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How sovereign wealth and pension funds can meet ESG tax challenges

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Sovereign wealth and pension funds engaged in responsible investing are prioritizing tax transparency to meet their ESG objectives.


In brief

  • Sovereign wealth and pension funds continue their journey to act responsibly in tax matters and manage long-term returns on their investments. 
  • With approximately US$10 trillion in assets under management, these funds play a key role in shaping investment strategies based on ESG considerations.
  • The biggest challenge they are encountering now is access to relevant data on their private investments and inconsistent data and reporting standards.

As environmental, social and governance (ESG) initiatives and tax transparency rules become more popular with the public and the press, demonstrating alignment with those values is also becoming a higher priority for sovereign wealth funds (SWFs) and pension funds.

EY recently queried 19 funds perceived by their peers as early adopters of ESG-based investing (a cohort representing a total assets under management (AUM) of nearly US$5 trillion). While more than 81% of the respondents ranked reporting on social responsibility initiatives as a priority for their boards, less than half reported on tax-related ESG issues to their board. As more companies include corporate tax responsibility in their reporting package, increased disclosure of tax information by SWFs and pension funds may be required and may be subject to greater scrutiny when investing abroad, even where the organization has put strong tax governance measures in place.

While companies with products and services can demonstrate a clear social contribution through their employees' benefits or circular production processes, pension funds and sovereign wealth funds do not have these direct, tangible operations. As a result, incorporating corporate tax responsibility into their strategies is critical to demonstrating responsible behaviors.

The tax has become an important aspect of ESG, not only because of heightened media scrutiny around their tax affairs but also because it reflects the contribution of businesses to society and the incentives of promoting public policy goals. Many multinational companies have begun incorporating corporate tax responsibility in their tax strategy, choosing to disclose details about their tax payments to the public. For example, some organizations publish an external tax strategy document highlighting their effective tax rate and total tax contribution.

 

In June 2018, the B Team, a global nonprofit initiative founded by business leaders who advocate for social and environmental changes, launched a set of guidelines and responsible tax principles for businesses to approach tax and transparency responsibly and sustainably. One principle that stands out is the provision of information around the approach to tax and taxes paid.

 

In April, Charles Emond, President and CEO of CDPQ, described the Canadian pension fund's leadership in sustainable investment as its pride. "CDPQ uses its constructive capital to take meaningful action for current and future generations," he wrote in the fund's 2022 Sustainable Investing Report¹.

 

CDPQ is not alone. It is one of around 100 active sovereign wealth funds and pension funds around the world that have shown a deep interest in ESG, whether through dedicated departments, investment professionals, or their board members. Together, those funds have AUM totaling more than US$10 trillion. ESG objectives factor heavily in how those funds are invested.

 

Emond also emphasized how CDPQ's focus on the S in ESG (its social contribution) relates primarily to taxes. "As a global investor, having our portfolio companies adopt a tax structure that respects communities is fundamental to our sustainable asset management approach," he wrote.

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.

Summary

By demonstrating responsible tax practices, pension and sovereign funds believe that their efforts contribute to sustainable economic growth. Their journey now is to get the privately owned companies in which they invest to meet this objective. Standardizing reporting on corporate tax responsibility could be a first step in that direction.

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