As more and more investors make net zero commitments in the lead up to COP26, sustainability is at the forefront of investors’ minds. But what does it mean to invest sustainably?

There is a plethora of events that tout the value of sustainable investments, but very few that interrogate the subject in the way that allows institutional investors to overcome the challenges of implementation.

The Top1000funds.com Sustainability in Practice event, to be held online on September 8 and 9, will do just that.

It will bring together asset owners, managers and academics for a practical take on sustainable investment. In order to implement the sustainability goals that asset owners have set as strategic initiatives they will need board and C-suite buy-in and directive. This conference is specifically aimed at CIOs and showcases practical case studies on how investors around the world are tackling these issues.

We will look at whether the metrics, measurements, returns and risks are adequately framed and understood; how investment leaders can navigate the politics of sustainability and prevent greenwashing from prevailing; examine the allocation strategies and investments that investors should be targeting and what the tangible implications for investors’ portfolios are; as well as the role asset owners have in allocating capital and how they overcome the obstacles they will face.

The event program has had the invaluable input from asset owners all around the world including AP4, OPTrust, OTPP, USS, PGGM and UPP.  Some of the speakers are highlighted below and you can click here to register or receive more information.

  • Jeb Burns, chief investment officer, MERS of Michigan
  • Evan Cairns, head of climate change strategy, Aberdeen
  • Niklas Ekvall, chief executive, AP4
  • 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
  • Janine Guilott, chief executive, The Value Reporting Foundation
  • Zsolt Kohalmi, global head of real estate, Pictet
  • Stephen Kotkin, Professor in History and International Relations, Princeton University
  • Bill Lee, chief investment officer, New York Presbyterian
  • Jie Lu, head of investments, China, Robeco
  • Innes McKeand, head of strategic equities, USS Investment Management
  • Dr Arun Majumdar, Professor of Mechanical Engineering and Photon Science, Stanford Energy
  • David Neal, chief executive, IFM
  • Carsten Stendevad, co-chief investment officer for sustainability, Bridgewater
  • Jaap van Dam, director of strategy, PGGM

The event is open to asset owners and consultants only.

 

 

Pensions and other institutional investors are increasingly focused on ESG investing. But what is the point of ESG investing?Obviously, the investing part of that question is focused on a fair return, and potentially some alpha, to the investor. But the ESG part of the question has numerous potential goals. Among those are avoiding harm, mitigating ESG-related investment risk, rewarding strong ESG performance, and encouraging improvement in corporate behavior.

This final factor – improvement – is often overlooked: what about companies that are improving their own ESG scores? Don’t we want to encourage them, and isn’t there an investment opportunity there? It is fine to invest with companies that already perform well, but the real difference will come with companies that improve how well they perform.

Let’s focus here on the environmental aspects of ESG. Here, the improvement factor has the potential to generate better investor returns, have a positive effect on the environment, and fit within the ERISA guidelines being developed by the Biden administration.

Improve returns

It stands to reason that an investment in a company that is improving its environmental performance should perform well. As energy companies and utilities focus on de-carbonisation and renewables, they are rewarded in financial markets. This is supported by the fact that, in recent years, MSCI ESG indices have outperformed standard MSCI indices in the US, in Europe, and globally.

Think of a company’s ESG scores in the same way we think about its price/earnings ratio, especially as a value investor. The companies with lower P/E ratios have the greatest chance to improve. A value investor does not just seek out companies with low P/E ratios. A value investor wants to see the chance or catalyst for change in corporate behavior or a systemic change in that company’s marketplace that gives the company a structural advantage.

Similarly, when utilities use less coal and more natural gas, or when automobile manufacturers move toward electric vehicles and consumers want them, they are rewarded by a market that believes that is where future profits lie.

Positive effect on environment

Just as investors seek access to opportunities for future profits, so should ESG investors seek out better future environmental behavior. Of course, companies with high ESG scores are likely to be solid investments because they are well managed. But the improver thesis is different.

If a company is already managed to a low carbon footprint and its business model is unthreatening to the environment, then an investor will not expect to make an impact on improving that company’s behavior or fossil fuel usage when that investor invests.

But if an energy or mining company sees where the world is headed and makes a commitment to cleaner policies, this holds the promise for a genuine improvement and effect on the environment. The investor must follow company communications closely or, with institutional investors, must engage with management in order to reach a conclusion about the company’s commitment to improvement. If that commitment is real, the company and investor together (like a value investor who sees structural change benefiting a low P/E company) have the chance to genuinely improve environmental outcomes in a measurable way.

What better way to invest: finding structural opportunities to go from lower performing to higher performing.

Coming ERISA guidelines

ERISA does not regulate public plans, but many public plans are guided by its provisions , and of course, corporate plans are governed by them.  The Trump administration issued a regulation under ERISA that would have limited the use of non-pecuniary factors in the selection of investments for ERISA plans. However, the Biden administration has issued guidance stating that it will not enforce those regulations. More importantly, President Biden also issued an Executive Order in which he directed the Department of Labor to “identify agency actions that can be taken under [ERISA] and any other relevant laws to protect the life savings and pensions of United States workers and families from the threats of climate-related financial risk…”.

This moves U.S. policy directly toward the improver thesis. It is likely that the DOL will not only permit the use of socially conscious factors; it may encourage or even require that they be considered material. Note that the language of the Executive Order does not speak about what factors may simply be considered. It directs DOL to “identify…actions that can be taken…to protect…savings and pensions…from…climate-related…risk.”

In short, investing in companies that are improving environmental performance and outcomes  will do exactly that.

If we want to improve environmental outcomes,we need to identify and invest in companies that are improving theirs.

Charles E.F. Millard is a Senior Advisor for Amundi U.S.; he is the former Director of the U.S. Pension Benefit Guaranty Corp.

Customised ETFs are the new active management according to Jeb Burns the chief investment officer of MERS of Michigan which is using ETFs for about a third of the fund.

MERS developed a customised ETF based on the S&P 500 quality, value and momentum top 90 per cent multi-factor index, which is managed by INVESCO and launched only a few weeks ago.

It’s designed to be a core holding although Burns says he expects ETFs to also be used to gain more thematic exposures.

“If there is an area where we don’t think traditional active management has a role, we’ll use ETFs,” he says. “They are more liquid so when markets fall off we can rebalance. The main advantage is they are liquid and you can target the exposure.”

The $15 billion fund now uses ETFs for about $5 billion of the fund across both equities and fixed income.

In fixed income the internal team has a proprietary model that informs when and where it should shift its allocations and it uses ETFs to express those views.

“It’s much easier to build the exposures you want with ETFs, I think that’s a trend you’ll see. People will create customised ETFs which will be the new active management.”

But Burns is also quick to point out that ETFs will not entirely replace traditional active management and the fund is doing an active emerging markets equities search right now.

Incorporating ETFs into the asset allocation program is one of a handful of projects the fund has underway this year.

As CIO Burns is acutely aware of maintaining the closeness of his team as the months of working remotely tick by. It’s currently going through an exercise to increase collaboration when the team can’t be face to face, with individual team members doing research on particular macro themes and presenting the findings to the broader team.

Economic risks, medium-term and long-term trends inform the portfolio and when the investment policy statement is reviewed annually typically some of the views developed by analysing those trends are reflected in the portfolio management view.

“Medium term risks inform us by look for trends in sectors,” Burns says. “For example we have been investing in medical technology for a while which is directly related to the aging demographics in the developed world.”

The aging population is one of about five long-term trends the fund looks at alongside rising taxes, aging infrastructure, de-globalisation and the rise of ESG.

“Demographics will tell you your view on interest rates. It informs the model we overlay the whole portfolio with. Retirement is inflationary as people like to spend money,” he says, estimating that inflation will be more like 3-4 per as the decade moves on because more people are retiring.

“There are inflationary forces that are slowing building, that helps us take positions earlier and inform the things we want to be concerned about.”

To mitigate this risk and for inflation protection MERS has invested significantly in real assets, which make up about 10 per cent of the portfolio, including farmland, permanent crops and infrastructure. It may also add some TIPS.

“When I look at all the real assets we have I feel in a good place regarding inflation. We are short on duration because rates are low. I’m old fashioned, if you print this money at some point you’ll have inflation.”

Some of the themes the fund examines – which also include the rise of populism, investment industry consolidation, and supply chain realignment – develop organically in the investment program.

But in this push for more team collaboration some of the themes being examined are more proactive, including an examination of crypto and nuclear energy, and if they resonate with the team they are captured as an addendum to the strategic plan.

“With crypto it is hard to figure out what it is, but if you rephrase it and say the digitalisation of finance, then that won’t go away and will create opportunities.”

He also points to the increase in electrification which means an increased demand for industrial metals as an opportunity.

“We want to capture these ideas and write them down in our documents so then in three years from now we can look at the strategic plan and see our objectives.”

The fund has performed well in the first half of the year, with outperformance of 220 basis points versus the benchmark.

“It is so nice to have a diversified portfolio and finally be rewarded,” Burns says.

The fund is slightly overweight international developed equities which he says should be rewarded in the second half of the year.

“We had a really good first half of the year. We are due for a little bit of a pullback but we are well positioned for the rest of the year. Inventories are still not filled up, we could be in a significant growth cycle.”

Asset owners looking for a heroic challenge need look no further than managing climate risk and playing a meaningful part in the net-zero energy transition.

There are three difficult beliefs in play on this. The first is accepting the strong scientific evidence pointing to potentially catastrophic risks and impacts if climate change continues on its current trajectory and that, without substantial collective action, society risks irreversibly damaging the natural and financial systems that sustain us. It’s hard to overstate the seriousness of this situation.

The second belief is that the nature of these risks is fundamentally different from the risks we have traditionally focused on in the investment world, in that they are systemic, undiversifiable, highly uncertain and impossible to hedge. These uniquely difficult risks make collective action vital and necessary through the nation-state commitments that are required to cascade down to all institutions to implement a just transition to a net-zero economy.

In a world looking for stronger leadership and for an investment industry striving for greater purpose, the net-zero framework is an appropriately purposeful and substantive change. Those asset owners that have made, or will be making, net-zero commitments are probably doing the right thing but there should be respect for every fund’s unique circumstances to reflect on this differently.
The third belief involves asset owners adding a net-zero-trajectory objective to run alongside and complement the central financial objective of maximising risk-adjusted returns on investments. The belief is premised on financial outcomes from net-zero investing being better in the long term, precisely because of the climate outcomes. While managing them together is a powerful proposition, it does imply a big modification of the current investment model. Not least because aligning two objectives at the same time can involve compromises or concessions. Here doing the right thing does not always make it possible to do things right.

For example, imagine in 2025 that net-zero-pathway companies make up only half the market. Does an asset owner pick from that half while recognising the material investment constraint and knowing also that the net-zero tailwind may now be a headwind. In other words, that these assets may be priced at a premium offering reduced forward-looking returns relative to others. So, doing the right thing may now mean struggling to do things right when trying to deliver both the highest risk-adjusted returns and alignment to net zero.

Challenges
It should be very clear that there are a number of large challenges confronting asset owners when implementing net-zero policies including these additional tasks adding to the already stretched asset owner governance budgets:

  • Identify and execute appropriate net-zero investment policies
  • Measure and report on the carbon journey through a plan
  • Maintain strong governance with robust continuity
  • Align with all regulatory requirements on climate
  • Manage the reputational risks arising from the public scrutiny of net-zero journeys.

But we should also recognise that there are investment and reputational risks from not committing to net zero.

The net-zero deliberations must weigh many uncertainties and complexities that make current decisions extremely hard to reach. In normal circumstances, the decision might more reasonably be taken when certain facts (investment, legal, political and science) have become clearer, but the current political agenda is pressing for an immediate decision.

There may be a silver lining to this cloud in that the trickle of early net-zero movers will trigger market interventions that may create disproportionate benefits. As the trickle turns into a cascade, more asset owners will move faster down de-carbonisation pathways and their actions will reduce the worry of failing unconventionally in isolation. This solidarity, across asset owners, in which shared interests and mutual dependence develop is the collective action we need and a case of the ends justifying means.

Road map
Having understood the challenges associated with a net-zero pledge and given serious thought to the beliefs and analysis required, a road map is necessary.

Starting with the objectives, asset owners will need to settle exact and multiple goals that are clearly drafted alongside the beliefs that support why they were chosen and how they will align with stakeholder expectations and fiduciary duty.

Then there is the carbon journey plan. There are the short-, medium- and long-term segments, in which the different sources of decarbonisation add up to the required trajectory.

Then there is the strategy. The chosen climate strategies should be categorised and described – both allocation and engagement; both decarbonisation and climate solutions. And the collaborations and delegations in the road map should be outlined with the necessary resourcing.

One point of emphasis is that the increased public disclosures of such investment plans and policies make much wider scrutiny inevitable. This reinforces the need for particularly clear beliefs and principles given that the justification of investment policies by reference to past performance in climate risk scenarios is not possible.

This road map must allow for much to change and so needs to be adaptive; which is easier done when constructed with maximum transparency, authenticity and competency. This is a big test of technical proficiency and cultural mettle.

We note how large funds play a special part in the net-zero transition under universal ownership* principles. Their capacity to play a proportionately larger part in addressing climate change comes from applying their weight alongside others in alliances that recognise their dependency on market beta combined with the leverage of collective action to build better beta.

These asset owners can currently enter net-zero commitments with solid financial arguments and use a supporting tailwind; but they no doubt will have to deal with tougher battles at various moments in the future. Under current fiduciary duty any concessions must fall on the climate ambition, not the risk-adjusted return but there may be a window of opportunity for them to lead change on this emphasis.

Fiduciary duty
This brings me to a personal view that fiduciary duty should be adjusted to provide better guardrails within which asset owners can operate. It seems that fiduciary duty, with its current high bar in financial primacy and poor air-cover for trustees, is fast becoming an anachronism in a world now focused on sustainability and wider responsibility.

Fiduciary duty varies by jurisdiction but using the UK’s fairly typical pension system as an example, there appears to be a fundamental disconnect between the government’s legal net-zero obligations and asset owners’ ability to help fulfil these. In order to be fit-for-purpose fiduciary duty probably requires a statutory override that accommodates net-zero commitments. This form of guardrail could help asset owners avoid the prisoners’ dilemma, of acting singly and selfishly, and instead act collectively and with solidarity as a better path for all.

It seems that only through collective action, and doing what we can with what we’ve got, that the investment industry can step up and avoid potentially irreversible damage occurring to our most important systems. Regulators will have a say in how influential asset owners become but whatever comes asset owners will play a substantial part. Out of great power comes great responsibility.

Roger Urwin is co-founder of the Thinking Ahead Institute

 

*Universal ownership combines the large-fund mindset of seeing themselves as long-term owners of a slice of everything – the world economy and market and its implied dependency on the market beta; with the large-fund strategy of leveraging collective action to build better beta to address systemic risk through active ownership, systemic engagement and allocations to more sustainable betas. ‘For universal owners, overall economic performance will influence the future value of their portfolios more than the performance of individual companies or sectors’. (Urwin | Universal Owners | Rotman Journal of Pensions Management 2011)

 

Global investors have overwhelmingly urged the SEC to provide corporate disclosure rules on climate. In submissions to the SEC many investors including CalPERS and CalSTRS said the rules should be mandatory.

“At this point, it is clear that the Commission must develop mandatory disclosure rules with line-item reporting which provide issuers with clarity on what is expected by investors on climate risk reporting,” said Marcie Frost, chief executive of CalPERS in its submission.

“For investors navigating the complexity of climate change, it is essential to have detailed scenario-based corporate disclosures regarding the potential impact of both the transition and physical risks to companies’ performance across time to help investors properly evaluate potential return on investment and to make informed comparisons among investment opportunities.”

In its submission CalSTRS called on the SEC to use rulemaking to mandate universal metrics and recognise independent standards to guide industry-specific disclosures and require that from companies of all sizes in all industries.

A study of 2,585 companies by Harvard Business School found that fewer than 20 per cent disclosed all of the data-points considered necessary for environmental impact valuation, making it unreliable for investors to use and adding weight to the argument that voluntary environmental disclosure does not provide sufficient data to evaluate corporate environmental impact.

In March this year acting chair of the SEC Allison Lee, asked staff to evaluate its disclosure rules “with an eye toward facilitating the disclosure of consistent, comparable, and reliable information on climate change”. Many investors have made submissions including CalPERS, CalSTRS, Norges Bank, CPP Investments, Harvard Management Company, San Francisco City and County Employees Retirement System, Colorado PERA, and NYCERS.

CalPERS’ Frost called on the SEC to act quickly saying the current disclosure regime for corporate reporting “falls short of our expectations as investors”.

“For investors, for capital formation and in the public interest, the Commission needs to move swiftly and decisively to provide the rules which will ensure the management and mitigation of a systemic risk,” she said.

The $1.29 trillion Norwegian Sovereign Wealth fund, managed by Norges Bank, owns 1.5 per cent of the world’s listed companies, this includes $399.5 billion invested in listed US equities and $139.9 billion in fixed income in the US.

In its submission Norges Bank said that the scope and quality of disclosure varies enormously. In the US companies provide better disclosures on their approach to climate risk management than on governance, strategy, and climate-related metrics and targets.

“We have assessed companies’ reporting on climate change since 2010. Although an increasing number of companies globally report some climate-related information, the scope and quality of disclosures varies significantly. The data published by companies is often incomplete and/or not comparable,” it said. “Based on our assessments, US companies in the technology, telecommunications and retail sectors have stronger climate-related disclosures compared to firms in the automotive, banking, basic resources, construction, insurance, and oil and gas sectors.”

In Norges’ disclosure assessments 80 per cent of the US companies reported their operational carbon footprint, but less than half of the companies reported emissions related to their value chains.

Investors unanimously said that for sustainability information to support investment decisions, risk management processes and ownership activities it must be consistent and comparable across companies and over time.

Kate Murtagh, chief compliance officer and managing director for sustainable investing at HMC said the current voluntary disclosures are not of a scope, breadth, and quality sufficient for market participants and regulators to fully understand and assess relevant climate risks.

“Since undertaking our net-zero commitment, our focus has been on improving our access to reliable, actionable climate-related data. Such data is currently very limited. Much of the available data is self-reported and unaudited,” she said.

In their submissions investors said they expected companies to disclose their climate plans and to set short-, medium- and long-term emission reduction targets that take into account the goals of the Paris Agreement. This allows investors to assess companies’ readiness for the climate transition. Investors also called for scenario analysis and for companies to assess the sensitivity and resilience of their long-term profitability to different transition and physical climate scenarios.

CPP Investments said that it expects companies to disclose financially relevant, potentially material climate change related factors in order to make informed decisions.

“Climate change remains one of the largest and most challenging investment considerations of our time. Specifically addressing its impacts in our investment activities better positions us to make more informed long-term decisions with regard to profitability and shareholder value, in line with our legislative mandate of maximizing returns without undue risk of loss. We require consistent, comparable and accurate information on climate change-related risks and opportunities that is ultimately decision useful. As such, we expect disclosure of financially relevant, potentially material climate change related factors from our portfolio companies to allow us to better understand, evaluate and assess potential risk and opportunities of these factors on a company’s performance.”

No need to reinvent the wheel

CPP said that when issuers seek input, it indicates its preference for companies to align their reporting with the Value Reporting Foundation (the successor to SASB) and the Task Force on Climate-related Financial Disclosures (TCFD).

These two third-party standard setters were preferred by all investors in their submissions, with a directive from Harvard’s Murtagh for the SEC to not “reinvent the wheel”.

“The Value Reporting Foundation and the TCFD have an important, and necessary, continuing role to play in helping fill in the white space of principles-based climate disclosure rules. The SEC should not reinvent the wheel where an existing voluntary standard or framework already is aligned with the SEC’s mandate,” she said.

Similarly Norges said: “We recommend that companies report financially material sustainability information following the logic of the TCFD and using the SASB industry-specific standards. The Commission could ask companies to use these existing standards for their reporting. Finally, as a global investor, we welcome the ongoing cooperation among regulators and the work of international standard-setters, to ensure comparability of sustainability disclosures at an international level.”

CalPERS also called for the SEC to examine human capital disclosures as part of its work to modernise corporate reporting.

“We are delighted to support the Commission’s work to modernize corporate reporting which should include moving the market forward with respect to human capital disclosures including a substantially greater focus on diversity and the addition of certain identified metrics. Comprehensive, high-quality, consistent, and comparable disclosures of climate risk, charitable and political expenditures, human capital management, and board diversity are critical to the long-term success of capital markets.”

Investor stewardship is beginning to come of age. Look no further than recent global media to see that the environmental, social and governance (ESG) interests of investors are starting to be accounted for in ways they never have before.

When it comes to climate change in particular, investors are demanding tangible action from companies and their voices are being heard. The 2021 annual proxy season was unprecedented, with a record number of climate and environment related shareholder proposals put forward. Climate Action 100+, the largest ever investor-led climate engagement with more than 570 investors responsible for over $54 trillion in assets under management, has led much of the charge.

In May, we saw a dramatic shake up at ExxonMobil where a majority of shareholders voted to replace members of the board with a selection of candidates experienced in clean energy and energy transitions. This was following concerns that the company was moving too slowly to align its strategy with global climate action.

Meanwhile at Chevron Corporation’s annual general meeting (AGM), 61 per cent of shareholders voted in favour of proposals for Scope 3 emissions reductions targets. In addition, a first-time proposal for climate-related financial risk reporting nearly passed, with 48 percent of the vote.

In Australia, the case of Rio Tinto has also been notable. Institutional investors echoed global outrage at the weak response from Rio Tinto following their destruction of sacred Aboriginal caves, destroying 46,000-year-old shelters, and lobbied to remove senior executives. At the company’s AGM in May, more than 60 per cent of investors voted against the pay-outs to former executives, notably including the former CEO.

It’s clear there is a shift underway, with investors stepping up their active ownership practices.

As shareholders of companies around the world, investors have a fiduciary duty to use their influence to maximise overall long-term value. This includes the value of ESG assets, upon which returns, and their clients’ and beneficiaries’ interests ultimately depend.

At PRI we’ve been working with global investors on Active Ownership 2.0 since 2019, an aspirational standard to help usher in a more ambitious era of stewardship, whereby investors seek outcomes, prioritise systemic sustainability issues and collaborate to overcome issues of collective action. With major deadlines for action on the Sustainable Development Goals and the Paris Agreement looming, we only see this trend continuing to accelerate.

Capital is truly global, and therefore investors are and will continue to respond to international corporations with both individual and collaborative stewardship practices. Yet, not every government has grasped the inevitability and importance of this global trend. My home country of Australia is the prime example, where the Treasury recently issued proposals that would create ineffective and burdensome disclosure obligations on proxy advisors, including in the advice they provide to Australian superannuation funds.

Proxy advisors play a valuable role in the market – enabling more informed voting in a cost-effective way. Many institutional investors use proxy advisory firms’ recommendations to supplement their research and understanding of multiple, detailed and sometimes dense proxies for their portfolio. They generally provide high quality, independent analysis, linked to voting recommendations based on institutional investors’ priorities.

Without confidence in the impartiality of proxy firms’ recommendations, investors — particularly smaller and mid-size investors — would lack the capacity to synthesise the relevant information they need to determine how they will vote their proxies and would have difficulty fulfilling their fiduciary duties as a result.

Of course, more transparency and accountability for proxy advisers and how investors vote is welcome. There has been a tendency among some proxy advisers to overlook how environmental and social factors affect long-term shareholder value, and a failure to scrutinise boards for these failures. However, measures such as those proposed in Australia focus more on reducing their ability to challenge management and hold boards accountable – the precise opposite of what is needed.

Yet, the Australian government isn’t the first to venture down this road, with similar Trump-era reforms having previously been enacted in the US.  Although they are already moving to rectify this retrograde policy which is impeding investors. The Securities and Exchange Commission (SEC) chair and staff from the division of corporate finance are currently considering whether or not to recommend the Commission revisit the interpretation, guidance and rules and in the meantime have decided not to enforce them until their review is complete. By failing to learn lessons from their predecessors, the Australian Treasury’s reforms could place complex and ineffective disclosure obligations on superannuation funds that would not result in any material benefit and may add additional costs and confusion to the detriment of members.

At PRI we’ve submitted a response to the Treasury’s consultation, with key recommendations on how to move forward. Our more than 4,000 signatories, who represent, A$133 trillion in AUM,  190+ of whom are based in Australia, have committed in line with our second principle, to be active owners and to incorporate ESG issues into their ownership policies and practices. It’s our belief that investors should be using all the stewardship tools available to them to their fullest potential—including voting—to advance the systemic issues that are most critical to investors and their beneficiaries.

With a distinct lack of empirical evidence as to their rationale, it’s clear the Treasury’s reforms would constitute a backward step for responsible investors.