Does Pension Funds' Fiduciary Duty Prohibit the Integration of Environmental Responsibility Criteria in Investment Processes?: A Realistic Prudent Investment Test

Abstract

Pension funds have recently developed an increasing interest in environmental, social or governance (ESG) criteria, but critics claim that the integration of any of these non-financial criteria into pension fund investment processes conflicts with fiduciary duties. On this matter, the 2005 Freshfields report concluded that pension funds’ fiduciary duties (e.g. prudent action for proper purpose) only permit the consideration of an ESG criterion, if this process has no detrimental financial effects. While a body of research exists on the general relationship between ESG criteria and financial performance/risk management, no study has yet investigated the financial and risk implications of integrating any ESG criterion into an investment process from the perspective of pension funds, whose unique financial and legal characteristics require a specialised research design (e.g. a prudent, very large scale investment process). To study this effect, we develop a test of the prudent integration of ESG criteria in realistic and synthetic pension fund investment processes. We analyse over 1,500 firms from 26 developed countries over a 77 months period using aggregated and disaggregated corporate environmental responsibility ratings supplied by EIRIS. Our results are twofold. First, we find zero indications that the integration of aggregated or disaggregated corporate environmental responsibility ratings into pension fund investment processes has any detrimental financial effect. Second, findings from our risk analysis even support integrating corporate environmental criteria into pension fund investment processes, as the downside volatility is substantially lower. Robustness tests for temporal consistency and industry controls for sector bias confirm these findings. Hence, we conclude that pension funds’ fiduciary duties do not appear to prohibit the integration of environmental responsibility criteria into their investment processes. Future research might want to investigate the effect of integrating other ESG criteria into a realistic prudent pension fund investment process.

Keywords: corporate environmental responsibility, environmental management, ESG investment, fiduciary duty, institutional investors, non-financial criteria, pension funds, responsible investment, socially responsible investing