Can trustees save the planet?

Environmental, Social and Governance (ESG) investing has been around for a while but is now gaining traction as an approach to the choice of investments. Socially conscious investors, and that means more and more of us, are looking to invest in companies which don’t just provide good financial returns but whose values align with their own.

Some of the factors they might scrutinise include:

• Environment: Does the company have a positive or negative effect on the environment? Does it use toxic chemicals in its manufacturing processes? How is it reducing its carbon footprint? How is it reducing energy use and how is it husbanding scarce resources?
• Social: Does the company’s business benefit or harm society? What is it doing to foster equity, diversity and inclusion? How is it ensuring that its ethical values are reflected in its supply chain?
• Governance: How does the company’s leadership promote positive change. How do they deal with executive pay? How diverse is its leadership? How does the company interact with its stakeholders?

Although millennials are driving the trend towards ESG investing, the desire to invest according to values is spreading across the generations. According to the Prudential’s Family Wealth Unlocked report, 61% of those surveyed said they cared more about the environment and sustainability than before the pandemic and they are putting their money where their mouth is. 60% of millennials, 44% of Gen-X and 35% of Baby Boomers confirmed that the pandemic has increased their appetite for sustainable investment. 39% are planning to increase the amount of their ESG investment in the next five years and 45% say that since the pandemic, they now only want to invest in ethical companies and funds. These are big numbers and indicate that ESG investing is, or is certainly becoming, mainstream.

The ESG credentials of suppliers of goods and services are also coming under scrutiny by potential customers and clients and can make the difference between winning and losing business.

Against this background, trustees are likely to come under increasing pressure, especially from settlers and beneficiaries, to invest their trust funds in ESG investments. Can and should the trustees do so?

The starting point, as always, is what the trust deed says. If this is important to the family, new trust deeds can include express powers or requirements to make ethical investments and it would be wise for trustees to include express provisions in the exoneration clause relieving them from liability for exercising those powers. Even in the case of new trusts with appropriate powers, it is not necessarily plain sailing. How are ‘ethical’ investments to be defined? What if some of the beneficiaries do not want the trustees to take an ESG approach?

Perhaps a better starting place is the trustees’ overriding fiduciary duty to act in the best interests of the beneficiaries. And that means all the beneficiaries including potential future beneficiaries, not just the current ones.

The 1985 case of Cowan v Scargill, which concerned a pension trust, made clear that ‘best interests’ normally means financial interests so that the ‘paramount duty of the trustees is to provide the greatest financial benefit for the present and future beneficiaries’ whilst having regards to risk.

In the context of charity, the court in Harries v the Church Commissioners held that charity trustees could restrict investments which conflicted with the aims of the charity or might alienate supporters but should not pursue moral objectives which would ‘incur a risk of significant financial detriment’.

The current position is that trustees must generally invest to provide the best financial outcome for the present and future beneficiaries commensurate with the risk profile of the trust.

On the other hand, if investment in companies which score well on ESG criteria can also be justified on financial grounds, trustees can take a preference for building an ethical trust fund into account.

Financial and moral considerations are likely to become more closely aligned. The Law Commission Report ‘The Fiduciary Duties of Investment Intermediaries’ issued in 2014 addressed the duties of trustees in relation to investment. Although the Report is focused on pension scheme trustees, its comments apply equally to private trusts. The guidance attached to the report states:

• ‘A.12 The primary aim of an investment strategy is therefore to secure the best realistic return, given the need to control for risks.
• A.13 The key distinction is between financial and non-financial factors. Financial factors are any factors which are relevant to trustees’ primary investment duty of balancing returns against risks.
• A.16 When investing in equities over the long-term, the risks will include risks to the long-term sustainability of a company’s performance. These may arise from a wide range of factors, including poor governance or environmental degradation, or the risks to a company’s reputation arising from the way it treats its customers, suppliers or employees. A company with a poor safety record, or which makes defective products, or which indulges in sharp practices also faces possible risks of legal or regulatory action.
• A.18 Trustees may take account of any financial factor which is relevant to the performance of an investment. These include risks to a company’s long-term sustainability, such as environmental, social or governance factors (often referred to as ‘ESG’ factors).
• A.19 The Law Commission’s conclusion is that there is no impediment to trustees taking account of environmental, social or governance factors where they are, or may be, financially material.
• A.22 the duty may be put in the following terms. When investing in equities over the long-term, trustees should consider, in discussion with their advisers and investment managers, how to assess risks. This includes risks to a company’s long-term sustainability.’

A non-financial factor is one motivated by other concerns, such as improving the quality of life of the beneficiaries or showing disapproval of certain industries. The Law Commission provides a neat example of the distinction between financial and non-financial factors.

‘Withdrawing from tobacco because the risk of litigation makes it a bad long-term investment is based on a financial factor. Withdrawing from tobacco because it is wrong to be associated with a product which kills people is based on a non-financial factor.’

In the pension’s context, trustees may only take non-financial factors into account if:

• they have good reason to believe the members [beneficiaries] would share the concern; and
• the decision should not involve a risk of significant financial detriment to the fund.

So, whilst trustees must still focus on financial returns v risks in determining their investment strategy, there is increasing recognition that ESG factors are relevant to the future success, or failure, of a company. A company that uses vast amounts of energy will be exposed to rising energy costs and a company whose processes pollute the environment will be affected by potentially expensive changes to regulation and tax, potential environmental liabilities and reputational damage. A company that looks after its workforce may have higher productivity and enhanced brand value and reputation. A well-run company with transparent oversight and disclosure and proportionate executive pay is likely to be more successful and have a more stable share price.

One might expect companies that take ESG seriously to outperform their non-ESG rivals and there is an increasing body of evidence that, in the longer term, this is indeed the case.

The take home message for trustees is that their fiduciary duty to their beneficiaries, so far as investment is concerned, is still to maximise the financial benefit to them, taking account of risk. However, it is becoming increasingly clear that ESG considerations feed directly into investment performance and trustees can, and possibly should, scrutinise a company’s ESG credentials before investing in it.