In a new working paper, the Pension Research Council at the Wharton School of the University of Pennsylvania examines the long-term risks of environmental, social and governance (ESG) investing by defined benefit (DB) pension plans and how they can best mitigate these issues.
The paper notes that, due to their long-term horizons, pension funds face enhanced exposures to the long-lived effects of many ESG risks. While there are many different approaches to ESG investing—and, certainly, many different types of ESG screens that can help pension plan managers make better investment decisions—the council says it appears that the best way for pension plan sponsors and their consultants to manage their ESG investments is by delving deep into each individual company’s approach to its ESG responsibilities.
The scholars who wrote the paper, Zacharias Sautner and Laura T. Starks, begin by laying out the benefits of applying ESG screens to pension investments. “Analyzing a firm from an ESG perspective allows pension fund managers to potentially identify risk exposures that would be missed using just traditional investment analysis,” they write in the paper, “ESG and Downside Risks: Implications for Pension Funds.”
“The types of risks most likely to be uncovered using an ESG lens can be categorized as reputation risk, human capital management risk, litigation risk, regulatory risk, corruption risk and climate risk,” they continue. Sautner and Starks go on to detail subcategories of these types of risk, namely, systemic risks, tracking error and downside risks, each of which can be affected differently by ESG issues. “Some of the risks, notably climate risk, have changed in importance over time, and even for others, such as corruption risk, the ESG lens can provide a heightened way in which to examine the effects of the risks on pension portfolios,” they write.
Given that ESG investing can be highly complicated, the academics then note that pension funds face large liabilities toward their beneficiaries. They also say that “the failure to meet those liabilities because of significant negative ESG-related events carries large penalties. Thus, with wealth protection being an important dimension, pension funds should have a strong preference to identify and address ESGrelated downside risks.”
Different Kinds of ESG-Related Risks
The authors next discuss different types and sources of ESG-related risks, with a focus on climate-related downside risks.
Reputational risk, or the threat or danger to the good name or standing of a business, is one of the biggest risks that publicly traded companies face, the scholars say. And over the span of many decades, reputational risk can be very costly for pension plan managers, they note, pointing to the “value of intangible assets for firms in the S&P 500 increasing from about 17% in 1975 to 90% in 2020.”
Climate risk is also a serious consideration when applying an ESG screen. “Climate risk can originate from physical risks (e.g., sea level rise, storms or extreme temperature), regulatory risks (regulation to combat climate change) or technological risks (technological climate-related disruption), all of which can be financially material.” The problem, they go on to say, is that “climate risk can be difficult to price and hedge due to its systematic nature” and the fact that climate risk reporting in the U.S. is behind that of Europe and other regions of the globe.
Yet another type of risk, systemic risk, is “the risk that a firm has in common with the market,” which can contain ESG elements. The paper also discusses tracking error, downside risk, climate-related downside risks and the pricing of downside-related downside risks.
In conclusion, Sautner and Starks say that institutional investors, including pension plan sponsors and consultants, are fully aware of the long-term implications of ESG-related downside risks.
“These risks are [already] priced in financial markets,” they say. ”The investors tend to prefer to employ risk management and engagement strategies, rather than divestment, to address the climate risk in their portfolios. Overall, our evidence implies that pension funds should develop processes to identify, measure and manage ESG-related downside risks, especially those related to climate change.