How Environmental, Social, and Governance (ESG) Criteria Have Evolved for Pension Investors

This summary of the Pension Research Council Conference entitled Sustainable Investment in Retirement Plans: Challenges and Opportunities was prepared by Olivia S. Mitchell with input from Shankar Parameshwaran.

Since its green shoots 50 years ago, acceptance of environmental, social, and governance considerations in institutional investing – especially at pension funds – has evolved with distinct shifts in investor preferences. Participants at the Pension Research Council’s two-day symposium entitled Sustainable Investment in Retirement Plans: Challenges and Opportunities, traced those shifts, leading up to the present day.

P. Brett Hammond, a research leader at the Capital Group noted in his presentation that ESG principles have been shaped by social movements, governments, and regulators, independent advocacy and service organizations, and asset owners and asset managers, notably pension funds. Hammond is also a member of the Pension Research Council’s advisory board.

Hammond traced the origins of ESG to the pre-modern era from the post-Industrial Revolution late 19th century to about 1970. That period was characterized by concentrated ownership of public companies in the U.S. and elsewhere, the transformation of work and consumption, and little to no activism by small shareholders or pension funds on social or environmental issues.

Governance concerns, however, were prominent in the pre-modern era. They included policies to limit monopolies and ownership of companies by banks and families, antitrust regulation, the emergence of uniform accounting, reporting, and disclosure rules, and the advent of a two-tiered board structures where supervisory boards retain control and management boards execute company strategies. Other features of the pre-modern era included regulation of working conditions and hours, food quality, and the beginnings of an environmental movement.

The modern era for ESG began around 1970, yet governance policies and practices varied across countries, as did social and environmental concerns, noted Hammond. For instance, in the U.S., company management was dominant, whereas family and/or bank control persisted in some European countries, and cross-holdings and bank influence were common in Japan. On social issues, the U.S. and the U.K. saw debates over employment practices and the declining influence of unions. The U.S. was ahead of others in tackling environmental challenges, with the birth of the U.S. Environmental Protection Agency coinciding with the dawn of ESG’s modern era.

Roles of the U.N. and universal owners

Notable among the big shifts in the evolution of ESG were the first wave of government mandates and governance attributes bringing an early focus on environmental and social issues, and catalyzing actions by the United Nations. In 2006, the U.N. helped frame the Principles of Responsible Investing integrating a global network of investors (UNPRI). In 2016, it articulated its Sustainable Development Goals which continue to inform much of ESG investment approaches. Those are in addition to the U.N.’s climate change conferences that goad signatory countries to implement laws to combat greenhouse gas emissions.

“The U.N. has been incredibly important in [the development of ESG principles],” argued Hammond. He pointed to the UNPRI’s latest definition of responsible investment “as a strategy and practice to incorporate ESG factors in investment decisions and active ownership,” in a paper with Amy O’Brien, global head of responsible investing at Nuveen, a subsidiary of Teachers Insurance and Annuity Association of America (TIAA). The UNPRI has adopted the theme of “building a bridge between financial risk and real-world outcomes” for 2021-2024. In addition to the U.N., “a wide range of institutions – not just investors, but independent organizations, governments and others that are that are essential to the development of ESG,” added Hammond. “It’s grown into its moment.”

While the U.N. and other advocates helped advance awareness of ESG among corporations and regulators, large shifts in ESG investing occurred only after institutions with substantial asset pools such as pension funds and other “universal owners” exerted their influence, Hammond pointed out. As of 2020, U.S. pension funds managed $6.2 trillion of total assets incorporating ESG principles, he noted, citing data from the U.S. SIF Foundation.

Hammond defined a universal owner as a pension fund or a large institutional investor such as BlackRock that “invests long term in widely diversified holdings throughout the global economy.” Universal owners must deal with or are incented to deal with externalities such as the environmental and social effects of the companies in which they invest. Moreover, governance systems can help those companies address their externalities.

In addition to the rise of universal ownership over the last few decades, Hammond argued that drivers of ESG investing include the economic transformation going back to the Industrial Revolution, the increased focus on stakeholder interests, and improved data and analytics that help capture the outcomes.

How ESG developed globally

ESG investing has developed differently across countries and much depends on national asset ownership patterns and legal frameworks, noted Hammond. Pension funds and other institutions have exerted the biggest influence on ESG investing and activism in that space, he discovered, by tracking shareholding patterns across countries in his video presentation.

Countries where institutional owners such as pensions have played a dominant role include the U.S., the U.K., Canada, and the Netherlands. A close second in terms of influence on ESG investing are those with relatively less institutional ownership, such as France, Germany, Japan and Sweden. That influence tapers off in countries where the public sector is the dominant owner, such as China and Hong Kong. Institutional ownership is also relatively lighter in Malaysia, Russia, and Saudi Arabia.

A combination of private corporations and strategic individuals dominates asset ownership in many nations including Argentina, Brazil, Chile, India, Indonesia, Pakistan and Turkey. Private ownership is particularly strong in Mexico, which Hammond described as the “Carlos Slim effect” – the companies Slim runs account for 40% of the listings on the Mexican stock exchange and he is the richest person in Latin America with an estimated net worth of $56.5 billion on the Bloomberg Billionaires Index.

Stages of ESG development

Hammond and O’Brien’s study traces the evolution of ESG investing over each of the five decades in the modern era, as follows:

  • 1970s: The concept of “ESG as a principle” took hold as investors aligned around key social concerns such as apartheid in South Africa and the Vietnam War. Also, pioneering institutions emerged in this decade, such as the Interfaith Center on Corporate Responsibility (ICCR), which broke new ground with shareholder advocacy among faith-based institutions to press companies ESG issues.
  • 1980s: This decade saw the articulation of “ESG as a product,” with the formation of dedicated industry networks such as The Forum for Sustainable and Responsible Investment (USSIF) and increased emphasis on corporate governance and the environment.
  • 1990s: The idea of “Responsible Investing as a Product” took shape in this decade, with the arrival of social indices to track ESG and Socially Responsible Investing (SRI) funds.
  • 2000s: In this decade, “ESG as a process” took hold, with investor convergence on climate issues and the formation of global investor networks such as the UNPRI and the Global Impact Investing Network, or GIIN.
  • 2010s: The concept of “ESG as an outcome” gained ground as responsible investing approaches expanded across asset classes, and ESG data and reporting practices saw refinements. The adoption in 2016 of the U.N.’s 17 Sustainable Development Goals was another key catalyst.
  • 2020s: This decade saw the evolution of “ESG as a system,” with many institutional investors going “all ESG” and an increased sense of urgency worldwide on climate issues. Companies that indulged in “greenwashing” or faking environmental friendliness in their products also began receiving increased scrutiny.

The era of convergence

Over the modern era, the three pillars of ESG developed separately before converging in recent times. Environmental and social issues that guided investments largely fell into three camps throughout the modern era, noted O’Brien. Those were “guideline investing,” which has taken many forms over the years from exclusions to product specific criteria to the more modern concept of ESG integration across portfolios; “shareholder advocacy;” and “community investing” which later came to be termed as impact investing.

Developing alongside has been a “trend toward E, S, & G convergence – of definition, process and organization – toward a more integrated investment perspective and process,” propose Hammond and O’Brien in their paper. “Convergence and integration are apparently irreversible trends as pensions and institutional investors around the world expand their sustainable investing capabilities or require their managers to do so,” they added.

In the early days, the debate was on whether institutional investors should have separate portfolios for E, S, and G, or a single common portfolio for all three. Hammond observed that there has been an increasing recognition that separation doesn’t work and that there should be true integration, concluding that “it’s very hard to have a separate portfolio [for each of those three] that’s going to win.” That debate has made way for the integration of ESG considerations into regular investment processes, he added. For instance, he said a portfolio with oil assets would gain as oil prices increase, and an integrated approach would allow its fund managers to “balance the potential for oil outperformance with ESG considerations.”

ESG to what end?

Within that trend of convergence and integration, a fundamental debate has centered on “ESG to what end? “ Some argue it enhances investment performance, others that it adds alpha potential, and still overs argue it can mitigate portfolio risk, according to O’Brien. She added that the debate is helping to clarify who gets to decide on ESG investing, particularly when it comes to ESG performance, and the role of the regulatory regimes.

In that context, clearly defining the end goal is critical, said Wharton management professor Witold Henisz, who is also founder of the ESG Analytics Lab at the school and director of the Wharton Political Risk Lab. “What is not clear is whether ESG investors are pursuing “values,” such as protecting the environment or working to control gun violence, or “value,” as in protecting the profits from their investments,” he said in his presentation.

Institutional investors such as pension funds face that question of ‘values versus value’ in virtually every investment decision they make. That is because they have a fiduciary responsibility to protect the financial interests of their members who depend on them to secure their retirement nest eggs. Therefore, all investment decisions must clear the test of financial prudence, including environmental and social factors in guiding those decisions.

“E&S has been very much viewed by pension funds and their trustees through the business case lens, although it’s been harder in some cases to make the business case,” said O’Brien. “A lot of pensions have really struggled to find that right balance between social responsibility and the fiduciary duty to act to maximize return on behalf of their participants.”

Finding a balance

How do pensions funds find that balance? According to Judith Stroehle, senior research fellow at Oxford University’s Said Business School, “regulatory embeddedness is quite strong for pension funds” as guides to the mandates and legal structures covering retirement plans. Her presentation entitled “The Origins of ESG in Pensions: Strategies and Outcomes” is based on her paper with Stephanie Lachance, managing director of Responsible Investment Public Sector Pension Investment Board (PSP Investments) in Canada. These mandates and legal structures form the basis for the corporate governance standards advocated by pension funds, as well as “the freedom their leadership has to decide whether and how to implement environmental, social and governance issues,” Stroehle added.

Stroehle pointed out that drawing from those, pension funds determine their investment strategies and asset mixes. Institutional investors thus select investment policies that can instill ESG principles in companies through “engagement and stewardship,” she said. Collaboration and advocacy are the tools they use by taking public stands around environmental and social issues, and by working with other funds as in collaborative engagements like the Climate Action 100+. Launched in 2017, Climate Action 100+ is now backed by more than 545 investors with more than $52 trillion in assets under management, including 145 North American investors.

The writing on the wall

Pivotal moves by some of the world’s largest pension funds to advance the case of ESG investing are listed in Stroehle and Lachance’s paper. For instance, in March 2020, the California State Teachers’ Retirement System (CalSTRS), the Japanese Government Pension Investment Fund (GPIF), and the largest U.K. pension fund–the Universities Superannuation Scheme (USS)–publicly pledged that they would integrate ESG factors into their investment decisions. Six months later, a similar pledge a similar pledge was made by the CEOs of the eight largest Canadian pension funds – the so-called ‘Maple 8.’

A related move came in December of 2020 from the New York State Common Retirement Fund, when it set 2040 as its goal to transition its portfolio to a net zero greenhouse gas emissions. “With $226 billion in assets, New York’s fund wields clout with other retirement funds and its decision to divest from fossil fuels could accelerate a broader shift in global markets away from oil and gas companies,” a New York Times report said, citing energy experts and climate activists.

In leading the New York State Common Retirement Fund on that clean energy agenda, New York State Comptroller Thomas DiNapoli is adopting “a very thoughtful divestment process where they’re going through rigorous reviews of their portfolio and going sector by sector,” noted Billy Nauman, a Financial Times reporter and producer of Moral Money, the FT’s newsletter on ESG and impact investing trends.

Nauman made those remarks in his presentation titled “Integrating Sustainability into Investment Analytics: What the Market is Telling Us.” He believes that the New York pension fund calibrated its efforts by starting with “engagement,” and is using “divestment as a last resort.” He sees those trends accelerating in the near future. “The markets have sent the signal: we need to know more about these types of risks, these types of opportunities, and how they’re affecting companies,” he said. He also noted that New Zealand in 2020 became the first country to require its financial sector to report climate risk disclosures. “The U.K. has indicated it is moving in that direction and that may be happening in the U.S. [as well],” he added.

According to Nauman, a promising discussion in the global ESG debate will take place at the United Nations’ November 2021 COP26 meet. Here, the International Financial Reporting Standards (IFRS) Foundation is expected to announce sustainability standards and disclosure requirements around them. “If you’re a major fossil fuel company looking at the future landscape, you have to see the writing on the wall that things are changing,” Nauman said. “Having loyal investors stick with you and help you along the way would be beneficial.”


Views of our Guest Bloggers are theirs alone, and not of the Pension Research Council, the Wharton School, or the University of Pennsylvania.