Pension Funds and Sustainable Investment

Chapter 1
Sustainable Investment in Retirement Funds
Introduction
Olivia S. Mitchell, P. Brett Hammond, and Raimond Maurer
Since its green shoots first emerged around 50 years ago, acceptance of
environmental, social, and governance (ESG) considerations in institution-

al investing—especially in pension funds—has evolved with distinct shifts in
investor preferences. This Pension Research Council volume traces these
shifts and their implications, leading up to the present day. Our volume
notes that investors have diverse reasons for devoting attention to ESG cri-

teria when deciding where to invest their money. Some have had religious
motives, such as Quakers who focus on values; this approach can offer some
risk mitigation. Yet models that look at whether divestment actually changes
behaviors of companies show that that rarely occurs. So, it is not always
screening and divestment that bring about the changes that investors seek.
Accordingly, this book offers a selection of distinct viewpoints from a variety
of countries, on whether, how, and when ESG criteria should, and should
not, drive pension fund investments.
The Long View
Economists tend to agree that ESG concerns may logically arise where there
are market failures, often of the externalities type. Such externalities gener-

ally arise because a firm will impose costs or benefits on third parties on
individuals or society, other than the consumer or producer, and these
occur when the externalities are not properly priced. For instance, an oil
refinery producing pollution that poisons the local population or the sur-

rounding countryside creates a gap between the price that consumers pay
for the refined oil, and the gain or loss to those injured by the pollution.
Economics offers two general types of solutions for such problems: either
the government can alter the costs and benefits of such production, or the
government can change the fiduciary rules under which the producer oper-

ates. In the case of pension investments, while a pension fund might wish

to invest in fossil fuel firms, it might not wish to impose the social losses on
society. It is this tension that often drives debate over the pros and cons of
ESG investment.
In Chapter 2, P. Brett Hammond and Amy O’Brien (2023) point out
that ESG principles have been shaped by numerous social movements, gov-

ernments, and regulators, independent advocacy and service organizations,
and asset owners and asset managers, notably pension funds. Their work
outlines the origins of ESG to the pre-modern era, from the post-Industrial
Revolution late nineteenth century to about 1970. That period was char-

acterized by concentrated ownership of public companies in the US and
elsewhere, the transformation of work and consumption, and little to no
activism by small shareholders or pension funds on social or environmental
issues.
Governance concerns, however, were prominent in the pre-modern era.
They included policies to limit monopolies and ownership of companies
by banks and families, antitrust regulation, the emergence of uniform
accounting, reporting, and disclosure rules, and the advent of a two-tiered
board structure where supervisory boards retain control and management
boards execute company strategies. Other features of the pre-modern era
included regulation of working conditions and hours, food quality, and the
beginnings of an environmental movement.
The modern era for ESG began around 1970, yet governance policies
and practices varied across countries, as did social and environmental con-

cerns, note the authors. For instance, in the US, company management was
dominant, whereas family and/or bank control persisted in some European
countries, and cross-holdings and bank influence were common in Japan.
On social issues, the US and the UK saw debates over employment prac-

tices and the declining influence of unions. The US was ahead of others in
tackling environmental challenges, with the birth of the US Environmental
Protection Agency coinciding with the dawn of ESG’s modern era.
Early on, the debate was over whether institutional investors should have
separate portfolios for E, S, and G, versus a single common portfolio for all
three; over time, there has been a growing recognition that true integra-

tion will likely work better. Hammond and O’Brien point to clear evidence
of ‘convergence,’ which refers to a shift in thinking about environmental,
social, and governance concerns such that they are now treated jointly. ‘Inte-

gration’ refers to the notion that investors need not consider E, S, and G
factors separately from other decisions they make regarding their portfolios.
For instance, some firms may currently underperform on ESG measures
yet are likely to get better in the future. In addition, investors with well-

integrated portfolios will need to balance and consider multiple dimensions
of assets at once. Moreover, it is possible that higher ESG returns have arisen
in certain sectors due to government support for ESG investments, as in the

Pension Funds and Sustainable Investment