Sustainability Reporting in capital markets: A Black Box? (ZIFO nr. 30) 2019/6.4.1:6.4.1 The Directive on the activities and supervision of institutions for occupational retirement provision (IORP Directive) and the EU Action Plan on Sustainable Finance (2018)

Sustainability Reporting in capital markets: A Black Box? (ZIFO nr. 30) 2019/6.4.1

6.4.1 The Directive on the activities and supervision of institutions for occupational retirement provision (IORP Directive) and the EU Action Plan on Sustainable Finance (2018)

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Occupational pension funds in Europe operate under the EU pension regulation. Since 2003 the Occupational pension funds Directive (Directive 2003/41/EC)1 applies to all European Institutions for Occupational Retirement Provision2 (IORPs). This Directive, known as the IORP Directive, regulates the IORPs’ activities and supervision with the main objective to “ensure a high level of protection for future pensioners (members and beneficiaries of pension funds) while guaranteeing efficient investment”.3 The significant changes in the financial markets that took place since 2003, among which, the 2008 financial crisis and continued growth of an ageing population in Europe, triggered a call for long-term investment in Europe.4 Pension funds, given their privileged position in capital markets, deep-rooted in their capacity of long-term investors allied to the fact that they are part of the group of largest European institutional investors, marked them as key players in the path for responsible investment.5

The above-mentioned reasons were in the base of the EU’s initiative to revise the IORP Directive. On the 30th of June of 2016, the European Parliament, the Council and the Commission have agreed on a proposal (based on the European Commission’s proposal of 2014)6 for revising the 2003 IORP Directive on occupational pension funds, known as the IORP II Directive.7 The IORP II Directive aims at improving pension funds’ governance, the clarity of the information provided to members and beneficiaries and it will support responsible investment.8 After formal approval of the European Parliament, Member States will have 2 years to transpose the Directive into their national legislation. Consequently, European pension funds will be required to integrate ESG risks in their investment decisions and report the way they are doing it in their three-yearly statement of investment policy principles. These key improvement objectives of the IORP II will contribute to strengthening the role pension funds can play in the European financial market.9

The Directive (EU) 2016/2341 of the European Parliament and of the Council of the 14th of December of 2016 on the activities and supervision of institutions for occupational retirement provision (IORPs), was formally published in the Official Journal of the EU on the 23rd of December of 2016. The Directive, often referred to as the IORP II Directive, entered into force on the 13th of January of 2017 and applicable from the 13th of January of 2019 when the member states have transposed the directive into domestic legislation.10 The Directive applies to the European occupational pensions market, which has over € 2.5 trillion of assets under management on behalf of around 75 million Europeans.11 Currently the Netherlands holds 30,7% of IORPs and the UK holds 55,9% of the occupational pensions market in Europe.12 These imminent developments mark a crucial change in the European financial markets, where responsible investment is recognized as essential to respond to clients’ demands and to secure the payment of pensions in the long-term. This regulatory change sets a new direction, one that positions pension funds in the center for achieving sustainable financial growth, respecting the environment, society and the financial markets. The reporting requirement of the IORP II will have direct influence on how investee companies will manage ESG risks and also how they will report this information to pension funds and other stakeholders.

Following the international commitments on climate (COP 21) and the sustainable development goals (UN 2030 Agenda for Sustainable Development) in 2015, in March 2018 the EC developed an Action Plan on Sustainable Finance, the EU Action Plan to achieve these goals and commitments.13 The EU Action Plan builds upon the report of the High-Level Expert Group (HLEG) (from January 2018) on sustainable finance created at the end of 2016, and sets a road map with the EU’s strategy to pursue a financial system that supports the EU’s climate and sustainable development agenda. It provides a regulatory framework to support and promote sustainable investment in the EU in line with the climate change commitments.14 The EU Action Plan has 3 main objectives, i) reorient capital flows towards sustainable investment, in order to achieve sustainable and inclusive growth; ii) manage financial risks stemming from climate change, environmental degradation and social issues, and iii) foster transparency and long-termism in financial and economic activity.15

The upcoming key actions of the EU Action Plan, were developed by the EU’s Technical Expert Group on sustainable finance (TEG) formed in July 2018 by request of the European Commission. To develop a codified sustainable finance market, the Technical Expert Group on sustainable finance (TEG) advises on the following key actions: to establish a common language for sustainable finance, an EU sustainability taxonomy, providing a classification system of climate, environmentally and socially-sustainable activities; to create an EU Ecolabel for green financial products and standards; given the fact that the duties of care, loyalty and prudence laid down in various EU Directives, such as IORP II, are not always clear on how institutional investors and asset managers should consider ESG risks in the investment decision process, the EU aims at clarifying the ESG duties of institutional investors and asset managers, foster transparency and long-termism in the investment decision process; develop an EU green bond standard and to strengthen sustainability reporting and improve accounting rule-making.16 These key actions of the EU Action Plan are expected contribute to mainstreaming responsible investment and responsible investement reporting and minimizing misperceptions in e.g. language, definitions and responsible investement product and project’ classifications. More importantly these developments indicate the growing interest and understanding of the benefits of integrating non-financial information with financial information. Moreover, it may suggest that integrated reporting EU policy and regulation may be a step closer afterall.

Although the EU regulation contributes to the harmonization of pensions’ regulation among the member states, given the differences in their national legal and cultural practices the European pension funds differ largely.17

a) Prudent Person Rule

The Prudent Person Rule is also relevant for sustainability and responsible investment reporting. This relevance is showed below in the partial translation of article 19 of the IORP II Directive. Generally in Europe all member states follow the Prudent Person Rule, as required by the IORP Directive, and more recently required by the IORP II Directive. This rule can be defined as follows:

“A fiduciary must discharge his or her duties with the care, skill, prudence and diligence that a prudent person acting in a like capacity would use in the conduct of an enterprise of like character and aims.”18

This definition includes three duties, the duty to act prudently and diligently, the duty of loyalty to the members and to the pension fund, and the principle of diversification, which requires a diversified portfolio and that unnecessary risk to be avoided.19

The relevance of looking at whether a country follows the prudent person rule or not lays in the importance of determining who is responsible for setting limits to the pension funds investment activities, if the pension fund or the Government. Research and practice has recognized the relevance of this debate for the long- term investment performance of pension funds.20

The prudent person rule is part of the IORP II Directive, in article 19, as partially translated below. Article 19 b) shows that prudent person rule is relevant for sustainability and responsible investment reporting (e.g. environmental, social and governance risks).

Article 19

Investment rules

1. Member States shall require IORPs registered or authorised in their territories to invest in accordance with the ‘prudent person’ rule and in particular in accordance with the following rules:

(…)

(b) within the prudent person rule, Member States shall allow IORPs to take into account the potential long-term impact of investment decisions on environmental, social, and governance factors;

(…)

According to the OECD, prudent investing by institutional investors “gives appropriate consideration to any factor which may materially affect the sustainable long-term performance of its assets, including factors of an environmental, social, and governance character.”21

In the countries part of this research, both Sweden and the Netherlands follow the IORP II directive. In Sweden the prudent person rule is part of SOU 2004:101 and in the Netherlands is part of article 135 of the Pension Act (PW).2223

b) Fiduciary Duty

In Europe, with the exception of common law jurisdictions such as the UK, there is no official definition of fiduciary duty, and it is seldom explicitly referred to. As a reaction to the financial crisis in 2008, only the Markets in Financial Instruments (MiFID 2) Directive (Directive 2014/65/EU), with a strong focus on strengthening the protection of investors, indirectly, article 24 of MiFID 2 requires institutional investors to “act honestly, fairly and professionally in accordance with the best interests of its clients”.2425

Generally in Europe, all jurisdictions impose fiduciary and prudential responsibilities, however, these may vary. The member-states have pension investment regulations (e.g. IORP Directive), which provisions limit the risk taking of the pension funds.26 Fiduciary duties remain largely unregulated in the EU, the IORP Directive itself does not explicitly impose a fiduciary duty, and therefore, national legislations differ on this matter.

Fiduciary duty discussions regarding the potential conflict with responsible investment have been clarified by the publication Fiduciary Duty in 21st Century (September 2015). This publication was the result of the work of the UN-supported PRI, UN Environment Programme – Finance Initiative (UNEP-FI), UN Environment Programme (UNEP) Inquiry and UN Global Compact. It concluded, “failing to consider long-term investment value drivers, which include ESG issues, in investment practice is a failure of fiduciary duty”.27 This report was based on a legal analysis of policy and investment practice in eight countries: US, Canada, Germany, UK, Japan, Australia, South Africa and Brazil. At the time it also concluded that there is a need to clarify investors’ obligations and duties.

In January 2016, following-up on the 2015 report, the UNEP-FI together with the UN-supported Principles for Responsible Investment and the Generation Foundation announced a three-year project to engage investors to fully support fiduciary duty and integrate ESG risks in their investment practices. The project’s objectives are, among others to harmonize the concept and practices of fiduciary duty; encourage governments and regulatory agencies in the eight jurisdictions covered in the 2015 report (Australia, Brazil, Canada, Germany, Japan, South Africa, the UK and US) to clarify the scope of fiduciary duty and to provide guidance on what ESG risks to report and how; and to develop an international statement on fiduciary duty and sustainable development.28 This international statement calls on international and supranational policymakers to clarify investors’ obligations and duties, in particular, in relation to the integration of ESG issues into investment practice;29 and calls on national policymakers to ensure that their national policies align with this clarification of investors’ obligations and duties and to ensure that these policies are effectively implemented.30

In Sweden, the AP funds have their fiduciary duties stated in the National Pension Insurance Funds Act, as goals.31 The funds are required by law to act in the sole interest of their beneficiaries and maximize risk-adjusted returns.32 Please see the goals of the investment activities, as stated in the Swedish National Pension Insurance Funds Act translated below.33

Chapter 4. Management of Funds

Goals of investment activities

Section 1. The First to Fourth AP Funds shall manage fund assets in such a manner so as to achieve the greatest possible return on the income-based retirement pension insurance.

The total risk level of the investments made by the Funds must be low. In conjunction with the selection of risk level, fund assets must be invested in such a manner that high returns are achieved in the long term.

In their investment activities, the Funds shall possess the necessary preparedness in order to be able to transfer funds to the Swedish Social Insurance Agency in accordance with Chapter 2, section 2. (SFS 2004:847).

Differently for the Seventh AP Fund, the fiduciary duties refer to the duty of the management team to act exclusively in the interest of the beneficiaries (National Pension Insurance Funds Act, 2000:5).34

In the Netherlands, fiduciary duty is not explicitly mentioned as such in Dutch law, similarly to current the EU’ requirements. It is however, part of the Pension Act (article 135), on reporting requirements, which refers that the fiduciary duty of the pension fund “always takes priority. At all times you [the board] must make every effort to fulfil your fund’s principal commitment: to take account of pension liabilities and ensure optimum returns at acceptable risk exposure.”35

Below I look at pension funds in Sweden and in the Netherlands, to provide examples of how European pension funds are leading responsible investment and why, and after follows an overview of this topic in the US.

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