Norges Bank Investment Management has established a new climate advisory board. Carine Smith Ihenacho, chief governance and compliance  officer, spoke to Top1000funds.com and explains the task at hand.

What is the role of the climate advisory board?

The board will advise on NBIM’s approach to managing climate-related risks and opportunities, including the implementation of its climate action plan. It will advise on sustainable finance and climate risk developments, review and contribute to NBIM’s policies on climate risk and advise on the exercise of NBIM’s ownership rights and the appropriate approach to companies, including on voting and dialogue, related to climate risk. It will advise on NBIM initiatives to develop market standards on climate risk, including approaches to regulators and other standard setters. The board will also be responsible for assessing and evaluating NBIM’s climate-related activities, results and reporting against NBIM governing documents and international best practice.

What is the rationale for setting up this advisory board now?

Setting up a Climate Advisory Board is part of the steps we outlined in our Climate Action Plan 2025 last September to be a leader in manging climate-related financial risks and opportunities. As a long-term and globally diversified financial investor, our return depends on sustainable development in economic, environmental and social terms. We will be a global leader in managing the financial risks and opportunities arising from climate change.

The Climate Action Plan sets out the actions we aim to take over the period 2022-2025. These actions are targeted at improving market standards, increasing portfolio resilience, and effectively engaging with our portfolio companies. At the heart of our efforts is driving portfolio companies to net zero emissions by 2050 through credible targets and transition plans for reducing their scope 1, scope 2 and material scope 3 emissions.

This is an ambitious plan with a focus on engaging our investee companies to change. We are convinced that we will benefit from the reflections by the board members and their support helping us implement the plan. Climate change is a fast moving-field, and insights from the board members can help us respond to new developments and refine our approach over time so we maintain leadership.

How did you select the board?

We believe that managing climate-related risks as an owner of companies through the climate transition requires a holistic and evolving understanding of how climate affects the global economy and financial markets. We therefore focused in the selection process on identifying candidates with complementary knowledge and insights relating to climate change developments.

The chosen candidates together provide a wide breath of relevant climate expertise spanning academia, business, sustainable finance and civil society with insights into the US, Europe and the specific Norwegian context.

NIMB has appointed Professor Jody Freeman, Jennifer Morris, Huw van Steenis and Bjørn Otto Sverdrup as external members to the board. Jody is Professor of Law at Harvard Law School and an independent director on the board of directors of ConocoPhillips. Jennifer is the chief executive at The Nature Conservancy. Huw is vice chair at Oliver Wyman and was previously chair of the Sustainable Finance Committee at UBS. Bjørn Otto is the chair of the executive committee for the Oil and Gas Climate Initiative.

How will the board challenge NBIM, and how do you envisage the board influencing investment strategy?

The four board members all have a deep and complementing climate expertise. They pick up new developments relating to climate change and their different perspectives can help us evaluate when and in what way we should further develop our approach. Our investment strategy is set out in our mandate issued by the Ministry of Finance. The role of the board is to support us in further developing our approach to managing climate-related risks and opportunities as an owner of companies through the climate transition within the limits of our mandate.

 

For years, private equity investment has been relatively straightforward. Buy a company, turn it around and sell it at a profit. Today there’s blood on the streets in a changed market. Aggregate headline US private equity valuations may still be elevated, but the information is lagged and doesn’t tell the whole story, warned the Massachusetts Pension Reserves Investment Management Board (MassPRIM) investment team, speaking in a recent board meeting at the $92 billion asset owner.

IPO activity has slowed (only 74 companies listed in the US in 2022) and proceeds have fallen, resulting in a collapse in the exit market turning cashflows negative and leaving contributions outpacing GP distributions. Valuations have crashed, and financing has got more expensive for private equity buyers.

As the cost of capital has increased, bank lending has shut down for new LBOs: leverage loan volume is lower, spreads are wider, and the approval process is taking longer, doubling the cost of debt. It’s slowed the pace GP’s are investing; slowed fundraising and left many LPs with unfunded commitments (money committed but not invested) now reconsidering the amount they commit going forward.

“Many investors are finding themselves over allocated to private equity. Combined with the slowdown in distributions and reversal of performance, investors are going to be forced to make tough choices in 2023 and beyond,” said Michael McGirr, director of private equity at MassPRIM.

MassPRIM, however, is staying the course and continuing to commit to its best performing asset class. In line with a multi-year effort to slowly increase the allocation to private equity, it is adding an additional 1 per cent to its range (13-19 per cent) and continuing with current pacing, ploughing $2.2 to $3billion into new funds and co-investment opportunities this calendar year, convinced that opportunities lie beneath the market’s uncertain and volatile surface: valuations are becoming less expensive (particularly for tech companies) offering buying opportunities, and history shows that the best performance in private equity originates when other investors are cutting back.

But success will depend on a few key strategies. Vintage year diversification is essential, as is sticking to consistent pacing models that avoid increasing the allocation all at once.

Unlike many peers, MassPRIM can maintain pacing because its current allocation to private equity has remained comfortably within range. The average actual private equity weight from a sample of ten peer funds is 18.1 per cent versus an average weight of 15 per cent – based on available records, six out of nine pension plans are above their target weight.

As more LPs rethink their strategy, GP’s will increasingly seek capital outside their traditional asset bases. The tougher fundraising environment gives MassPRIM a chance to pressure GP partners on economic and governance contractual issues too. “We’ll be fighting these fights in the trenches. We will have successes to share, but don’t predict wholesale change in the structure of the industry,” McGirr told the board.

In a new strategy, the team will also focus on opportunities in secondaries, buying and selling fund positions from and to others for the first time in a bid to benefit from the change in the market. Elsewhere, co-investment alongside approved co-investment managers will remain a key strategy, a part of the allocation founded in 2015 that continues to grow in maturity and scale. “I expect to see deal flow in 2023,” said McGirr.

Risks

Widening the range holds risks, however. MassPRIM’s global equity and private equity allocation account for most of the risk in the portfolio which in private equity manifest particularly in write downs in valuations (growth private equity has been hit particularly hard) while distributions are also down because of weakness in the IPO market.

It’s left a heightened focus on the weight of private equity cash flow, and the liquidity profile, making the benefits of vintage year diversification particularly apparent. Combined, both private and public equity portfolios account for about 56 per cent of the market value of MassPRIM’s largest PRIT Fund and 80 per cent of the total risk. The investment team will look to cut the allocation to global equity if private equity goes outside the range.

Performance

The board heard how allocations to alternatives, hedge funds, private equity, real estate and timber have helped anchor the fund in the stormy environment. Looking ahead, risk adjusted, forward-looking returns appear more favourable given the welcome recovery in public equity and bond markets.

The investment team flagged the first signs of a reversal with data pointing to a cooling economy and moderation in inflation. Risks on the horizon include another spike in inflation and weak corporate earnings.

The economic picture is not deteriorating, and there is no expectation that the stock market will discount more than it has already. Other topics discussed include a mooted increase to US active public equity managers alongside growth managers in developed and international markets. Elsewhere the investment team have an eye out for credit opportunities and unique fixed income.

A market taker and unable to control geopolitics, pandemics or slowing economic growth, the only thing the fund can control is the design and composition of the portfolio. Diversification and low costs are key with risk, return and cost comprising the three essential pillars of MassPRIM’s investment programme.

MassPRIM is also poised to schedule the first board meeting of its newly convened ESG Committee. The pension fund has been working with partners at MIT Sloan on the Aggregate Confusion Project, an initiative to improve ESG measurement in the financial sector.

MassPRIM, which prides itself on having one of the leanest headcounts in the country compared to the size of the investment programme, is adding a deeper bench of talent. Staff will be added to help build the diverse manager programme, enhance reporting and oversee the ESG initiative, amongst other things.

Global trends are leading asset owners towards a new era of investing, argues the Investment Management Corporation of Ontario, IMCO, in a new research paper. One where it becomes increasingly difficult to rely on the past as a predictor of the future.

Primary themes that IMCO expects to play a significant role in driving returns over the coming decade represent an “inflection point” or reversal of previously entrenched trends. Examples include the end of “low for long”, a shift away from globalization towards on-/friend-shoring and increased reliance on the fiscal policy lever relative to monetary policy tools.

“The tides are now shifting, as politicians prioritize domestic employment as a means of addressing inequality. After decades of relative wage gains, emerging markets’ labour cost advantage has waned making the decision to move production to domestic shores easier for global businesses,” says the report.

That resulting disruption will likely be more severe for China than for the US, as China relies more heavily on the US for imports and external demand than the US. Globalization drove the steady decline in costs and prices worldwide over the past several decades, and its reversal, or slowing, could impart inflationary tailwinds as the world heads into a new macroeconomic regime.

In this new world, investors could stand to benefit from a greater exposure to inflation-sensitive assets such as regulated infrastructure, inflation-linked bonds, and commodities. Other economic and market implications include greater volatility, an expected capital-intensive investment “boom” and a growing scope for unintended or undesired passive exposures – all of which can shape investors’ decision-making at the strategic and/or active levels.

Elsewhere, fiscal levers and real economic priorities will take growing precedence over monetary policy and its financial variables of focus, predicts the report. Europe has the potential for the greatest change, as it wrestles with the challenges of a shared currency.

ESG

The potential for “stranded assets” will rise as governments, companies and consumers increasingly adopt cleaner technologies and energy sources at the expense of legacy ones. For example, new environmental rules and/or changing societal preferences could put conventional oil production at greater risk. The notion of climate-related winners and losers is also likely to arise in terms of geographies, with some locations better able to withstand and/or adapt to changing temperatures and weather patterns. As an example, some agricultural activities might shift to relatively cooler areas, or real estate along coastal areas could face elevated risks from rising sea levels relative to those located further inland.

Governments’ push to decarbonize economies as part of climate change mitigation efforts will be expensive, requiring significant capital investments as well as new technologies. Government interventions such as carbon pricing and other policy measures are also likely to drive up energy prices, adding further tailwinds to the global inflationary trend.

Technology

Advances in computing, automation, and other technologies have continued to accelerate. The increase in innovation has become global in nature, with advanced and emerging countries pushing technological frontiers.

This technological disruption is no longer confined to a limited number of market segments such as the software, hardware, and pharmaceutical industries, however. Industries that were not prone to disruption have also been affected. For example, the increase in on-line shopping and home delivery over the last decade has pushed established retail companies into bankruptcy and weighed heavily on retail real estate valuations. The world is only just starting to witness some of the disruption that these developments will bring to large segments of the global economy.

More generally, these technological advancements have coincided with the concentration of gains amongst a narrowing group of firms, consistent with the rise in importance of network effects within many emerging – often digital – sectors and the increased prevalence of winner-take-all competitive dynamics. When such economics are at play, the related value creation tends to flow to first movers and/or those who manage to become the “standard” setters, states the report.

Growth in private markets

Attracted by the resulting potential for superior risk-adjusted returns, a growing number of institutional investors are dedicating resources to private markets. At the same time, demand for/supply of such financing is growing as post GFC regulations have encouraged a move towards private market-based financing over traditional bank-based sources. The net result has been an expanding pool of investment capital seeking a similarly expanding set of private market opportunities. This trend is expected to continue as suggested by estimates from Preqin – a firm specializing in alternative assets data and insights – which foresee private capital assets under management (AUM) increasing at a rate of nearly 15% per year to approximately $18 trillion by 2026.

However, index investing’s growing popularity among retail and institutional investors masks the growing risks associated with these passive exposures, flags the report. It is prudent to continue to build the ability to provide index-based exposures in ways that align with investors’ ESG beliefs and limit the potential for undue concentration risk.

Finally, the report argues that idiosyncratic country drivers highlight the need to look beyond broad, relative economic growth rates – both past and prospective – when evaluating potential investments. History suggests countries’ GDP growth rates and domestic equity market performance exhibit only a very loose relationship over the past couple of decades. Clearly, other factors also matter and point to the need for a thorough assessment of potential returns, risks, diversification benefits and investors’ own abilities to outperform.

For these reasons, a research-driven investment process that allows investors to monitor and respond to the changing world around them is imperative.

 

The discussion here relates to the winding down of fossil fuels. Arguably, the most high-profile use of the term was in the concluding statement for COP26. The draft statement included the phrase “phase-out” in relation to the global use of coal.

India pushed for, and was successful in, a change of words to “phase down” coal use. As an interesting aside, at COP27 India has pushed for agreement on the “phase down” of all fossil fuel use, which Saudi Arabia appears less keen on.

The two phrases relate to two different pathways, with the implication being that the paths converge on the same destination, such as ‘net zero by 2050’. In this case there can only be any interest in comparing them if the nature of the journey would be qualitatively different. Or, if the implication of convergence turned out not to be true. Let’s explore this.

We should first define our terms. In the absence of a commonly-held definition, we at Thinking Ahead suggest we define ‘phase out’ to mean the progressive reduction over successive periods to the point where no further usage occurs.

In contrast, ‘phase down’ will also mean a progressive reduction over successive periods, but to a level that is deemed acceptable to continue into the indefinite future. In other words, ‘phase out’ gets to net zero by 2050 by contributing absolute zero (annual) emissions from fossil fuels, while ‘phase down’ requires the simultaneous building up of carbon capture and storage (CCS) to a level that offsets the continuing ‘phase down’ emissions.

We can now consider the two scenarios introduced above. The first is that the down and the out pathways converge on net zero annual emissions by 2050. From the construction of this scenario there is no meaningful difference between the pathways in terms of their impact on the climate. Instead, the difference will be seen in the mix of energy types and, possibly, in the quantity of energy supplied. The phase out path means that the energy mix in 2050 will not contain any energy derived from the burning of coal, oil or gas. In turn, this would have big implications for certain sectors where electrification is less straightforward (eg shipping, trucking, flying, high-temperature manufacturing). The quantity of energy supplied in 2050 will directly depend on the rate of investment in new (non-carbon) energy generation between now and then.

The phase down path means that we will still be burning fossil fuels as part of our energy mix in 2050. Again, from the construction of this scenario the amount of fossil fuel (and, by extension, the total amount of energy) will depend on the rate of investment in, and the efficiency of, CCS. The amount of energy can be further boosted by also investing in non-carbon energy if there are sufficient funds. This path gives us greater scope to continue benefiting from the hard-to-electrify sectors.

The second scenario is that the pathways actually diverge. Phase out still gets us to zero absolute emissions in 2050, but it gives us the headache of finding substitutes for the hard-to-electrify services we currently enjoy. It could also result in a fall in the total amount of energy supplied, which would be an aberration in a historical context. This would imply some form of energy rationing, which is a difficult proposition for those of us in the global north to wrap our heads around.

The divergence, therefore, comes from the phase down path. We will either default on the phasing down (nobody likes energy rationing, so we keep on burning fossil fuels), and/or we will discover that CCS is more difficult, more expensive, or less efficient than we hoped – and therefore we will do less of it. In this scenario, ‘phase down’ does not get to net zero by 2050.

Why might CCS disappoint? First there is the technological angle. Every successful new technology takes a number of decades to mature. Solar electricity took 40 years to become price competitive with fossil fuels. CCS has only 25 years to show it can be successful, and to mature and scale.

Second, there is the physics. Capturing carbon from the air, compressing it and pumping it underground takes energy[1]. Why dig up more natural ecosystems to find the materials, to build new energy generating capacity, to power CCS when it would be simpler, cheaper and more efficient to burn less fossil fuel instead?

Third, there is the biology, or the human domination of natural ecosystems. It would be nice if the so-called ‘nature-based solutions’ could do the heavy lifting of carbon removal for us. Unfortunately that ship has sailed. The atmosphere enjoyed 10,000 years of stability in the run up to the industrial revolution. The concentration of carbon dioxide didn’t vary much from 280 parts per million (ppm).

In 2022 the concentration passed 420ppm. In other words, while nature has done its best, it was not able to offset the light economic activity of one billion people, let alone the heavy economic activity of eight billion people now. Tropical rainforests are transitioning from carbon sinks to sources, and permafrost has started to melt, releasing long-stored greenhouse gases. Against these considerations, how much confidence should we have in the effectiveness of CCS?

In this piece we have considered phase down vs phase out at the very highest level. A proper consideration would require a much longer piece and a breath-taking amount of complex detail.

For me, however, the primary importance lies in the high-level abstract realm. The choice of phase down or phase out will reveal our underlying values and beliefs. It is, pretty much, an ideological choice. In the run up to COP26 Greta Thunberg wrote that “we now have to choose between saving the living planet or saving our unsustainable way of life[2]”.

It is my argument that phase out is a choice to save the living planet, while phase down is an attempt to save our unsustainable way of life.

Tim Hodgson is co-founder of the Thinking Ahead Institute.

[1] Currently 2,000 kWhours per ton of CO2, according to James Dyke in We Need to Stop Pretending we can Limit Global Warming to 1.5°C, Byline Times (bylinetimes.com), 6 July 2022.
[2] There are no real climate leaders yet – who will step up at Cop26?, The Guardian, 21 Oct 2021

For pension funds with a large roster of external managers, balancing the integration of top-down strategy with managers’ bottom-up implementation is one of the most challenging tasks for CIOs.

The key, says Mark Walker, CIO of Coal Pension Trustees Services Limited (CPT), which oversees around £21 billion in assets on behalf of beneficiaries in two schemes from the UK’s legacy coal industry, is to ensure external managers truly understand the strategic reasons and goals for the allocation. It’s  a process that is more complex, and goes much deeper, than a mandate’s label or just trying to beat a performance benchmark.

Four years ago, CPT introduced short duration, higher yield, external bond mandates for one of its two pension schemes. Working in combination with other assets, the idea was that if the pension fund needed to meet future cash flows three or four years down the line, it could run off those mandates. The managers wouldn’t buy any more bonds and when they got to maturity, the proceeds would be collected and used to pay benefits.

In a classic, top-down strategy, the allocation was crafted to meet cash flows at the pension fund where up to 10 per cent of assets under management may need to be sold to pay benefits in a given year, explains Walker. It was only on closer examination of the portfolio he noticed that one of mandates had a bond with a maturity of 2054.

“This clearly didn’t link to our top-down strategy – it wasn’t going to mature for another 30-odd years!” he says.

Recalling initial discussions with managers around structuring the higher yield bond mandate, Walker cited conversations around timing cashflows out, diversification and manager flexibility around adjusting the duration or managing credit risk. Yet behind these discussions, it was also key that the manager understood the strategic, top-down resonance of the portfolio in the context of the pension scheme’s cash-flow priorities and that not implementing it correctly, held consequences for strategy. Even so, a rouge bond slipped into the portfolio.

Aligning top-down strategy and bottom-up implementation can only be achieved if external managers truly understand asset owners key purpose, Walker continues. For CPT’s two pension funds, that purpose is paying pensions against the backdrop of a huge pay-out ratio (no new money has come into the schemes for the last 30 years) pegged to RPI, meaning that if inflation is much higher than expected, the schemes must generate more returns.

It’s a cash flow focus that means every external manager must understand the importance to the pension schemes of selling an asset well (divesting is just as important as investing) alongside growing the assets to generate returns given that the more income the schemes can collect, the less they have to sell.

“Our starting point with managers has to be about ensuring they understand the liability characteristics of the schemes and the importance of making payments out of the scheme – our purpose is to provide benefits to members, and our payments are much higher than most.”

Property and ships

Top down, bottom-up alignment is a particular headache in the UK property allocation. The schemes’ property managers don’t just need to understand the importance of controlling fees and costs given the impact on vital rental income coming into the pension funds. Other factors are coming into play like the rise in capital expenditure to repurpose UK buildings in line with new environmental and energy efficiency rules, and the impact on cash flows ahead.

“You could argue this kind of expenditure is a bottom-up issue,” reflects Walker. “But it really makes us evaluate the place of property in our portfolio and the value from spending money on a property versus selling the property and committing capital elsewhere. Blending top down and bottom up in a segregated property mandate involves so many different factors. You think you’ve connected the two, and then you discover you haven’t.”

Similar themes have guided the rationale to sell ships, despite ownership of 50-odd ocean-faring vessels across both schemes earning double digit IRRs over the years and comprising one of the best-performing allocations last year alongside private debt and macro hedge funds.

“It has been a good time to sell some of our ships, not least because of increasing costs around environmental standards. Fitting sulphur filters to some of our ships was costly, and more environmental regulation is coming,” he says.

Successful alignment also requires the schemes’ external managers feed-up and share any information that supports top-down strategy. Witness another anecdote from the front line. When flicking through a report from one of the schemes’ global equity managers, Walker noticed the average dividend yield for the stocks in their portfolio was 1.4 per cent – but share buybacks had been at the level of 2.5 per cent over the year.

Since every ounce of income is collected and used to pay benefits, the fact not all the cash flows from companies in the portfolio was being paid out in dividends, but being used, instead, to buy back shares, would have hit the schemes’ all important cash flows.

“It was a facet of the stocks the mandate was invested in, but it impacted the income we received,” he says. “It was a useful piece of market information. Things might happen at a market or stock level that we will then need to think about at on a mandate, cash flow or strategy level.”

Manager shake-up

The quest for alignment with third party managers has resulted in a shake-up of the manager roster in recent years as Walker seeks to buid relationships with a smaller number of bigger names. Many managers have fallen away naturally, like long-term private equity or special situations managers where the investment is realised. Elsewhere, mandates have been consolidated or changes in the value of the asset class has led to fewer managers required.

However, Walker has also reduced the number of manager relationships by asking 25-odd existing managers and some potential new names to come up with ways to work more closely with the schemes, emphasizing their particular needs around high cash flow requirements and high returns, as well as key investment themes like climate and technology. Walker was looking for managers prepared to leverage their resources and help the pension schemes form macro views, access liquid growth opportunities, better structure the equity portfolio or manage climate risk without losing returns.

As a consequence CPT, on behalf of the schemes, now has four strategic providers and around 15 core managers (plus a further 10-15 core private equity managers).

“We are not completely closed to new managers, but the bar for others is higher now because we generally look to our core and strategic managers first if we want to do something new.”

Assets have also flowed to these managers. “Over the last 12-18 months, our percentage of assets with these managers has gone up. We’ve seen our number of legacy managers go down, and the value of assets go up with strategic managers.”

China

Now both pension funds are also revaluating their approach to China. The schemes first invested in Chinese private equity around ten years ago; an active, onshore public equity allocation followed, and together with a small exposure to Chinese fixed income and stocks held by global managers, onshore and offshore exposure to China is around 6 per cent in one of the pension funds.

“We’ve had some great investments, but the risks are increasing,” says Walker.

For example, some of the China portfolios increasingly drag on the Trustees’ climate and wider ESG metrics, and the geopolitics have got more complicated.

“In the past we’ve been relatively bullish on China, but the risk and complexity are increasing, and although we are not exiting, we are reviewing our exposure and I expect it will come down.” For now, he has no short-term plans to put new money into private equity and is likely to re-evaluate positions in public equity too. Still, he’s mindful of the potential short-term benefits to Chinese equities as China opens up after COVID.

The allocation to China sits in a wider equity allocation, divided three ways between Europe, US and Asia. Allocations include small cap and climate and healthcare allocations. Although he is positive on equities in the long run, he expects more downside in the short-term.

“The key issue for us is if they fall we don’t sell them because this is a permanent capital loss,” he says.

Outlook

With no LDI strategy, very few gilts or typical rebalancing requirements, the pension schemes escaped the worst of UK bond market volatility last year. However, the secondary impact from forced sellers as UK pension funds sold assets to meet margin calls did buffet the portfolios, impacting prices of assets the schemes had planned to sell and the balance between buyers and sellers at the time.

“Whilst we still have high return targets, much of our strategy is actually about what we have to sell. We have around 50 per cent of the portfolio in illiquid assets, and don’t want to or need to be a forced seller,” says Walker, who adds that sterling’s weakness has actually helped the pension funds. Many of the two funds overseas assets are unhedged and have seen their value go up. However this has increased illiquidity given the unhedged US private equity allocation went up in value, but the hedged public equity allocation fell.

Looking out on the best income-generating assets ahead, rising bond yields bode well.

“It’s easier to get income now – bonds are paying higher income, much more than they were 12-18 months ago.” However, he’s already feeling some impact from lower distributions in private equity and expects worse ahead.

“We still received hundreds of million in distributions from private equity and special situations debt last year. In private equity alone, we saw around £400 million in distributions last year but that was still less than expected.”

Price discovery in the illiquid allocation is also difficult.

“Private equity has not revalued down as quickly as public equity so understanding the value and a true price, rather than just a latest valuation, is a challenge.”

 

The idea that the ESG movement is impeding a successful response to the climate emergency sounds like a paradox. But John Skjervem, CIO at $43.2 billion Utah Retirement Systems (URS), believes today’s seemingly unanimous embrace of ESG investment and ESG groupthink is actually jeopardizing real transition solutions.

Divestment doesn’t work, he says, and Scope 3 reporting regulations portend a legal and bureaucratic morass that will stymie both economic growth and the pace of meaningful emissions reduction. Moreover, current (and, he says, largely narrative-based) ESG initiatives threaten pension plans’ long-term financial security and, in turn, their capacity to finance energy transition technologies.

“Now completely politicized, ESG is a waste of time,” says Skjervem, a self-confessed ESG apostate, speaking in a rare interview since he joined URS in November 2021 to work alongside State Treasurer Marlo Oaks, a prominent ESG critic.

Amongst the climate change cacophony, calls for divestment worry him most. Take one of URS’s best performing allocations: a 5 per cent strategic commitment to energy, mining, and infrastructure, most of which resides in direct oil and gas investments URS has made in the wake of other institutional investors’ exodus from fossil fuels.

Direct relationships with management teams and operating groups have allowed URS to make cost-saving investments and escape the co-mingled fund structures in which general partners add value and then quickly exit. Now URS can match investment duration with its long-term return and asset allocation objectives.

“We’ll hold these hydrocarbon assets for a decade or more,” he says, flying in the face of calls on pension funds to divest fossil fuels. “We earn great returns while also doing our part to maintain America’s access to cheap, reliable power and fortify its geopolitical position through domestic energy independence.”

Just as important, the unashamedly “fabulously successful” portfolio (boosted by the sharp appreciation in energy prices) has helped fund multiple investments in renewables and several separate commitments to “moon-shot” energy technologies like fusion. “From a place of humility, not ideology, we are deliberately allocating across a mosaic of energy investments because we don’t know exactly how the transition will evolve and play out,” says Skjervem.

He also points out the integral role natural gas plays in weaning economic activity off coal and providing backup power to the intermittent supply profile of wind and solar. “The reality is, we need aggressive investment in oil and gas to provide cheap reliable energy so plans like ours can remain fully funded and provide the risk capital needed to invest in transition technologies like renewables, modular fission, hydrogen and fusion.” He continues, “the energy transition is not an ‘either/or’ proposition, it’s a ‘both/and’ proposition.”

Fossil fuel divestment doesn’t only cause investors to miss out on returns – of which last year was a particularly good example – and plough more money into emerging climate solutions. Divestment is also disingenuous.

In an increasingly pervasive argument, Skjervem says divestment doesn’t work because selling hydrocarbon assets just means they’ll likely end up in the hands of other, less altruistic investors who are less knowledgeable and less concerned about sustainability. “Engine No.1 would not have prevailed if CalSTRS had divested,” he says, referring to the proxy battle investors forced on US oil giant Exxon.

Divestment is also flawed because if successful, it would raise the cost of capital for fossil fuel companies, resulting in fewer projects and less long-term capital investment, he continues.

“Constraining supply raises prices, and higher energy prices are essentially a tax borne mostly by the poor and working class who generally cannot work from home and for whom purchasing an EV is entirely cost prohibitive,” he says, warming to his theme. “Living in the Bay Area during summer power outages, the cause of which was at least partly the State of California decommissioning some natural gas-fired powered plants, I anecdotally observed the immediate activation of diesel-powered generators in affluent areas while poor neighborhoods suffered through extended heatwaves without any air conditioning. The hypocrisy is appalling.”

“At URS we know the energy transition is an imperative, but we also refuse to make investments or promote policies like divestment that shift transition costs disproportionally to the poorest members of society, undermine the economic progress of our state, and compromise the geopolitical security of the US,” he surmises.

Perhaps the aspect of divestment that frustrates him most is that the climate emergency looms ever closer, but clamours for hydrocarbon divestment only squander valuable time, throwing sand in the gears of efforts to find real solutions. “Proponents of divestment are wasting time and diverting valuable resources from serious people making equally serious investments across the energy transition spectrum. This misguided activism is just getting in the way.”

Governance, Governance, Governance

Skjervem, who was CIO at Oregon State Treasury between 2012 and 2020, cites the URS governance model as support for his team’s bold fossil fuel investments. Specifically, the URS board addresses investment matters in executive session which limits the “political grandstanding and virtue signalling” Skjervem says is commonplace at many US public plan board meetings.

The URS model has not only enabled staff to quietly profit from fossil fuel investments while many other public funds bow to divestment pressures. Skjervem says it also shields the entire programme from politics and “non-fiduciary” influences, allowing the team to focus exclusively on hunting for the best risk-adjusted returns without interruption or interference.

“Why do endowments outperform?” he asks. “Because they are opaque. You can’t dial into or attend Stanford’s or Yale’s investment committee meetings.”

Take the URS venture capital allocation for example, a particularly attractive element of the programme’s portfolio construction. Skjervem attributes the celebrated allocation and its impressive manager roster (on par with top endowments and mostly unprecedented among public funds) to the fund’s governance structure which allows VCs to pitch in privacy, protect their IP and stay under the media radar.

Together with enduring Board support (which often wanes at larger funds due to the negligible performance impact of typically small VC investments), he says the URS model has a distinct competitive advantage. “Allowing public comment and opinion on potential investment opportunities is not conducive to attracting high quality VC partners, but in our construct, general partners can be confident they’ll be insulated from the counter-productive elements that quickly emerge with public participation and transparency.”

The seven-member URS board, comprised of five professional investors and two participant representatives, sets asset allocation policy, the actuarial rate of return and employers’ legally compelled contribution rates. The only politician on the Board is the state treasurer, and all implementation and manager selection decisions are delegated to URS investment staff.

URS has an internal audit team that monitors investment process compliance as well as external auditors who review its financials and file reports with the Retirement and Independent Entities Committee of the Utah State Legislature, thereby ensuring multiple layers of accountability.

Skjervem believes this combination of delegated investment authority and multi-level fiduciary oversight is the programme’s “secret sauce” and manifests as excellence in both portfolio construction and team culture, which has enabled the easiest transition to a new role of his career.

So far, he hasn’t had to “put out fires”, “push boulders uphill” or any other metaphor for difficult and complex change management. In fact, he says the most important aspect of his job is keeping a steady hand on the tiller, a thinly veiled tribute to previous CIO Bruce Cundick who over a two decade span assembled “a terrifically dedicated and talented staff who have expertly capitalized on the program’s structural advantages to create a truly world-class investment portfolio.”

Smaller Managers

Nor could he find anything to change in the 15 per cent allocation URS has to hedge funds, a large commitment for a fund its size. This corner of the portfolio, where he particularly enjoys getting under the hood, has proved truly unique. Steeling for change when he took the helm, the hedge fund allocation has, in fact, produced the holy grail of low correlation and statistically significant alpha despite challenging markets.

It has also withstood rigorous empirical analysis and stress testing. “If I think back to the hedge fund portfolios I’ve been responsible for in previous roles, I wouldn’t have had the same success URS has enjoyed.” He attributes this success to Board support (as with the VC allocation) and a carefully cultivated list of around 30 smaller managers.

Rather than invest with the usual suspects, URS positions itself as the largest LP in the relationship rather than one of many. Other contributing factors he cites include ensuring the allocation is well-resourced internally and invested globally rather than with a US bias.

He was similarly circumspect regarding URS’s 12 per cent private equity allocation, especially coming from Oregon. That pioneering investor has a private equity portfolio that dates from 1981 and a pacing model that requires annual commitments of $3.5 billion allocated among the biggest PE firms. He quickly learnt that different principles govern the URS allocation.

Once again, URS plays to its strengths in terms of preferential access, and favours partnerships with smaller, lesser-known managers, made possible by bitesize annual commitments totalling around $1 billion. “There are many benefits to being smaller,” he says.

As the conversation draws to a close, he returns to his conviction that ESG is now hindering the energy transition, diverting valuable resources and time from the important task at hand. “We’re trying to figure out who’s doing it right in terms of both commercial viability and environmental sustainability, and if you’re not doing that, you are part of the problem.”

For all his talk of not changing anything, and the portfolio only needing a minor tweak here or there if at all, Skjervem is putting his mark on URS.