Local government divestment and the law in Scotland

By continuing to invest in the companies most responsible for global climate change councils are failing to protect their pension fund members’ best interests and risk losing huge sums as government action to curb climate emissions sees fossil fuel companies’ value plummet.

With these risks widely known by fund managers failure to act could leave them open to legal challenge.

What legal issues are relevant for councils considering divesting from fossil fuels and pro-actively investing in socially and environmentally beneficial projects in their local area?

The first priority of councils is their duty to act in the best interests of those who pay into and rely upon the pension fund: fund members and employers (1). This duty, known as fiduciary duty, comes first when councils approach their investment strategy: they must serve the best interests of their members.

There is a clear and strong case that council workers and other fund members have their interests best served by a pension fund which helps limit the threat of climate change and supports the development of their local community.

New Scottish legal advice published by the scheme’s advisory board (2) in 2016 has helped clarify how local councils should deal with environmental and social issues in their investments.

The advice says that funds are expected to have “long-term investment horizons”. This guidance echoes the approach given by the Law Commission of England and Wales who stated that “the primary aims of an investment strategy is therefore to secure the best realistic return over the long term, given the need to control for risks” (3). The legal direction here is clear: investing to make a quick buck, in companies with no long-term plan, is not consistent with funds’ legal duties.

Councils are expected to consider environmental and social issues at the point at which they make investments and to review such issues periodically.

Environmental and social issues may influence what they invest in as long as they don’t risk “financial detriment”. Since there is significant evidence showing that fossil fuels are of high risk and low long-term value, this enables an approach of ending fossil fuel investment.

Councils are advised that “investment options may be restricted where the investment returns to the fund may be negatively impacted by such environmental, social or governance factors.” In other words, if a financial case can be made, divestment is an option.

A recent update in the European Union rules for pension funds (4) compels funds to consider environmental and social issues when making investment decisions, and to carefully assess related risks such as the stranding of fossil fuel assets. Although Scotland is currently set to leave the EU, Scottish public bodies would do well to maintain compliance with EU law in the case of Scotland seeking re-entry.

When approaching any change to their investment policies councils should satisfy themselves that they have collected sufficient financial and legal advice to be clear that they are acting in their members’ best interests. However this is easy to achieve, and indeed has been done by those funds which have already divested from fossil fuels (5).

Where action has been limited it is attributable to funds focusing on short-term returns, failing to identify financial risks posed by the carbon bubble, and following outdated practices which do not give sufficient consideration to environmental and social issues (6).

A full appreciation of the legal framework reveals that far from being prevented from considering issues like climate change, funds are in fact required to take issues like climate change into account when making investment decisions.

The Bank of England has advised that funds may face “both regulatory and shareholder action if they fail to adequately consider, misrepresent or conceal climate change-related risk.” (7)

A 2016 legal opinion concluded that if it could be shown that climate change had financial implications for funds those funds taking no effective action would be in breach of their legal duties (8).

Funds could also face charges of intergenerational inequity: if fossil fuels are being retained due to their strong performance in the very short-term at the expense of exposing the fund to longer-term risks, this would be unfairly benefiting older members over younger members.

References

(1) I use members to refer to individual people who are members of pension funds, although they are sometimes referred to as ‘beneficiaries’. I refer to employers who contribute to pension funds as ’employers’, although readers should note that in other literature employers are occasionally referred to as members.

(2) In full, the Scottish Local Government Pension Scheme Advisory Board. The letter and legal opinion they issued can be found at http://lgpsab.scot/fiduciary-duty-guidance/

(3) Source: ‘Is it always about the money? Pension Trustees’ duties when setting an investment strategy: guidance from the Law Commission’, 1 July 2014.

(4) For more information see the announcement by Share Action and summary published on Go Fossil Free: https://shareaction.org/press-release/iorps-shareaction-welcomes-victory-for-responsible-investment-of-pensions-in-the-eu/

(5) See our article about council pension funds which are divesting.

(6) A review of why pension funds are not taking fossil fuel risks into account in their investment strategies was carried out by Share Action and ClientEarth in 2016. Click here to download the report.

(7) Source: http://www.bankofengland.co.uk/pra/Documents/supervision/activities/pradefra0915.pdf

(8) Source: http://www.clientearth.org/pension-trustees-face-legal-challenge-ignoring-climate-risk-leading-qc-confirms/