Allocations to real assets by asset owners globally are increasing in light of the outlook for inflation, but the performance of the entire asset class won’t be linear nor will it be predictable, Harsh Parikh, a principal in the institutional advisory and solutions group at PGIM explains.

Different assets will have different sensitivities to inflation and economic growth variables depending on investment horizons and economic environments, Parikh outlined.

Allocations to gold, for instance, might be increasingly discussed as an inflation hedge within investment teams, but the extent to which gold and gold proxies make their way into portfolios will depend on a fund’s respective time horizon and economic views, Parikh said. Investor disclosures in the United States in the last year have revealed increasing gold allocations among the largest pension plans compared to historical allocations.

Real assets with higher inflation and growth exposure such as energy commodities, natural resource equities, real estate and REITs, infrastructure equities and timberland might be coveted by funds and schemes worried about an overheating environment, Parikh noted.

Meanwhile, funds with more concerns about stagflation might be more interested in farmland, gold, infrastructure, natural resource and real estate debt, he said.

“The biggest risks [investing in real assets] are in some of the portfolio construction aspects; not aligning the investment objectives and using a broader real assets basket as well as also not property aligning with investment horizon,” he said.

Getting the sensitivities right is one of the four important principles CIOs and investment teams should consider when building and augmenting their real asset portfolios, Parikh continued.

Alongside understanding sensitivities of each individual asset, Parikh included knowing your time horizon, incorporating estimation uncertainty and reflecting your own individual economic environment outlook as the other important principles to consider.

Relying on averages and generic time horizons can hamper decision making around real asset portfolios, he said. Using off the shelf benchmarks can be problematic for funds building their real asset allocations too, he added.

For instance, a CPI [consumer price index] beta for commodities might imply a 11 per cent up-move for every 1 per cent increase in inflation, but that up-move might range from 8 per cent to 14 per cent with 90 per cent confidence, he explained.

“CIOs looking for inflation protection would rather have assets with sensitivities that are more certain rather than assets that have less certainty,” he noted.

Allocations to real assets among pension funds globally have increased between 10 to 15 per cent in the last decade, Parikh noted siting PGIM’s Institutional Advisory & Solutions research on the topic.

Real estate is still one of the dominant real assets as a proportion of this increasing interest, he added, drawing on the PGIM insights. Average allocations to other real assets including to natural resources, infrastructure and farmland have also increased risen from 2.5 per cent to 5 per cent in aggregate during this timeframe, he noted.

Baseline inflation expectations have risen to 2.3 per cent for the next decade compared to 1.7 per cent for the last decade, Parikh noted.

 

With a massive, nationwide effort the United States could reach net zero emissions of greenhouse gases by 2050 using existing technology and at costs aligned with historical spending on energy. Research from the High Meadows Environmental Institute plots a Blueprint for the next decade showing the key is overcoming execution challenges including the infrastructure deployment and the mobilisation of capital and labour.

Achieving net zero would involve an unprecedented infrastructure build over the next three decades and huge electricity generation to meet demand from electric vehicles and electric households making solar and wind energy the “linchpins” in the transition, said Chris Greig, Theodora D. ’78 & William H. Walton III ’74 senior research scientist in the Andlinger Center for Energy and the Environment at Princeton University.

Speaking at Sustainability in Practice, Greig said that positioning wind and solar installation would depend on social and demographic criteria, considering the lowest cost of production and cost of delivery. A huge build out of offshore wind, transmission infrastructure and solar farms would have far reaching implications for the landscape. Elsewhere, new infrastructure would include natural gas turbines critical for balancing intermittency in the grid.

Achieving net zero would also spur a new bioenergy industry, said Greig. This sector could produce energy for aviation and petrochemical industries.

He predicted a strong push back from the arable industry spurring a food versus fuels debate but reassured that only existing crops used for energy should go into the mix. Instead, bioenergy could come from new sources like municipal waste. Despite “all kinds of challenges” including bringing farmers on board and a lack of infrastructure, he said the opportunity was tremendous.

Elsewhere, hydrogen will become a key component to the transition. It could be used in chemical and steel production and Greig predicted enduring demand for liquid fuels. Carbon capture will be another vital pillar taking carbon from everything from cement plants (“we are going to need a lot of it,” he said) to biofuel plants and natural gas power stations.

He said the transition needed fossil fuel companies “to get good” at carbon capture and that without carbon capture and storage it would be impossible to get to net zero.

Noting that it is a difficult industry to develop, he said the oil and gas industry is uniquely positioned to build out the infrastructure needed like pipelines and storage capacity.

“It is like building the oil and gas industry over again – but in 30 years,” he said.

He said that the cost of new energy services could remain affordable, but that it also depended on the mobilisation of capital. Bringing assets to fruition takes decades, and depends on technical studies, feasibility and a successful build. He noted that fund managers tend to allocate to investors who own operating assets and seldom provide risk capital to build greenfield infrastructure. “The real challenge is mobilising at risk capital to construct the assets.”

The massive infrastructure build will require a huge workforce and shape new communities. “On the face of it is a great political story,” he said.

However, he said the surge in jobs and growth would not be homogenous or on a state-by-state basis. Some oil states would go through declines, underscoring the need for a Just Transition.

The conversation also touched on investor caution given potential changes in the US political landscape. “What is your level of conviction that this will actually happen; what level of confidence can investors have?” asked Alexandra West, chief strategy officer – investments at Cbus.

Greig countered that Republican (or Trump states) also prosper in a net zero pathway. The wind and solar industry would provide huge jobs and “bring the mid-west” along, he said.

The conversation also touched on how car companies will build electric cars no matter who is President – and how Republican governors will quickly solicit investment in new energy assets for tax revenue and jobs.

In the opening session of the second day of Sustainability in Practice, Stephen Kotkin, Professor in History and International Affairs, Princeton University warned that the sustainability debate needs to become less ideological and more practical. He added that policy on a carbon price would do more to counter climate change than Biden’s huge infrastructure spend.

Expect little progress at this November’s COP26 unless governments are held accountable for their promises. Looking back over progress in the wake of previous UN climate change conferences, Stephen Kotkin, Professor in History and International Affairs at Princeton University warned the lack of enforcement mechanism means that few government pledges and ever implemented.

Promises amount to a goodwill pledge that few governments, rarely in power at future meeting or when deadlines come due, see through. Even progress around implementation in France, home to the Paris Accords, has stalled in the face of political protest by the Yellow Vests, he said.

“The current path is not working,” he said, urging for a more consultative and less ideological process – and the ability to force governments to comply.

“When something is not working trying harder at the same thing is often not successful. It is better to change the terms of the debate.”

Ideology

He said the climate change conversation needs to lose its ideological zeal, noting how a backlash in the political space typically follows ideologically driven activity in the area of sustainability. Key policy areas to focus on include the carbon price and building a new electricity grid.

“If you look at Biden’s stimulus, the one thing not in there is a carbon price,” he said, noting that today’s ideological politics makes introducing a carbon price difficult.

Moreover, despite pledges to build out renewables, without grid transformation progress will stall. By introducing a carbon price and a new grid leaders could achieve more than they can by going to international meetings “to make pledges they won’t be around to see fulfilled.”

The climate debate can become less ideological if the conversation becomes more practical, he said. He said people didn’t want to be forced to make uncomfortable decisions; the solution is compromise and managing change in a sustainable way. He said people needed to be able to compare a cost benefit calculation of action (to counter climate risk) versus a cost benefit calculation of inaction.

Reflecting on the possibilities for compromise and practical thinking over ideological mantra, he said “ironically” big advocates of carbon pricing include carbon producers. A carbon price would allow them to calculate the cost into their operations without outlawing their business in a compromise that caters to interests on both sides.

Encouragingly, Kotkin said that debate about climate change had been won.

Moreover, huge consumer demand and changing behaviour is radically altering industries. For example, the rise of the meat-free sector and electric cars is indicative of big industries turning on their head because of changes in consumer behaviour.

Despite this, he noted pervasive greenwashing, stimulated by our approach to sustainability. However, he said that greenwashing would become more challenging when greenwashed portfolios performed worse than portfolios that measured climate risk properly.

Sustainable accounting

Elsewhere, encouraging signs of change include new international reporting standards for sustainability.

The IFRS Foundation, the body that oversees the work of the International Accounting Standards Board, IASB, in setting financial reporting requirements for most companies in the world outside the US (where these requirements are set by the Financial Accounting Standards Board) is on track to launch a Sustainability Standards Board, SSB, at the UN’s COP26 climate summit in November.

Kotkin warned that adoption will be a difficult process, but voiced his confidence in the foundation.

He said that new standards would be “worth their weight in gold” for investors and would herald a bonanza for potential investment.

“It is only investment that can get us where we need to get,” he concluded.

The climate challenge requires new investment on a staggering scale: new generating capacity, the electrification of everything, emissions-free fuel, carbon capture and sequestration, new supply chains and infrastructure, plus the building of negative emissions technologies. Stanford’s Dr Arun Majumdar explores the opportunities for new investment, the risk return trade-off and how investors should approach the opportunities.

The world has two decades to find the solutions to keep warming to below two degrees, said Dr Arun Majumdar, Professor of Mechanical Engineering at Stanford University and former Acting Undersecretary for Energy at the US Department of Energy.

“If we can’t get our act together in the next two decades, we are likely to cross two degrees and need to plan for risk associated with 2.5 or 3 degrees,” he said, calling it the “defining challenge and opportunity” of the 21st Century. Majumdar noted how Europe and the US have set bold goals, particularly within the vast US infrastructure spend.

He said the number of corporate commitments to tackle climate change will increase in line with customer demand for more action. Here he noted retail giant Amazon, poised to introduce its first electric van, developed by EV start-up Rivian.

“Consumer demand is at a tipping point,” he said. “Consumers are willing to pay a premium for clean brands.” He noted that this in turn is set to make sustainable goods more affordable.

He said companies will be able to meet targets around decarbonisation with renewable energy, energy storage and electrification. Innovation like AI and cloud computing will stoke innovation further.

“We have to innovate our way out of it,” he said.

On one hand, innovation will comprise “sustained innovation” of existing technology. Charting sustained innovation in the car industry over the last century illustrates how products can evolve, scale and change with the times. In contrast, “disruptive innovation” in the same industry – like Tesla – comprises new technology that is initially expensive but then becomes cheaper.

“Battery costs will come down over the next few years. Tesla has moved the needle on this one.”

Innovation easier with existing infrastructure and supply chains

Innovation also depends on companies being able to tap the infrastructure and supply chains they need to thrive. Electric cars will need a new supply chain in a different model that will influence the growth rate of innovative companies.

In early-stage investment, the focus is on feasibility and the extent to which a new product is cost effective or competitive, he said. In the next stage, access to a supply chain and infrastructure becomes a priority.

“If you can use existing infrastructure, it’s much better than being dependent on a new infrastructure and supply chain,” he said.

Regulation also plays a part in corporate innovation as does access to low-cost capital. It is important to think where there are things down the line that could hurt you, he warned. “What is coming down the pipeline, so you are not disrupted in the future? Take a systems view on this.”

Majumdar also espoused the potential of hydrogen to meet sustainability goals. Success depends on putting the infrastructure and regulation in place, but he noted that electrolysis (a promising option for carbon-free hydrogen production) wouldn’t necessarily require new infrastructure platforms.

He noted that investment in these pioneering sectors involved working with teams that understand the technology, regulatory barriers and supply chain risk as well as an understanding of the policy needed to create these markets.

The Boston Consulting Group – the consultancy partner of COP26 – has worked across multiple industries with investors to transform high emitting businesses while creating meaningful value in the process. The consultant outlines why decarbonization and value creation can go hand-in-hand.

Companies developing a decarbonisation strategy can create value for their customers, investors and the planet, said BCG sustainable finance leads speaking at Sustainability in Practice.

Decarbonization holds two main levers that can drive value, said Thomas Baker, leader energy practice, BCG, adding that the levers are not mutually exclusive and that companies can pull both. On one hand decarbonization will reduce Scope 1,2 and possibly 3 emissions; the second lever to drive value comes with identifying new business opportunities and looking for new value pools where companies can leverage their competitive strengths.

The conversation highlighted corporate examples where decarbonisation has created value. Finish oil and gas company Neste has invested in biofuels, pushing into refining and development. Now a household name, the company operates globally and has introduced clear investor value by recognising the shift to biofuels.

Elsewhere, Nextera Energy, a US energy group, has changed strategy to derive more of its generating capacity from renewables away from fossil fuels. The company had done two things over the last decade, explained Baker. It has reduced its Scope 1 and 2 emissions, divested out of coal and invested in renewable clean fuels for its own electricity production leaving the business now split between renewables development and its core utility business.

“It has created significant value for shareholders over the last decade,” he said.

He added that Nextera is an example of how decarbonisation can create a “win for climate, customers and shareholders”.

“When utilities shift to renewables it can lead to less cost for customers,” he said.

BCG notes that some of the hardest sectors to decarbonise are in industrial goods, and carbon intensive industries that use processes that can’t be easily electrified, requiring fuel as a unique chemical property. For example, aviation could be one of the hardest industries to decarbonise because of oil’s high energy density, needed to power planes. For sure, sustainable aviation fuels are developing but they are costly, and the supply of biofuels holds challenges. Similarly heavy road transport could be hard to decarbonise.

Panellists urged investors to take on exposure to sectors where opportunity exists. Importantly, investors should consider the fact some sectors need more time to reduce emissions. Net zero is exciting but ensure you have enough flexibility in the portfolio to tolerate assets with higher emissions if those companies are on track to achieve a lower carbon footprint, they advised.

Vinay Shandal, global leader, sustainable finance, BCG noted the recent proliferation in enabler funds, whereby investors take a stake in a company on track for a broad sustainability transformation.

Shandal also touched on how sustainability can drive value in other areas. Getting a company’s sustainability story right helps companies secure the best talent, informs consumers purchasing decisions and allows companies to break into new customers and secure a pricing premium. “Operational value creation is driving a lot of excitement,” he said.

He concluded that the combined function of maturing technology and policy frameworks is seeing value pools shift and said that investors should bring capability as well as capital to companies, and that technology, data, and measurement solutions are all vital.

What does it really mean to achieve a net zero strategy? As more investors make pledges for net zero, they need to set a strategy to achieve it. Investors leading the pack – ABP, Church Commissioners for England and CalSTRS – discuss the behaviour changes that are needed and how to allocate.

The Netherland’s €493 billion civil service scheme ABP has had a sustainable policy since 2008.

Since then, it has steadily strengthened policy and set more targets, with strategy shaped around asking the pension fund’s stakeholders and beneficiaries to list their ESG priorities.

“Every year we ask them how they view our sustainability strategy and for their preferences,” said Diane Griffioen, chief investment officer of ABP, speaking at Sustainability in Practice adding that the pension fund’s board is closely involved in the process.

The bulk of ABP’s assets are managed by Dutch asset manager APG although the fund does also use some external managers. If these managers wish to invest in a company that doesn’t fit the fund’s sustainability criteria, managers must put forward an engagement plan that the sustainability team then reviews. It led her to stress the importance of working with others around engagement and standards.

“Using the same standards would help comparisons.”

One of the key reason the £9.2 billion Church Commissioners for England embarked on its own net zero strategy was to align its own goals and ambitions with investee companies.

“We didn’t feel it was credible in our engagement and stewardship policy when we asked others to align with Paris, but were not doing it ourselves,” said Tom Joy, CIO at the fund.

He said skills across both the investment function and executive level, plus clear communication is key to success noting the “challenge of getting everyone on board with what we are trying to do.” The fund has a seven-member internal responsible investment team.

“It is a journey we have been on for the last decade,” he said.

At Church Commissioners, ESG is embedded in manager selection where the fund has recently added additional requirements around diversity and inclusion.

“We engage as much with managers as we do companies, asking them to improve,” said Joy, adding that “telling managers what to do” doesn’t work. Instead, relationships are based on partnership and cooperation. He added that the fund tends to partner with managers who are implicit about ESG integration; his team’s role is to nudge them to being more explicit so that the pension fund can take more assurance from the manager strategy.

Elsewhere he said the fund has a particular focus on real world impacts where it “looks under the bonnet” on how well the portfolio aligns to real world impacts.

Panellists reiterated the importance of building the right skills and frameworks at an executive and non-executive level. Frameworks like the TPI help assess investments and the extent to which companies are meeting the challenge. Clear and transparent communication is key given “the finance industry is good at over complicating,” warned Joy.

Board level buy-in is crucial to CalSTRS sustainability success, said Geraldine Jimenez, director of investment strategy and risk at the fund where sustainable investment includes a green bond portfolio, investment in a low carbon index and vocal stewardship and engagement as well as thermal coal exclusion. She said that achieving a net zero portfolio required investee companies to move into this new environment. Cutting carbon in the global equity portfolio is easier than in other allocations, especially a 30 per cent allocation to private assets where data is scarce.

Strategy is also influenced by CalSTRS passionate teacher beneficiaries – who often bring pressure to divest. The pressure CalSTRS and other asset owners bought to bear on oil giant Exxon that resulted in board level director changes will act as a flag to other companies on the importance of disclosure and the power of investor engagement.

She said greenwashing will become more difficult the more investors can use the same language and structures. Investing in-house helps prevent greenwashing, but the problem calls for the wide adoption of standards and the same measurements and working with like-minded investors.

Concluding with a look ahead to COP26, panellists reflected on the importance of the conference addressing the need for a Just Transition and stressed the need for regulatory ambition.

“We would like to see the end of fuel subsidies of fossil fuels that many governments have in place,” concluded Joy.