The Scheme's approach to ESG integration in fixed income is based on the following principles. We require our external managers to:
1. Take account of financially material short and long-term risk factors in our investment research and decision-making processes. These risk factors may include environmental, social and governance (ESG) issues.
2. Exercise our stewardship role in the companies and other entities in which we invest. We believe that good stewardship can create investment opportunities and reduce investment risk.
3. Support efforts that seek to improve the operation, resilience and stability of financial markets.
As the Scheme typically looks to hold bonds to maturity, ESG considerations play a critical part in the assessment of creditworthiness of issuers. To evaluate the likelihood of future changes in a company’s credit rating and the potential for a sudden change in credit quality, our external managers conduct detailed credit risk analysis. This involves an examination of the earnings of an issuer as well as its balance sheet structure, together with a forecast of a company’s future cash flows, debt burden and credit metrics. The analysts, working for the manager, assign internal ratings and a trend indicator to the companies they cover. An overall ESG risk score is assigned to each issuer that the manager covers. A failure to meet recognised standards of good governance and responsible management may represent threats to financial performance that are not adequately compensated by the expected returns; indeed, effective management of the environmental and social aspects of the business are useful indicators of the overall quality of management. The ESG data can provide evidence that management have adopted and implemented appropriate policies, systems and controls to manage risks and comply with relevant codes, laws and regulations and go beyond them to meet the expectations of key stakeholders. A full investment analysis is required to inform an investment decision and ESG risk scores are a necessary element in assigning a credit rating that indicates the relative risk of default loss. MSCI provided ESG ratings often supplement the fundamental credit work performed by the manager.
Whilst bond investors do not have the same right to vote equity investors do, we expect our managers to actively meet and engage with issuers to review performance, strategy, risk management and ESG issues. In addition, Hermes EOS provides us with their insight from its engagement.
Finally, as part of integral risk management, we expect our external managers to engage with policymakers, regulators, central banks, clearing house, trading counterparties to ensure that financial markets continue to operate efficiently and that risk management requirements are effective and not compromised.