United States policy has quietly encouraged India and other countries in Asia to buy Russian hydrocarbons to avoid a global recession, driven by energy and food shortages, according to US government adviser and Russia expert Stephen Kotkin.

While “no one wants Russia to get away with” invading Ukraine, an energy supply shock prompted by sanctions on Russian oil and gas by the US, Europe, Australia and others, would punish poor people in developing countries, he said.

Speaking at the Sustainability in Practice conference in Cambridge University this week, Kotkin said India, the world’s third largest buyer of oil, has taken advantage of cheaper Urals crude oil prices in March and April, buying more than its annual intake in what has been described as a large uptick in imports.

“If all Russian supplies were immediately taken off the market we would have that global recession,” the Professor in History and International Affairs at Princeton University said.

“Europe is immediately susceptible (and while the) US is trying to punish Russia with sanctions, we don’t want to hurt everyone including those poorer countries by inducing a global recession when there’s a possibility it might be avoided.

“(By the US) encouraging India to buy Russian hydrocarbons, Asian markets might pick up the slack of Russian supply and avoid a global recession,’’ Kotkin told the Sustainability in Practice, forum for investment leaders, organised for Investment Magazine’s sister publication Top1000Funds, in Cambridge, UK.

The problem with sanctions

While sanctions “felt good” as a punishment on Russia, there was nothing to gain by destroying commodity and food markets for many countries, he said.

In a scenario where Saudi oil supply faltered, the world would not be able to make up Russian supplies and this would halt manufacturing.

“German industry is dependent on Russian natural gas to power it. Fertilizer, for example, which is usually important, if you lose that, your yields go way down on your crops,’’ Kotkin said.

“There’s so much risk involved here to manage. No one wants Russia to get away with it but, on the other hand, we don’t want to punish innocent countries.”

Commodity supply issues

He said Russia’s commodity supply extended to palladium, titanium, neon, as well as “green” commodities cobalt, zinc and lithium used to make batteries and electric vehicles.

Kotkin quoted the late and former US Secretary of State, George Shultz, who said energy policies had to balance economic feasibility, environmental impact and national security.

In the last few years before Schultz’ death, in 2021 at age 100, environmental impact had been allowed to trump national security but with Russia’s invasion, national security might be allowed to trump environmental impact, he said.

Without a carbon price, which Australia had briefly legislated for, there had been a slow transition to renewable energy around the world as well as a slowdown in nuclear power plant rollouts which meant the world needed to invest in hydrocarbons in the short to medium term to avoid significant global food shortages.

Reducing reliance

Reducing Europe’s reliance on Russian oil and gas could see a “massive redirection” of liquid natural gas (LNG) from Asian markets to Europe building out LNG infrastructure in Europe in 18 months to two years instead of the usual five years, Kotkin said.

“If you’re optimistic you’d say it could be done without as much disruption as if it had to happen overnight,’’ he said.

“The move from Russian hydrocarbons is underway… you see the resolve and ingenuity of Europe and that’s cause for optimism.

“Europe has returned to the idea of being a buyer’s cartel, using its incredible purchasing power to form a cartel of buyers the way that OPEC Plus is a cartel of sellers.’’

Squandered recovery

But the Princeton professor said the world had squandered the Covid-19 recovery and an opportunity to transition faster to a greener energy supply.

“We have another opportunity again. Will we squander or take advantage of the invasion to change our behaviour and enact that successful management of the carbon market place?’’ he asked.

Kotkin closed his presentation by saying there were some challenges to a transition with stranded assets particularly with the need to invest in hydrocarbon infrastructure in the short term.

“If we’re making a transition, who’s going to invest in assets like LNG terminals that are significant in scale and capital, if those are going to be taken offline because of decarbonisation, how do markets manage investment in new assets designed to be obsolete at some point,’’ he said.

He suggested the trend towards deglobalisation would see countries work towards national solutions to decarbonise which were “piecemeal” but likely to work.

Investors struggle to influence sustainability in the trillion-dollar sovereign debt market. There is little evidence to suggest sustainability is important when it comes to pricing sovereign issuance, and investors that do prioritise sustainable sovereign investment are not sending a particularly strong message to the market, said expert panellists speaking at Sustainability in Practice at the University of Cambridge.

Moreover, many UK pension funds will continue to invest in UK sovereign debt to match their liabilities even if the country goes off track with its transition to net zero, said Will Martindale, group head of sustainability at Cardano, the pensions advisory and investment specialist which manages over £15 billion in DC assets across the UK and the Netherlands including operating the United Kingdom’s NOW: Pensions.

Martindale noted little attempt from sovereign governments to issue social bonds or bonds linked to sustainable KPIs, while fellow panellist Ella Hoxha, senior investment manager, global bonds at Pictet Asset Management (as pictured above), said there are inherent complexities for investors when it comes to “telling governments what to do” particularly in markets governed by undemocratic regimes or where sustainability has little traction.

Despite the challenges, panellists outlined the steps they are taking. Investors can invest in sovereigns that have committed to cutting emissions and meeting the Paris goals. “Investors can look at signatories to the Paris agreement; you can be an active allocator of capital on this basis,” Hoxha told delegates.

In developed markets this will incur a European bias and exclude the US, which will come in and out of sovereign debt portfolios depending on the US administration’s progress and commitment to lowering emissions. “This is a bias you can manage,” she said. Regarding the European bias, forming objective decisions on the different sustainable paths of, say, Germany and France is challenging for investors.

Understanding policy

Trying to understand sovereign sustainability policy exposes many complications. For example, emissions in Brazil could fall but on the policy side commitment to lower emissions or protect the Amazon remain weak. “The nuance behind the policy is important,” said Hoxha. She also noted that incumbent governments will prioritise elections over climate policy and that during elections, sustainable commitments may slip. She noted the importance of looking to governments future policies, a pertinent point in growing economies where GDP is rising and emissions creeping up. “We like to see an improvement in emissions for GDP reflected in policy,” she said.

Measurement

Accurately measuring sovereign emissions is another minefield for pension schemes. For example, investors need to consider whether they count state-owned companies only, or if they should count emissions of the country as a whole. Should they include a country’s exports and Scope 3 emissions, or just look at the issued debt of an economy?

Martindale added that when investors try and measure social issues in their sovereign sustainability calculations it gets even more complicated – particularly when policies run counter to factors going into that measurement like the United Kingdom’s 2021 decision to cut overseas aid.

Measuring commitments has also been complicated by war in Ukraine where Hoxha noted the resulting energy crisis will impact sovereign net zero pledges, many of which are now optimistic. Although on one hand governments need for energy security away from Russia will speed up investment in green energy, in the short-term, reliance on fossil fuels will grow. She also questioned investors ability to influence policy.  “The transition will take longer than we assume,” she said.

Counselling a realistic and practical approach, Hoxha said investors should look at sovereign policies, set their metrics and then “draw a line.” She added that investors are “not NGOs” and need to balance generating returns with prioritising sustainability.

The future

“We have more barriers than solutions,” concluded Martindale who also noted that investing in higher impact, sustainable sovereign assets can incur higher fees, liquidity issues and requires the support of trustees.

However, although engagement with sovereigns is still in its infancy the size of the government debt market means it will have a significant role to play in achieving the transition. Martindale also outlined his believe in the power of collaborative engagement to influence frameworks, policy, and behaviour.  Positively, sovereign sustainability could also become more of an investor focus given the challenging macro backdrop for fixed income as interest rates and inflation rise.

 

In today’s hot inflationary environment and where prices are forecast to rise further still,  the commodity markets (excluding oil and gas) could offer returns, inflation protection and impact, argued Carsten Stendevad, co-chief investment officer for sustainability at Bridgewater Associates, the world’s biggest hedge fund.

Speaking at Sustainability in Practice at Cambridge University, Stendevad said demand for inflation-proof commodities like copper, aluminium and nickel will grow given these metals’ role powering the energy transition, the essential components in building the renewable future from electric cars to offshore wind farms. Investing in these kinds of commodities also fits into Bridgewater’s 3D investment lens that focuses on impact as deeply and rigorously as risk and return.

Moreover, for the last decade investment in commodities has steadily fallen.

“Across all commodities there is a supply demand imbalance that will be exaggerated by the loss of Russian supply and the invasion of Ukraine,” he said. “It is very difficult to get to net zero without leaning into commodity production.”

Inflation on the rise

Stendevad argued that inflation is set to rise much more ahead.

“There is a market expectation that this is transitory and that after a tough environment, we will return to normal life. We don’t think this is realistic.”

Inflation will be fuelled further by the cost of financing the transition. Green public spending on renewables will fuel inflation further while supply and pricing of both fossil fuels and renewables will impact the macro environment. He noted however that advances in technology will have a disinflationary impact.

For the past four years, Bridgewater has been building out its sustainable assessment of individual metals and mining securities, exploring what different commodity companies are producing and how they are producing it. Stendevad advised investors to dig deep into individual companies to ascertain ESG integration in their production process like labour rights and the use of fossil fuels in extraction, as well as their products Scope 3 emissions.

He estimated that only around a quarter of the world’s companies have mapped their revenues, services and production processes to the SDGs in which cohort, listed metals and miners are few. While it is important to support mining companies on their transition journey, he noted that many mining groups are uncertain of their own transition path and don’t have a forward-looking carbon plan.

“It is too early for us to say that if we engage with companies, they will improve. It is really hard to assess most companies transition path.”

Still, Stendevad noted that some companies are doing better than others. A handful of mining companies provide increasingly valuable and granular data on their operations spanning water use, labour practices and community engagement.

“In the last year we have been surprised by the amount of information companies are starting to release,” he said. “It is about drilling into individual securities, and putting it into a portfolio that will be resilient in a tough economic environment. It is a complex task.”

3D approach

Stendevad said that the compulsion to invest for risk, return and impact is growing.

“Truly sustainable portfolios have an objective on carbon and financials,” he said. He noted that some investors find impact “a step too far” and that there are still asset owners who feel sustainability is not their responsibility. Yet he argued it is liberating to put sustainable investment through the lens of risk and return.  He reiterated the importance of investors understanding the goal of their portfolios and a systemic approach to define what they mean by sustainability.

“You have to own the concept and define what it means to be sustainable,” he said.

Different industries have different challenges. For instance the auto industry faces the challenge of shifting to electric vehicles. In the case of metals and mining, the challenge is less about the product and more about how it is produced. In the mining industry, core business will need to be transformed with KPIs around operating practices; investors will need to take a view on the key items that companies need to address and the credibility of those plans.

“Are they spending money to make the changes required?” he asked. “There are a whole set of things you need to look at to give you confidence.”

He warned investors to not be too reliant on commitments but look for signs of action and real transition.

“Companies know they need to change; when we speak to companies, we see a level [of commitment] we didn’t see before,” he concluded.

Infrastructure investors are choosing infrastructure assets based on whether they can decarbonise – and declining investments that can’t.

One example is asset manager First Sentier Investments’ recent investment in European district heating assets, sure in the knowledge that green energy sources like waste timber, solar and ground source heating would fuel the centralised heating provider for residential and commercial properties going forward.

“These were the considerations we had in the acquisition process,” said Niall Mills, managing partner of global infrastructure at First Sentier speaking at Sustainability in Practice at Cambridge University.

Elsewhere, the United Kingdom’s NEST turned down the opportunity to invest in an airport because of the asset’s conflict with net zero.

“The airport story is uniquely unconvincing,” said Mark Fawcett chief investment officer of the £20 billion defined contribution fund. “Airports claim to be net zero but ignore the emissions from their aircraft.”

Fawcett said that although NEST won’t exclude infrastructure managers that invest in airports from its mandates, managers should expect NEST’s investment team to dig deep into stranded asset risk, verifying the long-term rewards given the airline industry faces such disruption ahead.

“I doubt Heathrow will have five terminals in 2050,” he said.  NEST has the ability to invest longer-term than peers due to is young membership but Fawcett said trust and avoiding greenwashing are crucial seams to its renewable investment strategy. When it comes to choosing managers he said NEST seeks long-term partners who should be prepared for “left field” questions that uncover attempts to greenwash.

Delegates heard how transitioning some infrastructure assets from coal has been complicated by Russia’s invasion of Ukraine triggering a European energy crisis. Mills noted how plans to transition German infrastructure assets from coal to greener sources by 2028 are now likely to be delayed, requiring a “Plan B” and highlighting how some matters are out of investors’ control.

Policy challenge

Infact, one of the biggest challenges to lowering emissions in infrastructure comes from policy. For instance, First Sentier owns a city centre parking business in Spain where it would like to build charging infrastructure, yet people using the facility still drive petrol vehicles because of the absence of policy and regulation.

“We haven’t greened it quickly enough,” he said. “The speed of change is slow.”

Mills said the asset manager was uncomfortable investing in an asset where it didn’t’ believe it could control the agenda around decarbonisation.

“It has to be supported by the right framework so we know we are not going to lose investors money.”

compelling transition stories

Other compelling green infrastructure investments include ferries. Both First Sentier Investments and NEST have invested in ferry businesses where they have been able to decarbonise assets, swapping diesel fuel for battery technology, charged by renewable sources. Mills, who espoused the importance of equity stakes to help control asset transition and effect change more quickly, explained how one ferry business between Denmark and Germany uses hybrid energy sources, offering a greener alternative to a proposed tunnel linking the two countries.

“We are trying to prove that the ferry business is completely clean and doesn’t require digging up ocean,” he said.

Elsewhere, a wind farm investment in Portugal has championed local wildlife and local manufacturing, reducing transport costs and emissions.

NEST, which has invested in a Norwegian ferry business, is drawn to compelling transition stories, said Fawcett.

“If a business is transitioning, we want to see these examples in action. We want to see the environmental impact and how that will create value over the long term for our members.”

Technology

Panellists espoused the importance of technology in infrastructure but also flagged risks. In renewables, NEST favours proven technologies in wind and solar, although Fawcett noted newer technologies around storage felt like a “fertile area” for the future. Mills added that technology around voltage control amounts to one of the most exciting opportunities in the UK.

“It is a tiny investment with huge benefits.”

Investing in green infrastructure in emerging markets is challenging, particularly around governance linked to property rights. Indeed, this is still a factor in developed economies like Spain where government intervention on purchase power agreements has left investment in doubt.

Fawcett concluded that investing in carbon offsets was a “last resort” at NEST.

He said the pension fund would have to have made a lot of progress before it relied on investing in environmental projects in order to balance out the fund’s own carbon footprint.

 

Change has always been a feature of the investment industry, but the sustainable revolution underway marks a deep shift in how the industry works.

Victor Verberk, chief investment officer of fixed income and sustainability at Robeco told delegates in the opening session of Sustainability in Practice at Cambridge University that investors are increasingly focused on outcomes alongside risk and financial results, aligning their rate of return with a better society in a double materiality.

“Sustainability involves pushing boundaries and investing at the frontier, continuously learning and going into unchartered territories,” he said.

He counselled on the importance of investors being willing to learn and adapt how they serve their clients and other stakeholders. Developing a net zero road map requires building tools to measure climate impacts and exclusions.

“The winners are those who do this well,” he said.

He warned that the EU has “grossly underestimated” the cost of the transition, particularly the cost and requirement of data. To create sustainable outcomes, investors need to employ all the tools at their disposal and work together while regulation will also make the investment landscape more complex and change product demand.

investors need new Skills

Verberk stressed the importance of investors incorporating new skills into their teams. Investment teams need to include people who are comfortable working with unknowns; able to keep a close eye on evolving science and understand where data is leading.

“Business strategies need to become more flexible. It requires a deep change,” he said, adding that legal skills, and data and biodiversity expertise, are now essential team attributes. Skills could be a focus of consolidation in the industry where he said that building skilful teams and expertise is more important that accruing assets under management.

He noted how impact is no longer isolated in a corner office and that real world impacts are now integrated by investment team. Decarbonising portfolios requires every portfolio manager to understand the carbon footprint of all their holdings.

“Carbon awareness is intimately connected to the investment process,” he said.

He stressed the importance of investors engaging with all stakeholders, spanning the largest polluting companies but also governments, clients, and peers.

Elsewhere, Verberk warned that investors need to prepare for evolutions in the carbon market. Carbon markets are an essential component of a net zero future; Robeco provides guidance to clients on the use of carbon credits and will monitor the use of new carbon credits as an asset class in an evolving world.

He said that markets have already priced climate change and regulation coming down the line.

“Companies are getting priced already – the market will tell you which companies are doing this [integrating net zero].” He also warned of the emergence of winners and losers in an environment ripe for for stock pickers.

“This is exciting for seasoned investors.”

He said investors will have to increasingly integrate and align their investment activities with biodiversity. Robeco now partners with the WWF in a relationship that provides the asset manager with the opportunity to leverage scientific data and create an investment framework across all assets.

“In 12-18 months, we will have an investment framework and we will share this,” he concluded.

 

Traditional fixed income has always provided protection in down equity markets, but it is less effective when rates are rising like today. Still, the $250 billion Florida State Board of Administration’s 18 per cent allocation to fixed income primarily comprising U.S. investment grade bonds remains the best way to protect the portfolio in today’s challenging macro environment, said Alison Romano, deputy CIO, Florida State Board of Administration.

Speaking in a recent meeting of the Investment Advisory Council, Romano explained how the fund is exploring a range of strategies to boost incremental yields across fixed income. Around 64 per cent of the fixed income portfolio is actively managed – less than peers. Romano noted the opportunity to take on more risk via expanding core plus and adding exposures to out of benchmark strategies like structured credit, bank loans, mortgage derivative strategies and short duration credit in a flexible and dynamic approach.

Elsewhere she outlined how the fund will continue to explore diversifying strategies that have the same “liquid diversifying” characteristics as fixed income to generate yield. These could include increasing leverage in real estate and allocating to insurance linked securities and managed futures. “These types of assets add an alternative risk premium and can kick-in in different types of market,” she said.

Since 2007, Florida has steadily pared its fixed income allocation from 29 per cent to 19 per cent (including cash) reallocating to diversifying strategies like strategic investments and real estate. Relative to peers, the retirement fund has a smaller allocation to fixed income than most, and Romano warned Council members that this involves a trade-off between risk and return. The higher allocation to equities and lower allocation to fixed income means the pension plan has experienced higher volatility than many peers: fixed income plays an important role countering risk on many levels, she said listing volatility, tracking error, downside deviation and correlation as a few.

The benefits

Romano reiterated the benefits of fixed income as a vital source of liquidity, ensuring the fund can rebalance when stocks fall, pay capital calls and benefits. “If we can’t rebalance, we give up millions in capital gains,” she said. For example, fixed income played a key role rebalancing and providing liquidity in March 2020 when the pandemic broke. The fund rebalanced a total of $1.34 billion from fixed income to global equity in March 2020 when bonds also provided $634 million for benefit payments and capital calls needed at that time.

Strategy during the pandemic was the result of lessons learnt during the GFC. Back then the fund had a much higher risk budget and active exposures, and less liquidity which made rebalancing more difficult. After the GFC the fund reduced active exposure and the risk budget, building in more certainty around volatility and contributions.

She also discussed the pros and cons of other strategies away from fixed income to add diversification including increasing value exposure, non-US exposure and dividend yield strategies in equities. Yet she noted this approach increases volatility and tracking error and wouldn’t necessarily provide the protection the fund needs. She warned against increasing the REIT exposure – an alternative liquid allocation – due to its equity risk. Reallocating fixed income assets to liquid public markets will increase risk, she warned. “Without a change in asset allocation targets, reallocation of 5 per cent of the total fund increases risk approximately 50 per cent.”

Elsewhere, she said that putting on meaningful tail risk hedging strategies for the giant portfolio was challenging and expensive. It would require a willingness to pay the cost year after year to keep a hedge in place that might never be used.

The investment team has modelled the different risks ahead including rising inflation and equity volatility’s impact on annual liquidity needs. The models proved that fixed income gives the fund the flexibility to meet liquidity needs. “It did historically and will ahead,” she says.  The models also showed that over long periods, fixed income is expected to have the lowest correlation to global equities relative to other asset classes and that fixed income will be a diversifier in negative market scenarios.

Wider portfolio

Turning to the performance of the wider portfolio, Romano said that over the last three years private equity fuelled by record deal volume, fund raising and distributions, has led returns followed by real estate where high performing investments include industrial and multi-family units. Romano also stressed the importance of not being over tactical, despite the darkening macro picture. For example, European investments recently looked like “good value” but a tactical call would have seen investments subsequently hit by the war in Ukraine.