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.

Climate lobbying by powerful trade associations is delaying and diluting the impact of net zero policies and running counter to the effort policy makers, companies and investors are making to reduce their emissions, says Clare Richards, senior engagement manager in the investments team at the £4.3 billion Church of England Pensions Board where she has spearheaded CEPB’s push and ambition to limit climate lobbying since 2018. “The CEBP continues to invest resources to try and highlight the issue and shine a light to stamp out negative lobbying.”

Most recently, CEPB, Swedish buffer fund AP7 and BNP Paribas Asset Management have launched the Global Standard on Responsible Climate Lobbying (RCLS). Working with Chronos Sustainability, InfluenceMap, the civil society organization that tracks lobbying activity, and the London School of Economics, the Standard provides a rigorous framework to assess whether a company’s lobbying is governed and delivered in line with attainment of the Paris Agreement’s goals.

Other milestones in raising awareness include the inclusion of climate lobbying engagement within the Climate Action 100+ benchmark to ensure corporate lobbying is consistent with the goals of the Paris Agreement.

Scale of problem

Companies can have “hundreds” of trade association memberships with little sight or governance around how that membership feeds into those association’s influence on policy, says Richards. Moreover, many companies also have legacy memberships that no longer reflect their corporate climate policy. “In the last few years, we’ve seen notable actions from companies reviewing their trade association relationships because they no longer benefit from them. Companies have also decided to pull the plug on their membership because negative lobbying brings reputational risk.”

Rather than negative lobbying, trade associations should increase their responsible lobbying and use their significant influence as a force for good. “Lobbying is a legitimate activity that can help strengthen policy and test its rigour.”

Companies should urge their trade groups to use their resources and breadth and depth of membership to do more to publicise corporate positions on policy and efforts to achieve them. “Companies should interrogate trade organizations and find out what their membership brings. Otherwise, they are silent partners pushing against the type of policies that would enable the transition,” says Richards.

Proxy season

The up-and-coming proxy season will provide another chance to press companies on their relationships with trade organizations lobbying on their behalf.  Its a proven forum for change says Richards, citing the role of investor pressure helping push BHP to evolve its membership with the Minerals Council of Australia. Elsewhere she points to investors successfully pushing  Shell to annually disclose its membership of trade associations. In the past year, over a dozen other companies have published their trade association memberships, she says.

This season car maker VW is in investor’s sights having rejected calls for climate lobbying disclosure. In the next few days together with other investors, CEPB will pre-declare its vote on the discharge of the management and supervisory board at the company on the basis that is is failing to provide adequate oversight of company management on this issue.

VW has fallen behind auto peers Mercedes and BMW which publish their trade association memberships, says Richards. “For more than three years VW has resisted and refused reasonable requests to demonstrate the alignment of their lobbying. The company is spending money on lawyers to resist shareholder requests – it’s a real headscratcher.”

Indirect lobbying

The issue also spans investee companies direct and indirect association with lobbyists. Trade associations direct impact on policy making is clear, but they also carry influence indirectly, particularly via the media. “Media is a vehicle for the message of the lobbyists,” says Richards, adding that negative media coverage can create an environment where climate policy either flourishes or flounders. Its an issue in Australia’s media, recently flagged by the IPCC in its Sixth Assessment Report while in the UK, fracking has come back into the media where it is often reported as a suitable alternative energy source in response the energy crisis. But energy from fracking can be sold to the highest bidder and won’t necessarily solve the UK’s energy crisis, says Richards.  ““There is a growing move in the UK to push against Net Zero targets by vested interests that view them as an impediment to their business agenda,” she concludes.

As private equity returns continue to outpace all other asset classes, so investors have steadily increased their exposure in the hunt for performance. But the way asset owners have traditionally accessed private equity will no longer reap the same return, and higher interest rates and lower growth ahead are set to impact the valuations of many private equity and venture portfolios counting on high multiples and growth expectations, warns Barry Kenneth, CIO of the United Kingdom’s £38 billion Pension Protection Fund (PPF) that has around £1.6 billion invested in private equity across direct and co-investments, and funds.

Investors going into large cap private equity today will struggle to get higher exit multiples than they get entry multiples, he says. “The traditional private equity model where you buy at an entry level multiple, optimize the balance sheet through leverage to improve returns and then sell at higher multiples – I think that game’s over,” says Kenneth.

He argues that private equity investors need to be more selective how they choose their managers. Strategy at the PPF is increasingly focused on finding GPs staffed by teams that can transform companies though operational improvements, adding on different businesses and being more thoughtful about value rather than just playing on structural bias and the multiples game. The PPF is exploring opportunities in Europe where investors can pick up smaller companies, which often struggle to access capital through public markets, at low multiples. “Private equity in the mid European market is doing well.”

Tougher times ahead

Like many CIOs, Kenneth believes private equity’s challenge is part and parcel of a much tougher investment climate ahead. A sweeping inflation and interest rate hedging strategy shelters the PPF’s liabilities but a new macro environment, accelerated by Russia’s invasion of Ukraine stoking inflation, will hasten central bank rate hikes and hit growth assets – currently accounting for around 60 per cent of the PPF’s portfolio and which returned 17.6 per cent last year. “I started in financial services in ’95 and this is the first time I have been in a sustained UK hiking cycle,” he says.

The PPF is not de-risking – but it is on the defensive. Higher interest rates in the long-term will have a negative impact on equities and while some businesses with an inflation linkage will benefit, others will suffer. If the supply chain crisis continues and globalisation trends that have kept inflation low for decades unwind, higher prices will become engrained. Companies with real-time supply chains dependent on imports from China will struggle – while many are still bogged down by Brexit red tape.

Most sectors will struggle with high interest rates and high inflation, but Kenneth urges index investors to look under the bonnet to see which stocks will be most affected. Cyclical companies and growth equity, particularly exposed to high interest rates and low growth are the ones to watch,  he says. “Any asset classes impacted by higher nominal/real yields are worth worrying about, as are sectors like tech that generally have high valuation multiples and are most susceptible to a fall.” Elsewhere, long-term government bonds are now challenged by interest rates going up and the value of the asset falling.

Indicative of a new caution about how best to access certain asset classes, Kenneth favours infrastructure investments that aren’t linked to cashflows. The fund has invested in the United Kingdom’s Thames Link franchise, (a north-south rail corridor across London) yet the return is not based on traffic volumes but on the availability of the asset instead. “We are not doing opportunistic stuff,” he says. Similarly, toll roads where returns are based on traffic volumes are out and forestry, where the PPF now has a £1 billion portfolio that could benefit with the emergence of carbon credit trading backed by real assets, is in.

ESG

It reflects another theme pushing centre stage in today’s challenging environment. The PPF has integrated ESG since Kenneth joined nearly nine years ago, but now a number of key ESG strategies are on the agenda focused on private markets.

The PPF is improving its ESG data. Working with Dutch consultancy ORTEC, it is gathering carbon emissions data across every asset class in the portfolio with a particular emphasis on private markets. The depth of the process is most evident in the PPFs fund of funds allocation in private equity which comprises thousands of different companies.

“We are assigning a temperature score to every company we invest in so we can see how the portfolio aligns to Net Zero and Paris.” Only when the PPF can accurately measure this in a defined process will it set targets, says Kenneth. “Only by doing this groundwork can we figure out how to get to Net Zero without greenwashing,” he says. “There is no standardized process so in a complex portfolio made up of public and private investments where diversification is important this is how we have chosen to do it.”

According to recent data in the annual report, the carbon footprint in the PPF’s listed equities has fallen 16 per cent but it has increased slightly in the fund’s credit holdings, attributed to the inclusion of corporate bonds in the emerging market debt portfolio which tend to have a higher carbon footprint.

Elsewhere expectations of managers have risen. New managers are scored and must commit to minimum ESG standards enshrined in legal documents. The PPF’s internal team engage with managers on an ongoing basis and Kenneth estimates around a quarter of new managers have signed up with the PRI because of this pressure. “We are involved with moving managers to these platforms,” he says. “In private markets we are more dependent on the managers to push the companies to integrate ESG, but we have significant engagement with these managers to execute our beliefs/strategy here. If a company is listed, it is more likely they will report on ESG related issues, as they are more transparent to a wider investor base.”

The fund delegates stewardship to EOS at Federated Hermes but has the ability to overwrite and apply stronger stewardship if needed. “In our segregated mandates, we have an overwrite process whereby we agree standards on stewardship practices with EOS (at Federated Hermes) but if want to be able to overwrite and be stronger on some aspects, we can,” Kenneth concludes.

The increased adoption of RI principles was clearly visible in this second iteration of the Global Pension Transparency Benchmark. Scores within the RI factor saw the largest year-over-year increase with the average score across all funds increasing by 6.9, so where were these increased scores most evident?

Responsible investing (RI) is increasingly becoming a focus for many large funds across the world. Even funds that previous eschewed RI on the basis that their primary purpose was to deliver returns are coming round to the idea that RI is too important to their stakeholders to ignore.

For pension funds, concerned stakeholders are no longer limited to environmental activists and NGO’s , but also include regulators, plan members and their own employees. Results of early adopters of RI principles mean it is now becoming apparent that you can both focus on RI while still delivering value in the traditional sense – superior investment returns.

As more and more leading funds integrate ESG and RI principles and disclose such endeavors, stakeholders of other funds are asking why their funds don’t. This is forcing those lagging funds to catch-up. Evidence of the increased adoption of RI principles was clearly visible in this second iteration of the Global Pension Transparency Benchmark (GPTB).

Scores within the RI factor saw the largest year-over-year increase with the average score across all funds increasing by 6.9. Where were these increased scores most evident?
• Funds that scored below median in last year’s review saw slightly larger increases than funds in the upper half of last year’s rankings (an increase of 7.1 vs. 6.7).
• Within countries, the lowest scoring funds saw larger increases than average. Across all countries, the lowest scoring funds within countries improved their scores on average by 7.6 points.
• The increase in scores among the lowest scoring funds within countries was even more prevalent in countries that scored in the top half with an average increase of 9.1. Note that these funds didn’t all score poorly. Funds from top scoring countries (eg Denmark, Canada, the Netherlands) were often scored above average, even in last year’s review.

These results suggest that competition, peer pressure and comparisons between funds is driving change. Funds appear much more inclined to increase disclosures when they observe peer funds doing the same.

How are funds improving their disclosures?  Here are two examples that are informative and accessible to all levels of stakeholders.

Example 1: Impact investing case studies

One way funds can increase their transparency around RI, is by using case studies to demonstrate how their impact investing initiative. Eskom PPF from South Africa included a case study on its investment in sustainable housing in its annual report. This shows stakeholders clear examples of responsible investing in action and helps connect a fund’s words to their actions in a relatable manner.

There are similar impact investing disclosures at other funds as well. Many funds are already engaged in impact investing in similar ventures, so it is just one extra step to disclose and report on these sustainable investments.

Example 2: Corporate Stewardship Case Studies

Another way for funds to increase their transparency and reporting on RI is by reporting on their corporate stewardship activities.

For many funds, this involves disclosing an active ownership policy that describes how the fund should engage with portfolio companies. To increase transparency further, some funds also provide reporting on how they engaged with companies throughout the year, including their voting records. This is often done in a summary format, although some funds provide extensive details of their voting records.  These disclosures are useful, but often too technical to be accessible to all users.

Universities Superannuation Scheme (USS) from the UK published their UK voting policy in 2021, as well as a 2021 stewardship report. Its UK voting policy outlines how the fund should exercise its votes on various topics such as director elections, remuneration policies, and auditor elections. The USS stewardship report outlines its engagement activities throughout the year, including case studies on individual companies, as well as a section on significant votes. This allows stakeholders to understand the fund’s stewardship activities on a more tangible level. These two documents were the main factor in the increase in USS’s RI score this year.

The improvement in responsible investing reporting is encouraging to see and shows the need for leaders in this space. A pension fund that becomes a leader among its peers in the RI space is not only increasing long-term value for members, but is also driving positive change in the industry, and therefore increasing long-term value for members of pension funds everywhere.