How sovereign wealth and pension funds can meet ESG tax challenges

Finding a healthy equilibrium

Where is the healthy equilibrium? Sovereign wealth funds and pension funds’ mandate is to protect returns on investments and manage tax risks. Certainty around taxes paid where their portfolio companies operate and potential relief from exemptions on distributions post tax-profits can potentially achieve the right balance but this requires their asset managers to also be on the same page.

When asked about their views of tax in ESG, 61% of the 19 respondents agreed that the tax authorities were important stakeholders and that the idea of speaking up about their social contribution is an increasingly prevalent topic in their board discussions.

Sovereign wealth funds and pension funds are also interested in the issue from a financial perspective, as tax can materially affect investment returns.

One challenge is that the funds, with their long-term interests, must actively engage with their asset managers, who are often under short-term pressure to produce an internal rate of return (IRR). There can be tension between optimizing returns and other factors that need to be taken into account when making responsible investment decisions. How funds reconcile those two aspects is a potential pressure point on ESG. Yet by striking a balanced approach between long-term goals and short-term KPIs, funds can improve returns, even in the short term, and manage their tax risks, which is good for business overall because it reduces uncertainty.

The starting point for funds is to show that they are acting responsibly. They can do this by showing their investments, the taxes that are paid and the effective tax rates they monitor.

Getting the data right

The issue here is information flow – or lack of it. In the EY query, sovereign wealth funds and pension funds cited data as one of the obstacles to evaluating their ESG tax footprint, with 84% of respondents reporting inconsistent, available data from portfolio investments or asset managers.

This is a critical problem. ESG is all about transparency and disclosure. With the data, funds can match multinational corporations in demonstrating how they take responsible tax steps.

Many funds have taken concrete steps toward social responsibility including publishing externally a Tax Code of Conduct and including tax-related initiatives in their sustainability reports. Others are still struggling with producing more extensive reporting on tax matters beyond mandatory requirements.

This is potentially because reporting standards for ESG information have yet to be agreed upon across the investment community, and collecting the necessary tax data can be overwhelming. The extent of internal resources within sovereign wealth funds and pension funds may also present challenges.

The standard principles could be the same as the seven responsible tax principles that some multinational corporations began reporting on a few years ago. If those companies can do it in the private capital space, there is an opportunity to develop and standardize some of the same principles here. Of course, having reached some form of consensus among the major players in the market, everyone could then implement them based on their policies, guidelines and protocols.

A solution to the data issue for funds:

1. Get agreement on broad-based high-level ESG Standards.
2. Get agreement on Asset Manager/Direct Investment Reporting Standards.
3. Publish #1 and #2 on their websites and, in the future, require this information from their Asset Managers/Direct Investments.

With this information, SWFs and pension funds can ensure that their investments comply with ESG standards. They can also demonstrate to their government and stakeholders, the contributors and beneficiaries of the funds they manage, their employees, civil society and the general public their responsible, principled and transparent global investment footprint.