review of the application of environmental, social and governance principles to territory investment

99 Pages·2007·2.3 MB·English

REVIEW OF THE APPLICATION OF
ENVIRONMENTAL, SOCIAL AND
GOVERNANCE PRINCIPLES TO
TERRITORY INVESTMENT PRACTICES

29 June 2007

Prepared by the

Independent, Non-Executive Members of the
Finance & Investment Advisory Board
Review of the Application of Environmental, Social and Governance Principles to Territory Investment Practices

Report prepared by the:

Independent, Non-Executive Members of the
Finance & Investment Advisory Board

Those Members being:

Barbara Yeoh
Ken Searson
Phillip Charley

29 June 2007

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Disclaimer:
This report has been prepared by the Australian Capital Territory Government’s Finance and
Investment Advisory Board (the Board) at the request of the Chief Minister’s Department.

This Report is solely based on information provided by third parties, including Frontier
Investment Consulting and the Department of Treasury, and information in the public domain.
No warranty of accuracy or reliability is given in relation to information and documentation
provided by those parties or in the public domain. The Board will not be liable for the
consequences of any party that acts on the information supplied herein. Any reliance placed is
that party’s sole responsibility.
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Review of the Application of Environmental, Social and Governance Principles to Territory Investment Practices

Contents:

1. Executive Summary...................................................................................................................................5
2. Terms of Reference....................................................................................................................................9
2.1 Process...................................................................................................................................................9
2.2 Exclusions............................................................................................................................................10
3. ACT Government (Territory) Investments...............................................................................................11
3.1 Superannuation Provision Account (SPA)..........................................................................................11
3.2 Territory Banking Account (TBA)......................................................................................................12
4. A Brief History of Ethical Investment, SRI and ESG...............................................................................13
4.1 Recent Developments..........................................................................................................................13
4.2 United Nations Global Compact..........................................................................................................15
4.3 The “Freshfields Report”.....................................................................................................................16
4.4 United Nations Principles for Responsible Investment.......................................................................21
5. What’s Happening in Australia Today?..................................................................................................24
5.1 Commonwealth Government’s Parliamentary Joint Committee on Corporations and Financial
Services...........................................................................................................................................................24
5.2 Australian Stock Exchange..................................................................................................................25
5.3 Australian Council of Super Investors.................................................................................................26
6. Investment Decision-Making Framework...............................................................................................27
6.1 Territory Investments – SPA and TBA...............................................................................................27
6.2 Investment Decision-Making Framework for Other Types of Institutional Investments....................28
6.3 Case Law.............................................................................................................................................29
7. Terms of Reference #1.............................................................................................................................31
7.1 Values-Based.......................................................................................................................................31
7.1.1 Negative Screening..........................................................................................................................32
7.1.2 Best of Sector or Positive Screening...............................................................................................32
7.1.3 Advantages and Disadvantages of Screening..................................................................................33
7.2 Risk-Based...........................................................................................................................................34
7.2.1 Voting..............................................................................................................................................34
7.2.2 Risk-Based Engagement..................................................................................................................35
7.2.3 Advantages and Disadvantages of Engagement..............................................................................37
8. Terms of Reference #2.............................................................................................................................39
8.1 Other Government Jurisdictions..........................................................................................................39
8.1.1 Australian Government - Treasury..................................................................................................39
8.1.2 Australian Government – Finance & Administration......................................................................40
8.1.3 New South Wales Government.......................................................................................................41
8.1.4 Queensland Government.................................................................................................................41
8.1.5 Victorian Government.....................................................................................................................41
8.1.6 Western Australian Government.....................................................................................................42
8.1.7 Northern Territory Government......................................................................................................43
8.1.8 New Zealand Superannuation Fund................................................................................................43
8.2 Member Investment Choice Options...................................................................................................44
8.2.1 ARIA (formally the CSS and PSS Boards).....................................................................................44
8.2.2 VicSuper..........................................................................................................................................45
8.3 Institutional Investors..........................................................................................................................46
9. Terms of Reference #3.............................................................................................................................49
9.1 Background..........................................................................................................................................49
9.2 Australian Experience.........................................................................................................................50
10. Terms of Reference #4.........................................................................................................................55
10.1 Values-Based Implementation Issues..................................................................................................55
10.2 Risk-Based Implementation Issues......................................................................................................57
10.2.1 Voting Implementation Issues.........................................................................................................57
10.2.2 Risk-Based Engagement Implementation Issues.............................................................................58
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Review of the Application of Environmental, Social and Governance Principles to Territory Investment Practices

11. Terms of Reference #5.........................................................................................................................59
11.1 Values Based Implementation Issues..................................................................................................59
11.2 Risk-Based Implementation Issues......................................................................................................60
11.2.1 Voting Implementation Issues.........................................................................................................60
11.2.2 Risk-Based Engagement Implementation Issues.............................................................................61
12. Other Issues.........................................................................................................................................62
13. Summary..............................................................................................................................................63
14. Recommendations................................................................................................................................67
15. Acknowledgements..............................................................................................................................68
Appendix 1 Abbreviations / Definitions......................................................................................................69
Appendix 2.......................................................................................................................................................76
A2-1. Submissions Received by the Finance & Investment Advisory Board.........................76
A2-2. Other Contributions...................................................................................................................76
A2-3. Research and other References..............................................................................................77
Attachment A...................................................................................................................................................79
Attachment B...................................................................................................................................................91

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Review of the Application of Environmental, Social and Governance Principles to Territory Investment Practices

1. Executive Summary

The Chief Minister has requested that the Chief Minister’s Department, with the assistance of the
independent, non-executive members of the Finance & Investment Advisory Board (the Board),
undertake a review of the extent to which environmental, social and governance (ESG) principles
could be incorporated into the investment decision-making processes for the Territory’s investment
portfolios.

In this report the Board has limited its consideration of ‘Territory investments’ to the investment
funds of the Superannuation Provision Account (SPA) and the Territory Banking Account (TBA)
managed by the Department of Treasury (Treasury).

Other decisions of the ACT Government that relate to, for example, funding for the capital works
program, education, health, housing and specific social issues are outside the scope of this review.
These are matters to be decided by the Government in the context of its budget policy setting
process and appropriation framework and do not relate to institutional investment portfolio
management.

This review draws largely upon published research, much of it recognising the fiduciary
responsibilities of institutional investors, and the views of peak bodies and organisations that are
involved in, or have some interest in, financial investment management or operations.

The incorporation of ESG issues into the funds management framework has evolved over time from
one of applying ‘values’ to one of addressing investment risk. This changed emphasis reflects:

(cid:131) The fiduciary responsibilities of institutional investors to maximise investment returns
within acceptable risk tolerances, acknowledging that many ESG issues will ultimately
impact on valuations and hence investment returns; and
(cid:131) The inherent difficulties in deciding upon the suite of values to be applied.

It was not until the latter part of the 20th century that socially responsible investing gained
momentum in Australia, with investment objectives framed to incorporate social good based on a
set of ‘values’. Until recently these socially responsible investing (SRI) or ‘ethical’ funds were
primarily restricted to the retail market, with limited offerings becoming available within the
institutional investment market over the past few years.

In 2005 the landmark Freshfields Report, commissioned by the United Nations Environment
Programme Finance Initiative Asset Management Working Group, examined whether the
consideration of ESG issues as part of the investment decision-making process was legally
permissible in a range of countries, including Australia. The Freshfields Report concluded that
“integrating ESG considerations into an investment analysis so as to more reliably predict financial
performance is clearly permissible and is arguably required in all jurisdictions.”

The publication of the Freshfields Report was closely followed by the joint release in April 2006 of
the UN Principles for Responsible Investment (UN PRI) by the United Nations Environment
Programme Finance Initiative and the United Nations Global Compact. The UN PRI is based on
the premise that ESG issues can affect investment performance and that the appropriate
consideration of these issues is part of delivering superior risk adjusted returns and is therefore
firmly within the bounds of investors’ fiduciary duties.
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Review of the Application of Environmental, Social and Governance Principles to Territory Investment Practices

The UN PRI is designed to be compatible with the investment styles of large diversified
institutional investors that operate within the traditional fiduciary framework and suggests a risk-
based policy of engagement with companies rather than a values-based screening approach.

Consistent with the UN PRI, direct engagement with companies and proxy voting are the two key
processes that are being adopted by institutional investors in implementing a risk-based approach to
ESG issues.

The engagement process provides for proactive engagement with the management and boards of
companies on ESG issues and seeks to directly influence and change corporate behaviour. Within
Australia the engagement process is generally implemented through specialist third party service
providers and does not override the mandated responsibilities of the fund manager(s) appointed by
an institutional investor.

For institutional investors voting can be exercised directly by the investor or through delegated
authority to a third party (proxy voting). Where an investor places funds into a pooled fund
operated by a fund manager, the fund manager has sole responsibility for exercising votes on behalf
of the unit holders. To date the voting approach to ESG issues has been limited primarily to
governance issues.

This review has noted that governments in Australia overall have taken an arm’s-length approach to
the management of investments with little, if any, explicit recognition of ESG issues.

Many superannuation schemes offer SRI options to members under choice of fund arrangements.
Some superannuation funds consider ESG issues more broadly as part of the general investment
decision-making process. This review has also found that to varying degrees a risk-based approach
to ESG issues is also being implemented into investment management processes by the current SPA
and TBA fund managers.

The Territory’s two main pools of investment funds, the SPA and the TBA, are governed by the
Financial Management Act 1996 which requires the prudent management of fiscal risks arising
from the management of the Territory’s assets and liabilities. The Act also requires that the
investment of TBA moneys may only be made to increase or protect the financial wealth of the
Territory.

This review has assessed the relative merits and implementation of both a values-based and risk-
based approach to ESG issues in the management of the Territory’s investments. The Board has
come to the view that a risk-based approach is preferred.

Paramount to this view is the Board’s belief that the use of values-based screening for the
Territory’s investments is not consistent with the overriding obligations of the prudent fiscal
management of risks. Other key factors that have been taken into consideration include:

(cid:131) Screening does not necessarily influence or change corporate behaviour;
(cid:131) The establishment of ‘values’ criteria by the ACT Government is especially problematic in
that many of the activities that may be considered socially undesirable are legally permitted
activities and in some cases are engaged in by responsible governments;
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Review of the Application of Environmental, Social and Governance Principles to Territory Investment Practices

(cid:131) Screening reduces the size of the investable universe, potentially resulting in a higher
volatility in returns relative to the benchmark return and, particularly in the case of negative
screening, a less diversified portfolio;
(cid:131) A risk-based approach is holistic and broader in its reach than screening, recognising that
institutional investors are universal long-term holders of broadly diversified portfolios
consistent with the prudent management and diversification of risk; and
(cid:131) The implementation of a risk-based approach through the engagement process is directly
targeted at changing corporate behaviour as a means to achieving improved ESG outcomes.

There is no conclusive evidence on the expected impact on gross returns and risks resulting from a
values-based approach to ESG investment. In the current market the management fees payable for
values-based ESG products are some 0.3% to 0.5% higher than management fees payable for
traditional investment portfolios. In the absence of conclusive evidence and taking into account the
differential in management fees, the Board has some concerns that if it were to adopt a values-based
approach to ESG investment, the ACT Government would be open to criticism from taxpayers that
it was not meeting its fiduciary responsibilities.

The key impacts of a values-based approach to the SPA investment portfolio have been estimated as
follows:

(cid:131) An initial cost of $2.8 million to $8.5 million in transitioning to a values-based approach. If
ESG values changed for any reason, further transitioning costs may be incurred;
(cid:131) An increase in ongoing management fees of $5.7 million to $9.9 million per annum; and
(cid:131) An increased risk that the current funding plan objectives for the SPA portfolio may not be
met.

A risk-based approach to ESG issues would not require a change to the existing structure of the
SPA portfolio. Therefore, the key impacts of such an approach would be the additional estimated
costs of an engagement service provider of up to $500,000 per annum and $25,000 per annum for a
third party proxy voting service provider.

However, if it was determined that the ACT Government wished to exercise its voting decisions
directly, the existing SPA equity investments under pooled fund arrangements would need to be
liquidated at an estimated cost of $1.2 million to $ 3.7 million and placed with a fund manager(s)
under separately established mandates. This would result in an estimated increase in ongoing
management fees of some $2.0 million to $3.3 million per annum.

Under either a values-based or a risk-based approach to ESG issues it is the Board’s view that an
additional Treasury resource would be required to properly oversight and monitor these
arrangements.
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Review of the Application of Environmental, Social and Governance Principles to Territory Investment Practices

In considering the following recommendations, the Board requests the ACT Government to note in
particular the following:

(cid:131) The Freshfields Report found a risk-based approach to ESG issues is consistent with the
fiduciary duties of institutional investors;
(cid:131) A risk-based approach is current best practice for institutional investors; and
(cid:131) The approach to ESG issues in institutional investing is evolving and implementation
remains a challenge. Therefore it is important that the ACT Government takes a considered
and measured approach to the application of ESG issues to the Territory’s investment
practices.

Recommendations

The Board recommends that:

1. The ACT Government adopts a risk-based approach to the application of ESG issues to
the Territory’s investment practices.
2. The ACT Government adopts the principles for responsible investing, as set out in the
UN PRI.
3. ACT Treasury monitors the extent to which the Territory’s fund managers and asset
consultants are taking into account ESG issues in investment decision-making processes.
4. The ACT Government considers the appointment of a third party engagement service
provider to assist in the implementation of a risk-based approach to ESG issues for the
Territory’s investments.
5. ACT Treasury requires the Territory’s fund managers to provide their voting policies,
requests that they exercise their voting rights and report on their voting activities.
6. The ACT Government considers the engagement of a third party proxy voting service
provider.

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Review of the Application of Environmental, Social and Governance Principles to Territory Investment Practices

2. Terms of Reference

The Chief Minister has requested that the Chief Minister’s Department (CMD), with the assistance
of the externally appointed Members of the Investment Advisory Board (the Board), undertake a
review of the extent to which the Territory investment operations should incorporate environmental,
social and governance (ESG) principles.

The Terms of Reference are as follows:

The review will:

1. Consider the various approaches to ‘ethical investment’ including socially
responsible investment, sustainable investment and corporate governance
responsibility.

2. Report on the manner in which ESG principles are being incorporated into the
investment processes of other government jurisdictions, superannuation schemes
and institutional investors in Australia.

3. Report on the nature of and performance of ESG/ethical investment products
(both domestic and international) available to institutional investors.

4. Advise on the potential implications of incorporating ESG principles into the
Territory’s investment processes, including:
(cid:131) the financial impacts, including impact on risk profile, investment returns,
costs of funds under management and the implications, if any, for the
Territory’s superannuation funding plan;
(cid:131) transition process and costs; and
(cid:131) ongoing operations.

5. Identify the extent to which ESG principles could be implemented across the
range of the Territory’s investment portfolios, including consideration of any
market capacity constraints, changes required to current investment mandates
and any changes required to existing legislation and guidelines.

2.1 Process

This review draws largely upon published information and research, much of it recognising the
fiduciary responsibilities of institutional investors.

In addition, the views of peak bodies and organisations that are involved in, or have some interest
in, financial investment management or operations, as well as the views of the members of the
ACT Legislative Assembly and other State and Territory governments were invited. The
respondents are listed in Appendix 2. The submissions received contributed to the findings of this
review. The Board expresses its appreciation to all respondents for their contributions.

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Review of the Application of Environmental, Social and Governance Principles to Territory Investment Practices

ACT Treasury officers provided secretariat assistance to the review including the provision of data
and research. The services of the ACT Department of Treasury’s (ACT Treasury) asset consultant,
Frontier Investment Consulting (Frontier), were also utilised.

2.2 Exclusions

In this report the Board has limited its consideration of ‘Territory investments’ to the investment
funds of the Superannuation Provision Account (SPA) and the Territory Banking Account (TBA)
managed by the ACT Treasury.

There are two significantly smaller Territory investment portfolios that have not been considered as
part of this review. These are:

(cid:131) Trust funds invested by the Public Trustee for the ACT, with the investment processes
undertaken in accordance with prudent person trust investment principles prescribed under
the Trustee Act 1925.
The manner in which investments under the control of the Public Trustee are to be managed
is set out in the Public Trustee Act 1985 and the Trustee Act 1925. Appropriately, the
ACT Government is not able to direct how these investments should be managed.
(cid:131) Investments of levies collected to administer long service leave entitlements of employees
and contractors working in the ACT building and construction industry and the
ACT cleaning industry. The ACT Long Service Leave Board manages these levies and at
the end of May 2007 they totalled some $70 million.
These investment arrangements, given their size, were not specifically examined as it was
considered that any recommendations made in this report might flow through to these
investments in any case.

Other decisions of the ACT Government that relate to, for example, funding for the capital works
program, education, health, housing and specific social issues are outside the terms of this review.
These are matters to be decided by the ACT Government in the context of its budget policy setting
process and appropriation framework and do not relate to institutional investment portfolio
management.

Finance & Investment Advisory Board June 2007 10