A joint report by the International Energy Agency and the Centre for Climate Finance & Investment at Imperial College examines the risk and return proposition in energy transitions. It looks at publicly traded renewable power and fossil fuel companies in advanced and developing economies calculating the total return and annualized volatility of these portfolios over 5 and 10-year periods. Across all portfolios, renewable power generated higher total returns relative to fossil fuel.

Expect more clean energy capital investment and expenditure in 2021 following the recent slowdown due to the absence of clear policy drives and constraints in some markets, said Michael Waldron, head of the International Energy Agency’s investment team which tracks global capital expenditure in clean energy projects on the ground.

Still, he noted an uptick in spending in renewable electricity and efficiency in the US, Europe and China and noted early evidence that government stimulus in the wake of the pandemic is leading to an increase in capital expenditure.

To meet net zero goals by 2050 trillions more investment is vital. This will only happen if investors understand the risk and return of allocating to renewables versus fossil fuels.

He noted that renewable portfolios are typically more highly leveraged than fossil fuel portfolios and that fossil fuel allocations pay more dividends – though here he noted growing dividends in renewables too.

He also noted swings in profitability in fossil fuel portfolios, and said renewables are getting steadily more profitable compared to fossil fuel allocations steady decline.

Delving further into how equity portfolios focused on energy investment performed over time, he said renewable power generated higher returns compared to fossil fuels, exhibited less volatility and had less correlation to the broader market.

“There are higher risk adjusted return and diversification benefits (in renewables),” he said.

Still, caveats exist. Notably renewable outperformance isn’t visible in emerging markets. He said the investment gap in the energy transition is much higher in emerging markets, an area where investors under allocate.

“Emerging markets are at a lower stage of development in renewables,” he said.

He said that there is less fundraising for renewable projects in emerging markets in a disconnect that contrasts with advanced economies where sustainable debt markets have taken off as well as green bond markets.

The analysis also raises questions around next steps. Listed markets have significant untapped potential to allocate more capital to renewables, however the size and illiquidity of some companies could create liquidity concerns.

“These companies may not meet the needs of allocating investors,” he said.

He noted that much of the capital being raised is going into unlisted private assets.

Moreover, investors tend to favour investing in existing assets rather than greenfield.

“There is a lot of direct investment into existing assets, but how do we get more into new assets?” he questioned. “Institutional investment into new projects is important to lower the cost of capital.”

AP4’s head of alternatives Jenny Askfelt Ruud discusses how the pension fund integrates sustainability in its alternatives portfolio which includes avoiding investments in some sectors in line with its decarbonisation strategy and investing in sustainability themes by finding companies that are driving the transition with new technologies and services.

AP4, one of the five Swedish buffer funds, has around 17 per cent of its $50 billion portfolio in alternatives in a strategy designed to complement public markets and generate real cash flow. The pension fund also has the capacity to substantially increase the allocation since changes to its mandate in 2019 – a consequence of a vocal campaign for change pushed for by AP4 chief executive Niklas Ekvall, amongst others.

At AP4 the majority of its alternatives portfolio lies in real estate, with the balance in infrastructure, private debt and private equity.

Speaking at Sustainability in Practice, Jenny Askfelt Ruud, head of alternatives says AP4 has a core, holistic approach to integrating sustainability in alternatives and is targeting net zero emissions in the portfolio by 2040 with a half-way target to halve the carbon footprint by 2030. The fund uses its influence to actively engage with companies in a bespoke approach tailored to each investment.

“We apply different measures in public and private investments,” says Ruud. “We find the right tools for each type of investment.”

The fund avoids investing in some sectors in line with its decarbonisation strategy and invests in sustainability themes by finding companies that are driving the transition with new technologies and services.

 

Partnerships

In private markets you can’t vote with your feet, said Ruud. Here her focus is on investing with like-minded partners where investment is shaped around long-term relationships chosen for shared values and culture, underscored by investment rigour.

“Talking the talk is easy, but we prefer to put measuring and reporting into legal documentation,” she said.

The asset owner seeks to invest in structures where it can have real influence around sizing and legal documentation, and also invests via platforms. Transparency and measuring are a key tenet to the portfolio where the firm hopes to drive efforts where international standards are lacking, she said. For example, the fund already reports emission from its real estate portfolio which accounts for around 75 per cent of its alternatives allocation.

Noting growing dialogue amongst peer real asset investors in how best to position for climate related risk, Ruud described how she has built expertise within her team to ensure they can ask the “uncomfortable” questions themselves.

“Sustainability experts give great support, but I want this within my team,” she said.

Ruud said investors need to take a long-term approach when deciding where and where not to invest, and advised on a long-term thematic approach that avoids high emissions when allocating new capital. In the legacy portfolio, engagement and dialogue are key to “put pressure” where needed. Elsewhere the fund’s active decarbonisation strategy means it is not investing in some sectors.

She said a particular area of focus is sustainability themes like the energy transition, mobility and renewables, services and technology – markets which face lower risk over time. “It is a live discussion where we add themes and sectors as they mature,” she said.

Together with sister AP funds, AP4 has set up Polhem Infra, an investment company that invests and manages infrastructure assets targeting long-term sustainable investments in the Nordics. Elsewhere, again with other buffer funds, AP4 co-led financing in Northvolt AB, a Swedish battery developer and manufacturer specializing in lithium-ion technology for electric vehicles. We want to be part of the evolution of the European battery industry, she said.

She concluded that a key focus going forward will be around measuring and finding the right standards. “Data is crucial in private markets, particularly in more private equity focused investment.”

Scenario analysis shows that the ability of pension funds to pay their pensions will be severely impacted by climate. But a discussion between asset owners at Sustainability in Practice revealed the challenges in the process.

Although the United Kingdom’s USS Investment Management, the wholly owned investment management arm of the £67.6 billion Universities Superannuation Scheme, has conducted a scenario analysis to explore how assets behaved over time in response to climate change, Innes McKeand, head of strategic equities at the fund said scenario models can “only take you so far.”

Speaking at Sustainability in Practice he said scenario analysis offers a guide but is not precise given the tipping points and instability inherent in climate change, the economy and the market reactions to climate events. He told on-line attendees comprising some 250 asset owners with a collective $13 trillion AUM from 33 different countries that the last scenario analysis conducted by the fund suggested US equities suffered particularly, but that the impacts are difficult to assess.

“We need the next stage of evolution of models until we start moving the portfolio around.”

McKeand, who is responsible for all of USS’s listed equities portfolios across developed and emerging markets and is a member of the asset allocation committee added that sustainability has been embedded into the fund’s structure, beliefs and culture for some time and that responsible investment is now part of the fund’s fiduciary duty.

Scenario analysis at USS has been both top down and bottom up. Top down analysis has explored the impact of a warming world on asset values on a disorderly and orderly basis. McKeand noted limited impact on asset values in an orderly transition but much more of an impact in a disorderly transition.

“We see a visible impact here but it is all back-ended” he said.

Looking through a bottom-up lens, he noted how every asset the pension fund owns will ultimately have to be net zero. He said that knowing an investee company’s carbon footprint will allow the fund to use carbon pricing scenarios but said challenging data issues remain.

He also noted that the analysis has looked at the impact on assets, but now needs to look at assets and liabilities, and the climate impact on the fund’s covenant – university employers across the UK.

Governance and net zero

McKeand noted the importance of governance when it comes to scenario analysis and the fund’s net zero ambitions.

“How do you manage this thing? Net zero is an enormous topic,” he said.

He said USS was in the thick of trying to settle on a governance structure to steer the fund to net zero.

“It involves establishing how to set meaningful targets and holding ourselves to account.”

He noted the vital role of asset managers in progress and said that portfolio managers and analysts play a vital role in integrating net zero into valuations and the investment process.

He also noted the importance of governance in aligning incentives the right way so that managers and staff are aligned in the challenge. Nevertheless, he said that boards and trustees focused on their fiduciary duty “can’t do everything” and what is right for some asset owners won’t be for others.

“It is a rubbery concept as what is right for some, isn’t for others.”

While USS is far down the road other funds are only beginning the journey. Embedding governance around ESG is a central tenet at Canada’s newly created $11 billion University Pension Plan (UPP) said Barbara Zvan, chief executive of at the first fund of its kind in Ontario’s university sector.

“We have taken a lot of time to lay out governance, building an exciting plan that universities and members want to join and part of that is the ESG and climate lens,” she said.

The fund has already developed a responsible investment policy and due diligence guidance for investment managers.

Zvan noted how incorporating physical and transition risk given the breadth and depth of many pension funds assets is challenging.

“Capturing tipping points is difficult,” she said. She said it made collaborations and sharing research important.

For example, the fund has reached out to peer plans and used Mercer research, while analysis by the Bank of Canada, as well as regulators and Canadian insurance groups and banks, has helped develop climate scenarios. She said a priority was to ensure that ESG was embedded throughout the organisation with skills and oversight and not siloed. She said priorities include a governance budget and investment sophistication, either internally or externally.

“We won’t necessarily train in house,” she said.

Both panellists reflected on how their broad membership and diverse spectrum of opinions acted as a spur to progress.

“It is an advantage,” said Zvan “We are trying to figure out how to engage members. Asking what they think is important is a real opportunity.”

Policy makers response is the next pivotal step in sustainable investmen according to Victor Verberk, CIO fixed income and sustainability at Robeco. He predicts that policy makers reaction will appear via taxes or import tariffs with a “devastating impact” on companies that will create winners and losers.

The legislative consequences are already visible in the huge task of readying for EU disclosure regulation, currently dominating sustainability at the asset manager.

“It has created an enormous amount of work; it’s visionary but a little too soon”, said Verberk. Moreover, the task is complicated by the lack of support from policy makers – there is no “help line,” he said – making cooperation with peers all the more important.

Verberk said creating net zero portfolios was also challenged by the lack of data. He noted that the price of data is increasing, and that data ownership is increasingly centralised. Data and IT storage comprise key investments at Robeco, he said.

Elsewhere, the firm has hired strategists to help it report Scope 2 and 3 emissions in its portfolios in a reflection of the growing pool of expertise sustainable investment demands.

You need to be able to multitask, he told delegates, explaining that Robeco’s already expert teams are now supported by data scientists and people with PhDs in sustainability.

“This is the kind of support you need to build around your portfolio manager,” he advised.

Collaboration and working with others are vital to ensure progress in tackling sustainability.

“There are always smarter people outside your firm, no matter how smart you are,” he said, adding that Robeco already works extensively with peer investors and participates in policy initiatives. His key advice to asset owners is to cooperate and collaborate, engage with companies and work with NGOs and regulators in a quest for hard science.

China

Turning to China, Verberk said despite the obvious opportunity in renewables, investment could stall unless China tackles its human rights issues.

“If China doesn’t manage this, it will hit investor appetite,” he predicted.

That said, he noted how investors are focused on how China navigates growth with lower emissions and said the opportunity to invest in China’s green economy could be huge.

“China is committed to 2060; China could surprise us on their commitment to 2060 targets.”

Verberk said that sustainability is in Robeco’s DNA. Although staying at the frontier of sustainability is hugely challenging it is made easier by the firm’s excellence and leadership in the area. He predicted that sustainable investment will increasingly flow into biodiversity and natural capital.

Portfolio alignment is a hot topic and key area of focus for the TCFD and COP26 private finance team. But what is it really telling us and how will it influence investment decisions?

The Task Force on Climate-related Financial Disclosures (TCFD) has been looking more closely at the use of forward-looking climate metrics by financial markets. Following a recent consultation process, proposals include changing the 2017 TCFD guidance to recommend for the first time that asset owners measure and disclose the alignment of their portfolios with the goals of the Paris Agreement by using forward-looking metrics.

It has sparked concerns in the industry according to panellists speaking at Sustainability in Practice. Although many investors support the principle of portfolio alignment, they argue measuring and implementing such alignment remains a work in progress. Moreover, adopting portfolio alignment metrics could have undesirable consequences for asset owners around fiduciary duty and costs and trigger divestment over engagement.

Portfolio alignment to net zero goals is an increasing area of focus for the investment industry, said panellist Eva Cairns, head of climate change strategy at Aberdeen. For asset managers, portfolio alignment is now informing decisions as investors seek out transition leaders and climate solutions.

However, she flagged that portfolio alignment can steer investors away from investing in companies that may still be carbon intensive but are on a pathway to reduce those emissions.

“Investing in companies with very strong industry leading targets has more of an impact,” she said.

Moreover, she said the alignment metrics still have challenges around data and regional differences, comparability and transparency.

She counselled on the importance of observing the decarbonisation trajectories of different sectors in different regions and the need for an active research approach that draws on wider inputs and scoring methodology rather than just one temperature metric.

Adam Matthews, co-chair of the Transition Pathway Initiative and director of ethics and engagement at the Church of England Pension Board flagged similar concerns, particularly given the influence of the TCFD on pension fund strategy.

He said temperature-aligned metrics will become credible and decision-useful and will have a role. However, pension funds are not currently in a position to meaningfully use these metrics. Like Cairns, he warned the metrics could incentivise actions like “washing assets out” of portfolios, contrary to responsible investment which means holding difficult assets and working with companies on credible transition paths.

When investors aggregate a single metric across a whole portfolio they run the risk of questionable indications that stimulate wrong actions and unintended consequences.

“We want to get it right,” he said.

Fellow panellist Dominic Tighe who is policy advisor at the COP26 Private Finance Hub which is involved in shaping the TCFD proposals and consultation process as well as a framework for best practice due out in October ahead of COP, defended the process. He noted assets owner demand for forward looking metrics that measure the ambition of companies and distinguish between leaders and laggards within sectors.

He said the TCFD consultation was just a first step to driving consistency in methodology in these metrics to reduce divergence in outputs. He also said asset owners and investors didn’t have to use just one metric or warming score, and that the TCFD outlines different tools.

He reiterated that what matters most is not if an asset is high or low carbon, but if the asset is transitioning quickly enough. He noted TCFD cognisance of the risk of divestment and said the methodology made clear that benchmarks should take account of different sectors and geographies, allowing investors to drive engagement and tilt portfolios.

Tighe reassured that the portfolio alignment metric is evolving and said that recommendations have been reframed since the consultation with a less obligatory tone and without specifying the tools to use.

Still, Matthews urged the TCFD to build confidence in the process and voiced his concerns in the feasibility of large funds using the metrics.

“There are steps for us to work through in terms of how we aggregate this information.”

He said asset owners also need to perform their fiduciary duty and that more dialogue with managers and standard setters like TCFD is essential.

COP26 expectations

Looking ahead to Glasgow’s COP26 Matthews flagged his concerns that policy frameworks may not appear out of the conference.

Although encouraged by the unprecedented focus on finance, he said the policy has to match or the process risked “walking into a brick wall.”

He said pension funds are committed to net zero, engaging with companies but it also depends on regulatory changes.

“There has to be a matching part around policy,” he said.

Cairns also noted the action gap and that zero pledges are not possible without a policy framework.

“I would like to see COP as a tipping point in financial sector ambition on the road to a net zero ambition,” concluded Tighe.

Asset owners’ seeking to achieve net zero in their infrastructure allocations should embark on detailed strategic planning, set interim targets and ensure transparent insight and regular reporting. Strong leadership and clear governance frameworks are also essential – all the while fulfilling fiduciary responsibility to seek superior long-term returns.

IFM Investors’ journey to net zero by 2050 across all its asset classes – infrastructure, debt, private equity and listed equity –  goes hand-in-hand with mitigation of long-term risk, said David Neal chief executive of the investor-owned fund manager speaking at Sustainability in Practice.

Meeting its net zero target has involved setting interim targets over the next decade with IFM now targeting a 40 per cent reduction by 2030. The investor has Scope 1 and 2 emission targets and ensures a rigorous enhanced due diligence process when it buys new assets to ensure the investment team understands the challenges transition and physical risks pose to the asset.

Assets are tested versus reference scenarios and Neal told delegates that the level of the firm’s control of the asset is crucial in its ability to wield influence. He added that IFM is phasing out thermal coal.

“It doesn’t have a place in the energy mix,” he said. The firm is also turning its focus to solutions, building up skills to provide capital to the solutions that will drive the energy transition.

IFM owns high carbon but essential assets like airports, pipelines and utilities. These assets will play a critical role in a net zero future and the investor uses its ownership to influence a long-term trajectory of lower emissions.

“When you own assets for decades you can focus on influencing the long term trajectory for the broader benefits,” he said. He said planning for the transition in these industries involves prudence, constraints and rigorous bottom-up analysis.

Fellow panellist Michael Eisenberg, head of ESG integration at the $268 billion New York State Common Retirement Fund said it has a net zero commitment for 2040. Much of the pension fund’s low carbon strategy is focused on its relationships with infrastructure managers. Discussions with managers in each infrastructure sub sector focus on how the pension fund expects the manager to invest. The fact that the fund is already well on the way to meeting its pledge to invest $20 billion in sustainable investments and climate solutions, has given confidence to its net zero pledge, said Eisenberg.

The investors reflected on how a top-down strategy can make execution difficult. For example, at IFM which is an open-ended fund with an increasing number of investors wanting to invest capital, acquiring assets means portfolio emissions go up.

Moreover, when the manager sells assets, these cannot count as reduced emissions. “We don’t want to benefit from reducing emissions by selling the asset; this is not having a planetary impact,” he said.

Restrictions imposed from a top-down policy can also have other manifestations. Many asset owners have a complete exclusion on coal investment, yet excluding coal prevents investment in, for example, a diversified US utility that draws some of its energy mix from coal. Here an alternative emphasis could be on buying these assets and influencing the utility’s transition from coal.

Panellists noted how a board seat opens the door to better data. One area of data exploration should include how to measure avoided emissions, and how some investments lead to emissions avoided elsewhere in the economy. Eisenberg noted practical challenges around data gathering and the interpretation of data.

He said that good data gives a visibility and comfort to net zero targets and outlined the fund’s manager-by-manager and asset-by-asset data gathering processes.

“The management piece is the key element,” he said, adding how the fund’s focus is evolving away from just supporting companies that have pulled “the easy levers,” to next stage investment.

The conversation concluded with a glimpse at a future infrastructure portfolio. Renewables will be a key part of portfolios alongside hydrogen and the infrastructure to pipe it. Existing infrastructure already moving liquid energy might still be in place.

At New York State the focus will be on selling traditional industries and investing in cutting edge transition opportunities; deep dive partnerships with managers that consider the data and science will remain key.