The ESG Interview: On the Right Track

Caroline Escott, Senior Investment Manager at RPMI Railpen, highlights asset owners’ need for more granular data, including comprehensive climate accounting, as they refine their sustainable investment strategies.

Even for well-resourced asset owners, access to accurate, comparable data on climate and other ESG risks is the perhaps the biggest challenge for teams implementing sustainable investment policies.

“One of the things we’re most keen to ensure is that we get a flow of clear and consistent information from investee companies,” says Caroline Escott, Senior Investment Manager at RPMI Railpen, one the UK’s largest pension funds, with 350,000 members, £32 billion in assets under management and more than 100 staff. “Not just from firms listed on the public equities markets, but on the private market side as well.”

This need for more granular and comprehensive data is particularly urgent when it comes to understanding investee firms’ strategies for adapting their current business models to a low-carbon future (although Railpen is part of an initiative to increase information flows on workforce issues). As outlined in its recently published 2020 Stewardship Report, climate transition is one of Railpen’s four thematic engagement priorities for 2021, with ‘climate accounting and Paris-aligned accounts’ a key sub-theme.

In February, Railpen issued an updated voting policy document for the 2021-2022 AGM season, which outlined expectations that investee companies – especially those in highly carbon-intensive sectors – incorporate “material information” about climate-related issues in their financial statements, not just narrative reporting.

“Where they have not done so, or where we find inconsistencies between narrative reporting and financial disclosures, we may vote against the Reports and Accounts, the Audit Committee Chair or the reappointment of the auditor,” the document reads.

“In order to achieve the net zero or other climate goal that they set for themselves, we think firms need to allocate capital in a way that is consistent with that ambition,” adds Escott.

“Companies need to be able to properly assess the impact of climate change on their future operating models and this should be used to drive how they value their assets. This is really important when you think about things like asset life,” she explains, noting that firms should consider – and reflect in their statements – the impact of climate change on the value of long-term assets, such coal-fired power stations or coal mines.

Climate accounting guidance

The IFRS Foundation’s planned International Sustainability Standards Board is “definitely one piece of the puzzle” in terms of more granular climate reporting, potentially providing a baseline for clear and consistent metrics.

But Escott believes there is also an important part to be played by other accounting and auditing standards-setting bodies, acting as conduits between auditors, their clients and other stakeholders, and providing consistent guidance on how and where to include information about material climate risks.

“All bodies in the accounting and auditing space should be thinking about what they can do to encourage consideration of climate change in the accounts and offer guidance as to how an auditor might consider whether or not a company’s accounts are Paris-aligned,” she adds.

Railpen has seen progress among firms with which it has engaged on the alignment of their accounts with the goals of the Paris Climate Agreement, but Escott regards this as a next step for most. “There aren’t many companies who’ve really got their heads around that yet,” she observes.

In the 2021 AGM season to date, Escott says Railpen’s concerns have been voiced via a “nuanced vote against” firms that have not met expectations on climate accounting, warning that further pressure may be felt next year.

“We will be engaging with audit committee chairs and CFOs at some of our target companies, over the course of this year. if we haven’t seen any noticeable improvement or recognition of the impact of climate change in the accounts by next year, our expectation is that we will be escalating our voting and other engagements activity accordingly,” she says.

Asset owners in transition

This ratcheting up of pressure on investee companies to explain their plans and disclose their risks relating to net-zero transition is itself evidence of a transition on the part of asset owners themselves. In their case, it is a shift to integrating a wider range of factors into the investment decision-making process and it involves a lot more than plugging a few more macros into a spreadsheet.

As well as investee firms’ climate transition plans, asset owners have also had to carefully weigh up the different types of resolutions being brought at AGMs in the wake of the ‘say on climate’ movement, says Escott.

“The investor community as a whole is still getting to grips with how you assess a climate transition plan,” she says, adding that Railpen has recently drafted internal guidance on evaluation. “This will help us, at least for this year, figure out what we’re looking for from climate transition plans, i.e. what we really want to see and the red flags that will make us think twice.”

Escott regards voting policies as a “powerful tool” given the very public nature of their outcomes, but is also aware of the responsibilities that come with wielding it. When assessing resolutions or climate-related votes, past performance and indications of future trajectory of individual companies need to be considered.

“You can’t look at any report or disclosure generally in isolation. If you have engaged with a company, [you might consider] whether you are getting the sense they are genuinely committed to managing climate change, and mitigating it where possible, or whether they’re just paying lip service,” she says.

Other factors might include the firm’s general performance and prospects beyond its climate risk exposure and the materiality of the holding to the asset owner’s portfolio. Escott is hopeful that the recent intensity of the focus on transition plans should put asset owners in a much stronger position to scrutinise investee firms next year.

“When the next AGM season comes around, we should as an industry be very well prepared to take a considered look at the transition plans that are being presented to us.”

Making a difference to members

As if climate transition isn’t enough of a challenge, Escott and colleagues are also working hard on Railpen’s other engagement themes for 2021: the worth of the workforce; responsible technology; and sustainable financial markets.

These themes derive directly from Railpen’s long-term investment horizons and its overall approach to sustainable ownership. Effectively the pension scheme for an entire industry, Railpen is nominally answerable to the Railways Pension Trustee Company. But in practice it has responsibilities to and relationships with multiple underlying schemes, members, employers and other stakeholders, making for a highly consultative and collegiate ethos.

The trustees’ statement of investment principles enshrines a belief in the materiality of ESG issues and the role of active ownership in achieving positive member outcomes. The trustee board is 100% nominated by members and employers and 50% nominated by trade unions, lending a natural focus on workforce-related engagement themes.

More broadly, Railpen’s approach to sustainable ownership is filtered through four lenses: improving returns; reducing risk (both idiosyncratic risk at the stock-specific level and systematic risk at the portfolio level); impacting the world into which beneficiaries will retire; and impacting the fund’s leadership position as a responsible investor.

This means Railpen tries to select engagement themes in areas that make most difference to members, through consideration of the value of investments at risk, but also where the fund is best-positioned to make a difference, either through individual action or collective initiatives as an investor or by engaging proactively in a public policy debate to encourage change.

“How we invest is obviously a really important ingredient in protecting the value of our member savings,” says Escott. “But we also recognise that the world into which members retire is impacted by how everyone else globally invests. And if we can play a role in a small way, at the UK level and increasingly globally, then we welcome that opportunity. That’s one of the reasons why we do so much public policy work and are actively involved with a lot of [collaborative] organisations.”

Sustainable financial markets

Once the factors outlined above were taken into consideration and weighted alongside other investment-related criteria via a ‘materiality matrix’, Railpen finalised its 2021 engagement priorities through consultation with trustees, stakeholders and service providers, including asset managers, as well as bearing in mind the experience and expertise of its in-house team.

Last year’s three engagement themes – audit quality, climate transition and the impact of Covid-19 – find continued expression in 2021, and Escott sees the four themes as having relevance for perhaps the next three to five years. The impact of Covid-19, she hopes, will take less prominence within the ‘worth of the workforce’ engagement theme, as the pandemic’s effect becomes more normalised.

Meanwhile, focus on two aspects of Railpen’s focus on ‘sustainable financial markets’ is determined partly by regulatory and legislative timetables. Activity around audit quality is tied closely to the UK Department of Business’s reform proposals, laid out in its ‘Restoring trust in audit and corporate governance’ paper. The current consultation phase closes next month, but the drafting and implementation of legislation could take another 18 months to two years, with measures phased in gradually.

Similarly, Railpen’s long-term attention to minority shareholder rights is currently bound up in plans to introduce dual class share structures (DCSSs) as part of a government review of the UK Listings Regime. In concert with trade associations and other investors, Railpen outlined its objections to DCSSs and drafted proposals to limit their impact, several of which have been taken up, and will seek to influence the Financial Conduct Authority’s implementation.

“In an ideal world, the DCSS proposal would not have gone ahead. We’ll be continuing to work with the Financial Conduct Authority to make sure that as many corporate governance safeguards as possible are pulled through,” says Escott.

Destination: decarbonisation

Railpen has also been engaging with policymakers on an aspect of financial regulation with implications even closer to home: the UK’s adoption of climate risk reporting in line with the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD).

The fund responded to the Department of Work and Pensions’ consultation last year on climate reporting by occupational pension schemes and is preparing to report under the Pension Schemes Act 2021 in October, having already disclosed voluntarily against TCFD.

“We thought it was important to try to use what we think is a really sensible framework – one that we have asked our portfolio companies to use for some time – to think about how we approach climate risk and opportunity in a way that is accessible for our members,” says Escott, who is also keen for UK implementation of TCFD reporting to yield up to asset owners detailed climate information from asset managers and underlying companies.

As well as reporting on its climate-related exposures, Railpen has been exploring options for decarbonising its portfolio. It was involved in the development of the Paris-aligned Investment Initiative’s Net Zero Investment Framework (NZIF), and has established a cross-functional climate working group.

“We’ve been using the NZIF to think about what we might do to decarbonise our portfolio, but also how we invest in climate opportunity as well. A number of investment teams at Railpen are already investing in climate opportunities, such as renewable power and green infrastructure projects,” Escott comments.

Although Railpen is keen to invest in opportunities arising from the transition to a low-carbon economy, much of the work to date has focused on achieving emissions reductions, both in the portfolio and in the ‘real world’.

“We have been looking very closely across our portfolio, and particularly where we have high allocations. The work of the Institutional Investors Group on Climate Change and others has helped us realise that quite a significant proportion of one’s overall portfolio emissions can potentially come from quite a small number of holdings, proportionally,” says Escott.

Railpen is a strong supporter of collaborative investor action on climate issues and has taken the role of engagement lead for a number of high-emitting companies as part of the ClimateAction 100+ coalition. This also reflects the firm’s belief in engagement rather than divestment.

“We do have an exclusion policy on climate grounds, and have done for some time, but we prefer to engage. The trustees believe that engaging with a company, using all the different tools at our disposal: collective engagement, behind-closed-doors discussions, public discussion, public letters, using your vote, and shaping the public policy framework. We think that can be really powerful in terms of achieving positive member outcomes, and having and positive impact on the economy and society generally.”

The practical information hub for asset owners looking to invest successfully and sustainably for the long term. As best practice evolves, we will share the news, insights and data to guide asset owners on their individual journey to ESG integration.

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