Poor corporate sustainability disclosure and the absence of global standards is now a systemic risk for investors, said panellists at Sustainability in Practice which included chief governance and compliance officer at Norges Bank, Carine Smith Ihencho.

Investors need a global standard against which they can measure corporate sustainability based on comprehensive disclosure, said Carine Smith Ihenacho, chief governance and compliance officer, Norges Bank, manager of Norway’s giant SWF which invests in an estimated 9,000 public companies.

She told delegates that better disclosure was essential to enable investors to make better decisions.

“How companies deal with sustainability issues affects how much money they make,” she said. It affects how they address business opportunities, and disclosure is also vital in informing the engagement process. Norges Bank held over 3,000 meetings last year she said, outlining a strategy grounded in access to information, regular reviews and divestment considerations.

Ihenacho said that investor knowledge of corporate sustainability risk should includes sight of risk in corporate supply chains and customer bases, entailing “a list of suppliers and country-by-country revenue.”

Moreover, she said investors needed to know how companies are managing these risks including reassurance of board level oversight, strategic decision making and policy initiatives to deal with the risk. Performance metrics to measure how a company is responding to the challenge around, for example, reducing Scope 1 and 2 emissions, are also key.

She noted that corporate reporting is getting much better but that there is still a long way to go – particularly around corporates producing correct and comparable data.

Janine Guillot chief executive of The Value Reporting Foundation referred to the lack of corporate ESG disclosure as a market infrastructure problem. Solving it involves pulling three levers – a regulatory lever where she noted the EU’s leadership, and an investor lever.

“Investors are doing a fantastic job mobilising globally to get standardisation,” she said.

A third lever must come from companies themselves where she noted many lagging in terms of engaging with a global solution. She said investors’ ability to integrate information on sustainability into their decision making and have access to quality investment products is now a strategic issue.

In contrast, companies are not facing the same strategic issue – although companies want sustainable reporting simplified and less costly. She said the drive towards standards needs CFOs to get involved in the same way they were involved in creating global accounting standards. All the while investors need to continue to work directly with companies, helping them understand why change is so crucial.

One of the most important regulatory levers will come via 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, on track to launch a Sustainability Standards Board, SSB, at the UN’s COP26 climate summit in November.

The hope is the new standards will give investors and other stakeholders as clear a view of corporate sustainability as they currently do financial performance in one integrated report.

Guillot noted that the initiative is a “building bloc” and will not meet the needs for every jurisdiction around the world. However, it will offer different regulatory organisations a global baseline.

The conversation detailed how investors are also closely watching progress in the US where SEC chair Gary Gensler has said he is in favour of the regulator stepping in to bring greater clarity and consistency to corporate climate disclosure. Panellists agreed that investors are united in their demand for standardised data and mandatory disclosure, unlike corporates where there is less call for regulatory action.

“Regulators are hearing mixed messages,” said Guillot. Given regulators will react differently in each market, she said a global solution will likely have to come from market forces, putting pressure on investors. “Investors need to be mobilised around engaging with companies and clear on their information needs.”

Reflecting on the SEC consultation process ahead of possible changes to corporate disclosure, Norges Bank’s Ihenacho noted that investors need better reporting beyond just climate change. The SEC should ask companies to use current frameworks like the TCFD, she added.

Delegates heard how Europe is leading the way when it comes to introducing regulation governing sustainable investment. Sven Gentner, head of asset management unit, European Commission’s Directorate-General for financial stability, financial services and capital markets union explained how high-level targets have been broken down to apply to individual parts of the EU economy and the financial sector.

He said the EU’s taxonomy, a common classification system for sustainable economic activities, will now be the common language. Elsewhere, he noted how the EU is proposing a European green bond standard and changes to reporting corporate reporting.

Mass PRIM is involved in an MIT initiative to improve ESG with better data, ratings and ultimately products. Executive director and CIO explains how the ambiguity around ESG ratings creates acute challenges for investors trying to achieve both financial and social return.

Rating agencies often capture the wrong or bad data and products in the market are not robust from an impact or investment perspective, according to Michael Trotsky, CIO of Mass PRIM.

This ambiguity around ESG ratings creates acute challenges for investors trying to achieve both financial and social return. He said Mass PRIM has analysed countless products from vendors and “they all come up short,” sounding concerns at pervasive greenwashing and commercialisation.

“We are committed and want to do better,” he said.

MIT’s involvement in trying to find a solution to the “bad data problem” involves Roberto Rigobon, Professor of Applied Economics at the MIT Sloan School of Management, renown for developing maths techniques to make noisy data actionable.

“He is not an ESG sceptic, he is a staunch ally and wants to make an impact,” said Trotsky, reiterating that ESG ratings are the Achilles heel of the sector which requires more robust techniques to “do ESG better.”

Boston-based Mass PRIM is partnering with the MIT Sloan Sustainability Initiative to improve the quality of ESG measurement and decision making in the financial sector, charting a course toward more rigorous, coherent methods for ESG integration.

Speaking at Sustainability in Practice Trotsky, who oversees around $100 billion in pension assets, outlined how the project includes development of an app that will allow beneficiaries to prioritise their different ESG preferences, listing which issues they care most about.

The hope is it will allow the investor to find common ESG themes that unite its diverse beneficiaries to then weave into strategy. The Aggregate Confusion Project aims to reliably assess investor preferences to enable ESG indices to be more customised and attuned to investors’ values, said Trotsky. He said the initiative is a consequence of current ESG indexes being crafted without consideration of investor preferences, and a growing belief that ESG investment urgently needs to better capture values.

 

Mass PRIM’s involvement in the initiative is linked to the investor struggling to find which ESG issues its 300,000 diverse beneficiaries in the pension funds it manages (ranging from teachers to firefighters and policemen) collectively care most about.

In what Trotsky described as Mass PRIM’s stakeholder problem, the broad range of views of its beneficiaries make it difficult to find commonality. Moreover, since the fund’s board also mirrors these broad views, it is similarly split.

“We hope to solve this problem by finding agreement on ESG values and attribute preferences,” he said.

Fellow panellist Bill Lee, chief investment officer of New York Presbyterian Hospital, overseeing its $9.5 billion investment program noted although the asset owner has started a bit later than others in ESG investment it is benefiting from learning from the more advanced efforts of other portfolios.

“We will catch up as we have great examples ahead of us,” he said.

He also noted that better technology and data will lead to more optimal positions, adding that data reveals which managers and companies are truly committed to improving sustainability, making it possible to better discern ESG laggards.

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.