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Institutional investors who committed to net zero a while back now face a dramatically different world, including Brightwell Pensions which supported its client fund, the BT Pension Scheme (BTPS), to set an ambitious 2035 net-zero goal in 2020.

Since then, the world has been shaken by the pandemic and wars, and Brightwell has seen a significant shift in its stakeholder landscape. The asset manager has a different trustee board, and the population has turned sceptical about climate investment.

“Things are changing and for us the critical thing is to make it clear why we think [our net zero target] gives a better risk adjusted return. We are not doing it to save the world,” Morten Nilsson, chief executive of Brightwell Pensions said at the Fiduciary Investors Symposium at Oxford.

Brightwell’s net zero journey is marked by annual targets, backstopped by a belief that it is hard to predict how fast the pace of change might become and, therefore, it is important to prepare now. The focus is on real-world outcomes, and Nilsson said the team won’t turn down good investments just because a company doesn’t have a 2050 net zero target.

Robeco has developed a model that tracks corporate net zero and transition plans across the asset manager’s entire investment universe. Lucian Peppelenbos, climate strategist at Robeco, explained how the model charts companies in terms of carbon efficiency in their sector, and signposts how likely a company is to deliver on its targets over time.

The model explores the governance sitting behind a company, and if climate strategy is embedded.

“We look at the track record in reducing emission and green revenue and capex,” he said. For companies with high emissions, the model translates the capex spend to analyse the surplus or gap in capex,” he said.

“It tells us about the ambition and credibility.”

Ambitious companies pass into Robeco’s “green zone” signposting an improvement in their transition plans, where they are taking action and a clear view of the opportunity to allocate capital.

Prevailing issues

Peppelenbos added that “hardly any energy companies” are in the green zone with a credible transition plan. Industrials have stronger transition plans, particularly sectors like cement in emerging markets. He also noted that the tech sector, once lauded as the net zero leader, is reneging on its commitments because of the demand for energy to fuel data centres feeding AI. “On their websites you don’t see net zero,” he said.

Nilsson said that Brightwell has seen some of the most encouraging changes in real estate, noting that green real estate achieves higher rental incomes.

The session reflected on the importance of fiduciary duty around climate investment. For many investors, fiduciary duty only allows “a little bit” of impact or climate solutions.” Much of the investment in net zero has come with the expectation that public policy will drive the transition yet public policy has stalled.

Much of the investment in net zero was based on the idea that investors would be in the right position when government policy starts to drive the transition. However, this is not happening, and the policy position remains out of kilter whereby net zero investors are front-running behind the policy proposition. Delegates heard that the certainty of a net zero future is now in doubt.

Peppelenbos stated the need for policy, noting that Robeco is front-running net zero policies based on risk/return considerations.

US public asset owners are not mandated to integrate sustainability. Nor does Brazil have public policy demands on its funds – only 13 of the 400 public pension plans in Brazil have joined the PRI.

Panellists reflected on the importance of public and private partnerships in the transition, noting that governments need to work more with private capital.

“They need money and we have it,” said Nilsson.

But he noted that it is difficult for investors to trust policymakers. It is vitally important for investors to be able to pass on rising costs to consumers. But referencing how investors lost money in UK utility Thames Water (an asset heavily impacted by climate change) he said someone “has to pay” for assets to be investable.

“Political risk not to be underestimated in all of this,” he concluded.

The US is only powerful enough to fight a war on one front and fading US power and military muscle has huge ramifications for the rest of the world.

Speaking at the Fiduciary Investors Symposium at Oxford, leading global affairs scholar Stephen Kotkin, senior fellow at the Hoover Institution and at the Freeman Spogli Institute, Stanford University and Birkelund Professor Emeritus at Princeton University, warned delegates that although the US remains the most powerful country in history, it is less capable of applying power at the necessary level.

The US is in the process of retrenching to hone resources on a potential war with China.

“America no longer has the wherewithal to fulfil its commitments,” he said.

The US accounts for 5 per cent of the global population and 25 per cent of global GDP. It holds 50 per cent of global military capability and companies in Silicon Valley are global leaders on innovation. But Kotkin said the US only has the power to fight one war, and reflected on the mismatch between the demands on US power and the inability of the government to meet those demands.

The US is particularly stymied by its “hair-raising” level of debt for which Kotkin said the government has no solution.

“We are undermining US power from within. We are doing it to ourselves,” he said.

The realisation that America can only fight one major war in a single field is reflected in the absence of a defence industrial base. America’s military commitments remain and are expanding, but it has no ability to meet them.

Yet global stability rests on US power. Post-WW2 Europe has been built on the basis of never having to fight a war again. Today, Europe is under pressure to re-arm, but Kotkin warned Europe will have to change its DNA for this to happen. Europe and other “middle powers” like Japan are reliant on America’s nuclear umbrella. Today America is increasingly saying that it is incumbent on these countries to defend the peace and prosperity going forward.

Kotkin warned that if the US goes to war with China, US support of Europe will disappear.

“US assets in Europe will be gone. There will be nothing but the nuclear umbrella,” he said.

He warned that Russia would be set free by the collapse of NATO but suggested that Europe could form a mini-NATO to defend itself. He singled out Poland, Sweden and Finland as potential leaders.

Kotkin reflected on Obama’s legacy to illustrate America’s fading power. He said Obama wanted to retrench, but got into forever wars in the Middle East by doubling down in Afghanistan, and overseeing failing strategy in Syria and Libya. These wars were constant demands on American power, even at a time Obama recognised the demand on US power superseded its capability. Now, Trump has reduced the Cold War to China.

Kotkin warned that a US-China war “is the end of the world as we know it”. More than the humanitarian tragedy of Ukraine or Gaza, he said a US-China war would involve unprecedented destruction. China has built up massive military capability, and he pointed to the country’s population of 50 million 18-25-year-old men with the capacity to fight.

Never before have China and the US been this powerful at the same time. China observed the Japanese and South Korean model, growing rich by exporting to the US market and building its middle class. The US thought that China would be a responsible stakeholder in the international system yet China doesn’t want to exist in a US-dominated world.

Kotkin compared today’s challenges to the 1930s when multiple conflicts like Italy’s invasion of Ethiopia, Hitler’s marching troops into the Rhineland and Japan’s seizing Manchuria acted as a precursor to WW2. Today those conflicts are wars in Ukraine, the Middle East, and China’s growing presence in the South China Sea. Although driven regionally, he said global war begins when regional conflicts come together. “It’s only after it happens that it becomes obvious,” he said.

Kotkin said that the tragedy in Gaza and Ukraine is existential only for the people being killed; these wars do not represent geopolitical risk. He said that Israel is standing up to the expansion of Iranian proxy power, but that Israel will struggle to consolidate its gains and win the peace.

However, if the US and China go to war, the global economy will no longer function the way it does, with profound implications for whole cities and industries.

KEY Issues coming together

Kotkin said that the world’s attempts to solve the climate crisis have failed. International meetings led to governments making promises they haven’t kept in a “pantomime bluff” most recently manifest in Azerbaijan, its most “grotesque version” yet.

“This is now where the solution is going to come from,” he said, arguing that the solution to climate change will ultimately come from technology.

Meanwhile, tech companies that pledged net zero have now erased their promise because they are consuming huge amounts of power to drive the data centres supporting AI, in “another bluff.”

“Demand for power and energy is only going up,” he said.

Kotkin said social media was corrosive and elevates the fringe into the mainstream. Fringe voices that promote falsehood and extremism were always present, but less visible. He said that the business model of social media is to destroy free and open societies that cannot censor and control: when they try to they just make the problem worse.

Reflecting on the challenges for investors to prepare for a Trump presidency, he said the man himself “has never prepared for anything” and will run a government based on improvisation. “It’s hard to predict where it will go,” he said.

Kotkin reflected on the challenge Trump faces in withdrawing from Ukraine. Trump is mindful of the harm Biden’s poorly managed withdrawal from Afghanistan did to his ratings. “Americans don’t like getting involved in wars, but they hate being on the losing side,” he said.

He attributed much of Trump’s election victory to the electorate seeking to punish the Democrats and an enduring pattern of incumbents being thrown out. Some democratic policies were particularly unpopular like decriminalising the border and the inflationary consequences of policy.

“Voters can’t get what they want so they can punish what’s in front of them,” he concluded.

Allocating capital to net zero opportunities doesn’t mean investors are prepared to give to charity. While many fiduciary investors are interested in tapping into the energy-transition mega-theme, or are simply trying to meet their ESG mandates, ultimately the investments have to generate returns for their beneficiaries.

At the Fiduciary Investors Symposium, Cameron Hepburn, Battcock Professor of Environmental Economics at the Smith School of Enterprise and the Environment, University of Oxford, said when people say there is a massive investment opportunity in transitioning to net zero, what they mean is “there is a massive need for investment to get to net zero”.

“Some of it is an opportunity…but quite a lot of [it] is an opportunity to lose a lot of money,” he told the symposium at Oxford.

In a universe of potential transition solutions, Hepburn said investors should at least look at them with these filters: is the investment technologically sensible; is it economically viable and attractive; is it acceptable to the public; and does it offer sustainable investment returns?

Hydrogen fuel cell cars are an example of a technology that doesn’t make sense, Hepburn said, as they only convert approximately 30 per cent of the incoming electricity to propulsion at the wheels, whereas an EV has close to an 80 per cent conversion. The same applies to hydrogen boilers, which use six times as much electricity as heat pumps to deliver the UK’s heating demand (70 gigawatts).

Another part of the story is understanding the economic progress of technologies. One common argument against deploying clean energy on a mass scale is that it’s too expensive, Hepburn said, but data suggests its unit of cost has been on a steady decline over the past decade.

Meanwhile, costs of oil, coal and gas are highly volatile and lack long-term trends.

“This is not to say there aren’t lots of smart people in these spaces doing clever things…but what they’re achieving, in a sense, is they are counteracting yield declines, as we have to dig up difficult sources of oil and gas in harder places,” Hepburn said, adding that these actions do not result in secular cost declines.

“As of 2023, wind and solar have now added more energy – not just electricity, but energy – than oil.

“Don’t get excited. We’re still like 70 to 80 per cent fossil fueled, and we’re talking about incremental change, but we’re on the beginning of that exponential curve.”

However, Hepburn stressed that the combination of good technology, economics and public options does not always amount to investments with good returns. Solar is a good example where it is hard for investors to make money despite having all three advantages, he said, because the market is fiercely competitive and must deal with “distortionary tariffs” from certain countries.

There are some questions for investors to consider if they are seeking “rent” in parts of the transition value chain, Hepburn said. These are things like: will my technology be outcompeted by the next iteration; can I invest in the infrastructure of transition technologies; how concerned am I about supply chain risks; does the political environment view climate change as a serious problem; and how much pushback will I receive from incumbent providers?

“As an example, [for] those who get very excited that the cost of renewables is now cheaper than the cost of fossils, forget that,” Hepburn said.

“To win in total, you are going to have to go all the way down the supply stack.

“You can dig out oil and gas between 5 and 10 bucks a barrel from Saudi Arabia, so the fact that you’re competitive at 60 [dollars] doesn’t mean that’s the immediate end of oil.”

Asset owners and managers may not always agree on fees, but one thing both parties are thinking a lot more about these days is creating innovative structures which – if done right – could provide rewards for the former and value for the latter.

Albourne Partners head of fintech and implementation Gaurav Amin said fees shape what a manager or an investor does from both an economic and behavioral standpoint. Albourne is a non-discretionary alternatives investment consultant.

Amin told the Fiduciary Investors Symposium at Oxford that one economic impact of fees is on investment strategy.

“One of the big things which is going on right now is multi strategy managers who are using pass-through fee structures, effectively charging 7, 8, 9, or 10 per cent management fees,” Amin said.

“For them to earn that level of fee, or to justify that level of fee, what we have calculated is they need to be a third more levered than any other multi-strategy manager delivering the same level of return.

“Your investment strategy is being directly driven by the fee structure that you have.”

Behaviorally, fees influence how much risk managers take, and also impact the team-building and the culture of a manager organisation, which asset owners should consider when they are looking for long-term investment partners.

Amin said one of the common reasons why managers ask for high fees is to attract talent, but asset owners need to consider how the fee is distributed within the organisation.

“[Managers say] ‘talent is very expensive nowadays, and that’s why we want to create the higher fees.’ However, a team is more important than the collection of stars,” he said.

“How the bonuses are given out is quite important and drives the culture of the company. So, if you’re looking for a sustainable investment…that you are willing to live with for a long period of time, then having the right fee structure within the company itself can be quite important.”

Amin urged asset owners to consider the “three gripes” of fees when negotiating the next mandate with managers. The first one is the level of fees.

The problem with traditional fee models such as a 2-and-20 structure is that there is an imbalanced investor profit share. Albourne’s analysis shows there is likely to be an equilibrium of fees when investors’ share of profit reaches 60 to 70 per cent – below that range, investors may deem investment in a fund unworthy; higher than that range, managers may not be sufficiently incentivised. The level of fees is hence critical, because there is always the likelihood that investors will lose patience before it reaches equilibrium, Amin said.

The second gripe is the shape of the fee structure, where there are more nuanced opportunities for asset owners and managers to align their goals, Amin said.

For example, if asset owners are investing in a fund to provide a hedge, then there should be higher management fees and lower performance fees. If it’s a pure alpha fund, then asset owners should seek a higher performance fee and lower management fees.

The shape of the fee structure is also where investors can get creative with incentives for different types of managers. With hedge funds, there are levers such as high watermarks, crystallisation periods, and hurdles; for private market funds there are things such as carried interest, catch ups, and monitoring fees.

Amin reminded managers that “one fee structure is not going to solve all your problems”.

“Each investment – each investor – in the same fund could have a different objective, and therefore they have a different fee structure. So, it is up to the manager to offer those,” he said.

“That will help align the interest of that particular investor.”

With that said, however, no fee solution should come at the expense of the last gripe of fees, which is transparency. It is notable that different variables and structures often make fees difficult to measure and benchmark.

Amin said there might be a bigger role for consolidated metrics such as investor profit share (IPS) to play in fee measurement. He defined IPS as share of gross returns that the investor earns or is expected to earn for a given fee structure.

“This is where transparency comes in: how is the manager managing the money? And how much transparency are they giving you? Are they making those decisions for the fee structure or for the performance?” he said.

“That’s the collaboration that you need to have with your manager, to have that constant dialog saying, ‘you are doing these things for the right reason or the wrong reason’.”

Institutional investors strive to link their strategic asset allocation to their key objectives and ensure it evolves alongside technological advancements. A discussion at Fiduciary Investors Symposium Oxford explored the complexities and trade-offs inherent in portfolio construction.

At the C$25 billion Canadian pension fund OPTrust, the portfolio is tailored to meet liability and funding commitments alongside returns, and risk mitigation. The investor has a total portfolio approach and views risk and liquidity as scarce resources. Elsewhere, the public allocation is dynamically managed and includes a currency management approach at a total fund level.

The illiquid allocation adds another level of complexity, particularly given that at any time, total fund-level risk is deployed. OPTrust actively manages its private market exposure where investments include private equity and real estate, said Jacky Chen, managing director, completion portfolios, total portfolio management.

Railpen, the multi-client pension fund for the United Kingdom’s rail industry is open and growing, and its strategy is keenly focused on asset valuations and cash flows. A key priority for John Greaves, director of fiduciary management, is to understand the objectives and preferences of trustees. Asset management is approached with the view that both public and private markets are exposed to the economy and shouldn’t be viewed in silos: although real assets operate on a different cycle, they are still blown by the same winds as public market investments.

The analysis extends beyond just risk-return and correlation to integrate different scenarios. For example, what if illiquid investments don’t distribute much? This will result in a need for higher cash flows, alongside careful analysis of any over-allocation to illiquid investments.

Governance is focused on ensuring the team can manage the portfolio through time with an eye on resilience, liquidity, complexity and sustainability that goes beyond just risk and return.

The team also explore trade-offs. For example, real assets might not offer as high a return as other assets, but they bring valuable diversification and inflation protection and can also support sustainability.

“It is about finding the right balance,” said Greaves.

Adam Petryk, chief executive of solutions at Franklin Templeton, counselled on the importance of integrating qualitative and quantitative factors. Pension funds must first think about their diverse range of clients, understanding their differences in liquidity premia and risk appetite.

“Start first with the client need,” he said, highlighting the importance of using proxy assets to ensure a better-informed risk perspective.

Border to Coast, an LGPS pool in the UK, provides its underlying local authority pension fund clients with investment choices, offering a detailed proposition in private debt and infrastructure, amongst other assets. Its offering is balanced by the experience and knowledge of the right investment models amongst the skilled investment team.

More work in benchmarking

Joe McDonnell, CIO at Border to Coast, explained how the asset manager is selling public markets, buying private markets and moving more into alternatives. Conversations with partner funds include the importance of benefiting from long-term secular trends like climate investment and investing more in the UK.

McDonnell said one area of ongoing work includes benchmarking and measuring success. He noted that building out internal capabilities includes ensuring the fund has the right tools and learns from best practices.

“We are confident we are moving in the right direction,” he said. “Private markets for us is hugely important as a long-term investor.”

McDonnell noted that other LGPS pools need to catch up with pooling assets and allocating to illiquid investments, and called the government’s move to mega funds a positive development for the LGPS. However, he also recognised the need for leadership in the LGPS and that board turnover is high.

Petryk agreed that measuring success in achieving outcomes and gauging the success of the team and investment strategies remains one of investors’ biggest challenges. Articulating the investment value proposition through the lens of outcomes requires consideration of what investors are trying to achieve and the integration of peer benchmarks. The process is complicated by the fact that end investors are individuals who don’t measure you “against the S&P.”

Chen said that OPTrust is focused on managing the portfolio more dynamically to achieve long-term value and noted the importance of aligning incentives. In public markets, the team are responsible for beating the benchmark and trying to make sure they manage returns and drawdown risk.

Some of the team focus on portfolio construction and others focus on security selection. The process also allows them to work together to manage asset allocation and execution, and manage the portfolio dynamically on a day-to-day basis.

Chen referenced the importance of going into assets at different times in the cycle, and warned that investment in buckets risks missing out on opportunities. OPTrust is currently exploring the right governance to support a better understanding of assets through a factor lens rather than an asset bucket silo.

Railpen’s Greaves also reflected on the importance of alignment between investment decisions and ultimate goals. For example, the capital markets group at Railpen has an inflation-plus return target that is challenged when inflation spikes. Like Chen, he reflected that a top-down strategy to fill buckets doesn’t reflect changes in opportunities, and things fall between the gaps, requiring the team to meet their investment objectives “in different places.”

He noted how many investors are currently experiencing the impact of being over-allocated to illiquid investments. They have made decisions that risk undermining their long-term objectives and the benefits that these assets can bring.

“Think through the scenarios,” he warned.

McDonnell spoke about the importance of moving away from a culture characterised by investment teams talking their own book by championing preparation and consistency instead. In alternatives, teams often fight for the same space, but success involves thinking through why a particular decision makes sense. “It is about your own book and the wider book of the pension fund,” he said.

Panellists reflected on the importance of liquidity, a constant constraint that forces schemes to think about the trade-off and put a liquidity premium on valuations. It’s possible to have a situation where investors think they are delivering a risk-adjusted return but are, in fact, loading on the same type of risk.