Who or what will make climate investing more mainstream? According to our panel, the role of investment consultants will be pivotal.
Mike Clark (founder director, Ario Advisory)
Diandra Soobiah (head of responsible investment, Nest Corporation)
Lydia Guett (investment consultant, Cambridge Associates)
Rob Skelton (head of investment research, First Actuarial)
Funds Europe – Where do you see the most interesting opportunities within climate-related investing?
Lydia Guett, Cambridge Associates – There are a lot of opportunities in the thematic space, both in public and private markets, with a focus on infrastructure, clean energy and electrification.
For example, there are large industrial companies that need to replace their current way of working and realise new opportunities, and similarly there are also very innovative, small, dynamic start-ups that are finding ways to disrupt established players.
Both of these are very interesting themes and could have a huge impact on the way society uses electricity.
Rob Skelton, First Actuarial – Many DB [defined benefit] pension schemes could benefit from access to less liquid, low-risk and income-generative assets. However, until recently, opportunities were concentrated in property and PFI contracts. Renewable infrastructure, solar farms and windfarms and biomass plants extend the opportunity set. The operational projects are of particular interest given their lower-risk nature. And of course, there’s the potential for renewable energy to offer a natural hedge to some of the climate change risks faced through investing in the stock market.
There are, though, risks associated with such assets, not least the political ones. However, with diversified pooled funds available, the idiosyncratic risks of renewable energy can be diversified, even by smaller pension schemes.
Diandra Soobiah, Nest Corporation – Risk mitigation approaches that are emerging – particularly for pension fund passive equity allocations – are particularly exciting. There are now a number of passive approaches that are enabling investors to both mitigate and manage carbon-related risk and to also position themselves for climate-related opportunities.
Nest helped develop and invest in a Climate Aware Fund last year that enabled us to tilt away from the biggest carbon risks in our portfolios, such as companies not making the necessary adjustments to reach the ‘2o’ scenario [limiting global warming to 2 degrees Celsius], and instead to invest more in companies that are actively involved in renewable energy consumption and provision.
These types of systematic funds that allow investors to reduce exposure to climate risk and invest more in climate-related investment opportunities as part of a cost-effective index approach are really exciting. Partnering and working with fund managers is another theme that’s developing, where asset owners take ideas and innovations to fund managers to build effective solutions that the whole market can then use.
Nest has nearly seven million members now, the vast majority in their 20s and 30s, meaning climate risk and opportunities are something we can’t ignore.
Mike Clark, Ario Advisory – What is interesting is the way that asset owners, pension funds and others at the top of the chain are developing their thinking. I grew up with the efficient market hypothesis, CAPM, alpha/beta - that sort of thinking. Pension fund trustees are beginning to think beyond these established patterns, although it is still going to take time to feed through completely. But the exciting thing is seeing investment decision-makers stimulated to consider the UN Sustainable Development Goals (SDGs) and how they match them up with strategic asset allocation and risk. This is happening now and reflects a whole evolution of investment thought around environmental investing.
Funds Europe – Earlier this year, investment consultancy Mercer found that only 5% of European pension schemes have considered the investment risk posed by climate change. What can be done to advance climate-related investment beyond just this small group of leading funds?
Clark – Start by looking at the influences on trustees: influences from their members, their advisers and from regulation. There’s a whole group of influences on asset owners, so look to increase those first.
There has been some regulatory ‘nudging’. The UK parliamentary Environmental Audit Committee inquiry on green finance took the bold step of writing to 25 pension schemes to ask about their stance on climate change and this led to some clients ringing up their actuaries due to the fact that the report raised points about actuarial risk.
Also, some of us are seeking to encourage the Pensions Regulator, the Financial Reporting Council and the Financial Conduct Authority to become reporting entities (under Defra’s Adaptation Reporting Power – Defra being the UK’s Department for Environment, Food and Rural Affairs) in a similar way to the Bank of England report on climate change and insurance a few years ago.
The more the regulators make climate change a part of their remit, the more it will encourage activity.
As with broader ESG, climate change is often seen as an investment manager product issue. But actually, climate change needs to be seen as a strategic risk. Trustees need the awareness that this is something the world around them is interested in and which is no longer just about alpha and beta, but about the real economy.
The Dutch trustee says to members, “I’m not just thinking about the size of the cheque I’m going to pay you in 30 years, but the world you’re going to spend it in.” That attitude is common also in Sweden and some other places, but quite unusual in the UK.
Skelton – When looking at risks, consultancy firms have focused on balance sheets for the year ahead. Climate change risks are too long-term to be picked up by this sort of standard analysis.
Once the industry focuses on longer-term risks and carries out sensible scenario testing on the pension scheme and sponsor, I think we’ll see climate change risks being picked up.
That said, climate change risks are just one of many investment risks faced by pension schemes. Climate change risks will have to fight with scenarios like high inflation, low interest rates, market volatility and manager underperformance for trustees’ attention. But where climate change mitigations offer investment opportunities in their own right, the question should be ‘why not mitigate climate change risks?’
Soobiah – To convey this really important message to smaller funds in the market, investment consultants need to make ESG a part of their mainstream advice. At the moment, I don’t think it is. Many still try and pitch ESG as a separate piece of advice that clients ought to pay separately for. They also need to start incorporating ESG ratings for fund managers within the investment processes and once consultants start changing the way they see these types of risks, that will automatically factor through to smaller clients. I think consultants have a huge role to play.
Regulation has been quite slow, too. The DWP [Department for Work and Pensions in the UK] has just consulted on how trustees should be thinking about ESG risks and it mentioned climate change as one of those specific risks. That’s five years too slow – but hopefully this will now bring positive change in how trustees take account of ESG risks and opportunities.
It echoes back to the short-termism debate. Climate change is a long-term strategic risk and so it is again about shifting mindsets from reliance on short-term returns and risk, to thinking about the long-term strategic risks that could affect beneficiaries in the years ahead.
Clark – Long-term value creation in the real economy is very important to that because investment returns follow from it. There is a challenge within the investment world, including central banks and regulators, to do with pricing risk on a ten-year horizon – a timeframe that climate change fits into. Asset owners have to work this out.
An actuary of a DB scheme that considered there to be less financial risk in a portfolio with a lower carbon risk exposure would be very forward-looking - but I think we are beginning to see this happen now.
Guett – Overall, we know that regulation will be a key driver for pension funds in this area. At the moment, only trustees who think the risks and opportunities in ESG are material will integrate them into their portfolios. I think we will see this voluntary principle move toward compulsion quicker than many expect.
Many solutions are unique to each pension scheme. Every portfolio structure has to be designed for the different needs of a scheme owing to their particular assets and liabilities. No one solution fits everyone, but the first thing that pension schemes should do is sign the PRI, which encourages thinking about the framework and about engagement with fund managers and consultants on ESG factors.
Schemes should also think about developing a climate change and a wider ESG policy; this is what their beneficiaries want and although it’s very challenging, it’s a fantastic exercise for everyone to go through.
Integrating ESG risks and opportunities with default funds could move the needle much more quickly. Australia is a great example, where they have developed tools so beneficiaries can easily move their portfolio from one pension scheme to another with instant access to their holdings and related ESG factors. This has gamified it.
Clark – You’re right and I think IGCs [Independent Governance Committees] have got a lot of work to do in the UK where a challenge for contract-based schemes is in giving the saver a voice.
Basically, IGCs should represent their savers to the providers. We can look at how California’s insurance commissioner looked at the investment portfolios of over 600 insurance companies and questioned their alignment with a two-degree scenario. This exercise in benchmarking with the Paris goals is something that should happen elsewhere.
Soobiah – I agree, but I think in order to get a wholescale shift of mindset across the pensions landscape, the clarification of trustees’ fiduciary duty is key. I have received questions from non-Nest trustees about squaring their fiduciary duty with climate-aware funds. We’ve always said that this is about meeting our fiduciary duty and that if we don’t address this risk for our members, it would be a breach of duty. This is financially material to their portfolios.
Guett – We see that also with private clients. When the younger generation takes over, there is an absolute shift in mindset. The first thing they do is to understand what they own, and then they want to see how this aligns with their personal values. In this regard, diversity of trustee boards is important.
Funds Europe – How can investors be certain that an ‘impact’ fund does what it says it does? Do clients of fund managers need a more sophisticated form of reporting in the climate and wider ESG sector to ensure these approaches are robust and that managers are not ‘greenwashing’ funds?
Soobiah – Impact investing for Nest is about meeting our risk and return objectives for members while also meeting specific environmental and social goals., Whilst this does come under the ESG umbrella, it is more thematic.
Impact investing needs good-quality reporting. Individual fund managers that sell impact funds tend to do their own impact assessments and the problem is a lack of comparability against other fund managers and benchmarks. Investors are in a predicament because they need robust impact data to be able to inform their investment decision-making and fund choice. The market still has a way to go. It is still early in the development of metrics and standardised reporting.
Guett – Some fantastic products are available today and some fund managers can demonstrate a measurable impact and competitive returns. Also, a positive development is where endowments are rethinking how their main portfolios could have an impact that is aligned with the original aims of their foundations.
But vigilance for greenwashing is absolutely critical. Rigorous investment selection is key and the evaluation of ESG criteria within a strategy. There are some third-party verification services that are helpful, as are providers of ESG fund ratings.
A fund manager’s approach to the PRI should be part of the selection criteria, but it is also good to have someone knowledgeable enough to do in-depth due diligence. In my experience of this, there are many times when discussions start with the view that ESG is really integrated into a process, only to find the claim does not stand up well to scrutiny.
Skelton – Engagement and voting policies – these are really important, and that includes in passive funds where much of the money these days is. We find cases where clients who may want to vote differently to other unit holders are sometimes too small to influence their fund manager. Platforms, whilst offering many advantages, put a further barrier between the ultimate owners of asset and voting rights.
Clark – Most investment managers are in charge of the voting process because that’s the way the world works, but clients have started to pre-declare their votes and are starting to override fund managers. That’s getting interesting. There are cases where asset owners have taken greater control – certainly some of the bigger ones who might stipulate as a condition of a fund manager’s appointment that the asset owner gets to vote the shares.
Funds Europe – Are ESG factors – mainly environmental - under-utilised in fixed income investing? Might ESG factors be able to play a role in credit analysis?
Skelton – Relevant here are time scales. Many fixed income mandates are short dated in nature e.g. the fund manager might lend money forthree months to five years. Climate change is unlikely to be a concern when lending over that timeframe.
However, a liability matching ‘buy and maintain’ credit portfolios’ lending might be over 20 or 30 years. The risk of climate change leading to defaults is important if you’re lending money over that period and so it’s important that the fund manager takes the risk seriously.
Soobiah – ESG in fixed income is developing, with increasing numbers of fund managers starting to factor it into investment processes. By how much can depend on the instruments being invested in. For longer-dated, smaller issuers, I think bondholders could have an influence in negotiating stronger covenants for better downside protection, which is important in certain markets like emerging market debt and global high yield where there is more risk. These issuers tend to be in ‘dirtier’ sectors. There is a lot of coal and oil pipeline companies in there and that was a huge concern for us when we procured a manager last year. The manager we spoke to was putting securities through a rigorous screening process on carbon, but we also wanted to see evidence they were engaging with issuers where possible.
ESG risk is mispriced and sometimes not at all priced in, so there is alpha generation to be had within fixed income. From the procurements we’ve put out, we have seen some good practices.
Clark – Another relevant area is infrastructure. Infrastructure is often a 30-year or more project. It may start with a risky bit of fixed income finance at the start, but then a refinancing or two later should result in an income stream which trustees are happy with over the long term.
If you’re building infrastructure in Bangladesh, two metres above sea level, this is potentially unwise on a 50-year view. Different capital providers come at different stages in the life of the asset and what we might call the ‘long-term horizon issue’ is baked into it. Can the initial, say, five-year fixed income funding ignore the climate change issue when the project is not completed for two decades? Probably it can. But actually, when you come to refinance in five years, then it probably cannot be ignored.
Skelton – Infrastructure finance can often be private and this means investors cannot get out of it so quickly should things start to go wrong.
Soobiah – And that’s the thing: you’ve got to hold it until maturity, so there’s even more impetus to take these factors into consideration when you can’t just sell an asset back through secondary markets.
Clark – However, as pension provision moves towards DC, pricing is becoming more relevant and long-term value creation gets challenged when there’s a daily pricing mechanism, which makes getting DC contributions into something illiquid a challenge.
Skelton – There are products starting to emerge for DC that invest in private debt and private equity. It’s expensive now, but I think that will change. DC investors can invest in property funds, so why shouldn’t they invest in infrastructure funds?
Guett – The G factor in ESG is what sticks out in fixed income. Governance is clearly something utilised greatly just to define the quality of a particular bond. But environmental and social factors – the E and S - are arguably less utilised.
If the issuer is funding a solar plant, which is a very long-term asset, that has a fantastic E impact. But the building might entail a community being resettled, and that becomes an S factor. There are a lot of different factors to consider.
You also have to look at the sponsoring company. Is the sponsoring company a mining company that happens to build a renewable energy plant? If so, is this aligned with your investment approach?
A bond does not get used to force an issuer to change their behaviours. With a bond, it’s very difficult to engage. Once the bond is issued, it’s issued for a long time, making it really difficult to change behaviours. I personally think that is absolutely under-considered.
One approach for some active managers is to hold not only one bond, but different bonds aligned with certain themes and which have different maturities. This means they are more flexible and can rotate their portfolios with the understanding there might be durations or issuers an investor is not aligned with. You can either choose a bond manager that has a positive impact, like green energy, or just have a negative screening process for, say, certain governments or sectors. There again, similar to equities, we have different approaches on how to structure the portfolio, but overall arguably if you work with active managers, it’s much easier to align the portfolio with your personal values than if you just invest in a passive bond index.
Clark – My experience suggests that we would find investors who, although they screen equity investments for tobacco, would still lend to tobacco companies in their bond portfolios. This points to a product gap for ethical bond funds.
The challenge of high yield is sometimes that it is high yield for these very reasons. I know a high yield bond manager who was happily running his portfolio and suddenly said, “Have I looked at the coal risk in the portfolio?” He made quite a lot of changes in his portfolio over the following few months.
Green bonds are a part of the process, although some people say they are only 1% of the solution. There are some issues about additionality. There has been a provocative paper about the role of green bonds that identified ‘additionality’ as a factor.
Soobiah – We really like the idea of green bonds but there are still a few challenges like low issuance, liquidity and transparency that may hinder investment. Investors will ask about how they are going to be paid and want to be assured that proceeds will come from the actual ‘green’ project. They will want to know whether the issuer is aligned with what that project is trying to do and about how they will report on it, using what metrics. Some aspects of green bonds need to be improved before there is a widescale acceptance of green bonds as part of the fixed income universe. The green bond principles should be made mandatory.
Guett – Greenwashing has been a significant issue. There have been a number of cases where proceeds didn’t benefit the actual project that was advertised and went into the main pool for the company. That’s very risky for the entire green bond industry because investors will not limit perception of this to the errant bond issues, but transfer the experience to the entire green and climate change investment space. It’s in everyone’s interest to ensure that green bonds are truly green, which is where third-party verification comes in.
Funds Europe – Where do you see the topic of climate investing going over the next two years?
Soobiah – Nest’s priorities are to focus on member engagement by communicating with our members about the ESG credentials of their pensions. We think talking to them about responsible investment issues is going to be a great hook to get them engaged and hopefully excited about pensions. Pensions is an area that people generally haven’t understood or engaged with in the UK, so telling them about how their money is invested and how it’s being protected from risks like climate change, we think would get them interested and intrigued by their pension savings and hopefully boost trust and confidence in long-term savings. We also want to provide them with the channels for communication so they can tell us their views and what’s important to them if they wish to do so. This is in line with what the DWP is proposing in the new regulation around seeking members’ views.
Skelton – Over the next two or three years, the bulk of our clients will have carried out their next strategic review. Given we’re incorporating long-term scenarios into these reviews, I’d hope that all of these pension schemes will have considered climate change risks. Whether they take any action will really depend on their timeframes and extent to which their investments and sponsor are exposed to these risks.
Clark – I expect to see a richer sense of purpose among pension funds and other asset owners regarding their investment decision-making so that strategic asset allocation and strategic risk allocation are no longer just confined to the finance element, but will be about real-economy risks. For many years it’s been about alpha and beta, but asset owners are beginning to manage systemic risks more. They’re not just taking the beta the market gives them, but getting the beta they want. After that, you can do active or passive.
Guett – In the next two years I expect a significant increase in demand from investors across the entire spectrum - private investors, endowments, foundations, pension funds, individuals - who are very keen to understand what they own.
Specifically looking at the next generation of investors, the millennials, they want to align their investment objectives with their personal values, and for this they really want to make a purposeful impact in society along with where their values lie.
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