hit net zero.

    Investors subscribing to the universal owner concept recognise the financial impacts of externalities. And those focused on the net-zero transition see the value not only in making companies accountable for their emissions, but also in championing decabonisation across the entire economy.

     

    Source.

    [1] Thamotheran, R. and Wildsmith, H., cited by Seitchik, A. in Climate change from the investor’s perspective. Civil Society Institute via KIPDF [website]. Accessed August 2022.

     

    important information.

    For professional investor use only
    This document has been issued by Lombard Odier Funds (Europe) S.A. a Luxembourg based public limited company (SA), having its registered office at 291, route d’Arlon, 1150 Luxembourg, authorised and regulated by the CSSF as a Management Company within the meaning of EU Directive 2009/65/EC, as amended; and within the meaning of the EU Directive 2011/61/EU on Alternative Investment Fund Managers (AIFMD). The purpose of the Management Company is the creation, promotion, administration, management and the marketing of Luxembourg and foreign UCITS, alternative investment funds ("AIFs") and other regulated funds, collective investment vehicles or other investment vehicles, as well as the offering of portfolio management and investment advisory services.
    Lombard Odier Investment Managers (“LOIM”) is a trade name.
    This document is provided for information purposes only and does not constitute an offer or a recommendation to purchase or sell any security or service. It is not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful. This material does not contain personalized recommendations or advice and is not intended to substitute any professional advice on investment in financial products. Before entering into any transaction, an investor should consider carefully the suitability of a transaction to his/her particular circumstances and, where necessary, obtain independent professional advice in respect of risks, as well as any legal, regulatory, credit, tax, and accounting consequences. This document is the property of LOIM and is addressed to its recipient exclusively for their personal use. It may not be reproduced (in whole or in part), transmitted, modified, or used for any other purpose without the prior written permission of LOIM. This material contains the opinions of LOIM, as at the date of issue.
    Neither this document  nor any copy thereof may be sent, taken into, or distributed in the United States of America, any of its territories or possessions or areas subject to its jurisdiction, or to or for the benefit of a United States Person. For this purpose, the term "United States Person" shall mean any citizen, national or resident of the United States of America, partnership organized or existing in any state, territory or possession of the United States of America, a corporation organized under the laws of the United States or of any state, territory or possession thereof, or any estate or trust that is subject to United States Federal income tax regardless of the source of its income.
    Source of the figures: Unless otherwise stated, figures are prepared by LOIM.
    Although certain information has been obtained from public sources believed to be reliable, without independent verification, we cannot guarantee its accuracy or the completeness of all information available from public sources.
    Views and opinions expressed are for informational purposes only and do not constitute a recommendation by LOIM to buy, sell or hold any security. Views and opinions are current as of the date of this presentation and may be subject to change. They should not be construed as investment advice.
    No part of this material may be (i) copied, photocopied or duplicated in any form, by any means, or (ii) distributed to any person that is not an employee, officer, director, or authorised agent of the recipient, without Lombard Odier Funds (Europe) S.A prior consent. In Luxembourg, this material is a marketing material and has been approved by Lombard Odier Funds (Europe) S.A. which is authorized and regulated by the CSSF.
    ©2022 Lombard Odier IM. All rights reserved.