(The author is a Reuters columnist. The opinions expressed are his own)
LONDON, Nov 7 (Reuters) - The body that reviews British law has sought to remove all doubt that investors can target more-sustainable companies, but is less clear-cut over an environmental campaign against fossil fuel investment.
While trillions of dollars of assets globally are invested according to environmental, social or governance (ESG) criteria, the legal grounds for doing so have been remarkably uncertain.
Much depends on the interpretation of a duty of asset managers to act in the best interest of clients - such as pension funds and their beneficiaries - and specifically to maximise financial returns.
ESG criteria include data on staff turnover, board composition, executive pay, safety procedures, human rights violations, energy efficiency, carbon emissions and waste.
In a significant step last month, Britain's Law Commission proposed to clarify how fiduciary duty should apply to asset managers.
London is the global centre for ESG investing.
"It is clearly established in law that pension trustees are required to act in the best interests of their beneficiaries," the consultation paper said.
"There are, however, some difficult questions in determining how far pension trustees can take into account environment and social factors and other factors which go beyond maximising financial return."
The Global Sustainable Investment Alliance earlier this year estimated that at least $13.6 trillion of professionally managed assets "incorporated ESG concerns into their investment selection and management".
That represented 21.8 percent of all assets managed professionally in the regions studied - Europe, the United States, Canada, Australia, Asia, Japan and Africa.
Europe accounted for about two thirds of the assets by management team location, while the United States and Canada added most of the rest.
The group's report, the "2012 Global Sustainable Investment Review", reported a broad spectrum of ESG strategies.
Negative screening was the most popular, and involves excluding investment in particular companies or sectors, such as tobacco.
One of the most referenced cases in the debate over fiduciary duty and ESG investing involved British union members who were also trustees of a mine workers' pension scheme.
Union member and pension scheme trustee Arthur Scargill argued in 1984 that the pension scheme should not invest in overseas coal assets because doing so would undermine the British industry.
The court held that the union member trustees were in breach of their fiduciary duties.
"When the purpose of the trust is to provide financial benefits for the beneficiaries, as is usually the case, the best interests of the beneficiaries are normally their best financial interests," said the presiding judge, Robert Megarry.
"If the investment in fact made is equally beneficial to the beneficiaries, then criticism would be difficult to sustain in practice, whatever the position in theory. But if the investment in fact made is less beneficial, then both in theory and in practice the trustees would normally be open to criticism."
In a narrow interpretation, the implication could be drawn that pension schemes should not invest against ESG benchmarks if that sacrificed financial returns.
Legal doubts have resurfaced recently as a result of a new campaign for fossil fuel divestment among some green groups who argue that coal, oil and gas companies represent a risk to investors, given the likelihood that penalties and costs on carbon emissions will rise over time.
The mayor of Seattle said last month that plans to shift the city's pension scheme out of fossil fuel assets had run into legal hurdles because of the possible impact on returns.
Fossil fuel divestment could be viewed as an extreme case of negative screening, although it is unclear whether it could be classed as an ESG strategy, depending on whether its motives were to reduce risk or a moral statement.
The debate about ESG investing crosses a broader question over whether investors' focus should be short or long term.
Several studies have shown that accounting for ESG factors can reduce share-price volatility and achieve better or equal returns over the medium and long term. But it could reduce shorter-term returns.
The economist John Kay last year published a review of the effectiveness of equity markets in supporting British companies and generating returns for savers ("Review of UK Equity Markets and Long-Term Decision-Making"), also called the Kay Review.
One of his main findings was that there was excessive "short-termism" as asset managers - who invest on behalf of pension funds - sought to drive returns through trading rather than by identifying underlying value.
Kay's overall message was that the goal of equity investing should be the pursuit of long-term value.
He concluded that there should be a clearer legal basis for investment against ESG criteria, and warned against confused messages as a result of the rising involvement of intermediaries including asset managers.
"The Law Commission should be asked to review the legal concept of fiduciary duty as applied to investment to address uncertainties and misunderstandings on the part of trustees and their advisers," he said.
The Law Commission has duly obliged with a consultation paper published on Oct. 22, "Fiduciary duties of investment intermediaries".
It sought to "finally remove" doubts over whether ESG factors can be applied.
"Given the evidence that ESG factors can lead to better returns in the long run, the answer is clearly that pension trustees may use wider factors. There can be no objection to using ESG factors as a way of increasing long-term performance."
A more interesting question, perhaps, is whether criteria can be applied to achieve wider economic or environmental goals than directly maximising returns.
In the case of the financial crisis, investors continued to invest in profitable, short-termist banks which collectively caused massive global economic harm.
Supporters of the fossil fuel divestment movement would argue that climate change will result in even greater damage.
In this case, the Law Commission was less explicit.
"The aim of a pension fund is to secure returns across the whole portfolio. Therefore there can be no legal objection to making a decision which, on a due consideration of the factors, is designed to provide financial benefits to the portfolio as a whole. The anticipated benefits should outweigh the likely costs. Trustees should also ensure the financial benefit is not 'too remote and insubstantial'."
"Often the problem is not a legal one but a practical one. Whatever the benefits of combating climate change, it is unlikely that one pension fund acting alone can make an appreciable difference to the problem."
Divestment from coal, oil and gas may present a problem for liquidity, returns and asset diversification.
It seems that such divestment may be more acceptable to trustees if applied in a limited way and with a sound rationale for reducing risk.
Norway's opposition Labour Party this week proposed banning the country's $800 billion wealth fund from investing in coal producers, a motion that may gain traction as several outside backers of the minority government expressed support.
(Editing by Dale Hudson)