Climate risk remains systematically under-priced, the world isn’t on course to meet net zero and investors must prepare for the risks of climate and environmental change.

So warned Nicola Ranger, executive director of the Oxford Martin Programme on Systemic Resilience and a senior research fellow at the Institute for New Economic Thinking at Oxford Martin School, opening the second day of Sustainability in Practice at the University of Oxford. She said that climate risks are coming thick and fast, with a direct impact on assets, labour productivity, patterns in demand, supply chains and markets.

Ranger urged asset owners to re-evaluate climate risk and bring this analysis into their decision-making. For example, few asset owners report on the physical risk of climate change in their portfolio.

“Not managing this risk means the wider economy is not getting the economic signals it needs to create changes. Financial institutions need to price risk properly, and signal to the wider economy that it needs to adapt.”

If governments and countries meet all their pledges, she predicted global warming could be capped at 1.8 degrees, below the threshold for catastrophic tipping points. But she also described a much more pessimistic view based on progress to date and the fact global emissions keep climbing and still haven’t peaked. “We are not on course.”

The risks of climate change are already visible. For example, high temperatures is causing deaths, disrupting transport networks and leading to floods and drought as rainfall patterns change, impacting agricultural systems. She flagged implications for water-dependent industries and big increases in volatility of commodity prices. “Sixty percent of our food comes from five countries,” she said, predicting shocks to supply chains and impact on sovereign credit ratings.

Investors have a role to mobilize finance across geographies, countries, sectors, infrastructure and agriculture. But she warned that many investment decisions are not building resilience. For example, new infrastructure investment doesn’t always consider climate-related risk. “We are still building physical infrastructure that economies depend on, but we are not doing it in a way that is considering climate risk, risking both investors and society,” she said. Similarly, she flagged the much of the estimated annual $6 trillion invested in agriculture doesn’t consider future climate risks.

Ranger urged asset owners to take a holistic approach to managing risk and align their portfolios with resilience. They should ensure they “do no harm” and manage risk in their own portfolio to ensure it doesn’t create risks for society. For example, she said water companies have a significant impact on water scarcity.  Elsewhere she noted that data centres are exposed to climate risk like heat, and they are also water dependent. Adaption can bring returns from investing in new technology, but adaptation also incurs long term costs. For example, retrofitting buildings requires upfront investment.

“We, as a society, are mismanaging climate risk. We are putting insufficient emphasis on our safety and not properly valuing the impact of climate change or logging or exploitation of the soil. Many things doing that are impacting environment that are impacting on us.”

Society can reverse the rapid decline in biodiversity by changing habits, of which reducing meat consumption is the most effective. Trade also helps restore biodiversity because it lets land recover by allocating agricultural production to different areas.

Speaking at Sustainability in Practice at the University of Oxford, Michael Obersteiner, professor of global change and sustainability and director of Oxford’s Environmental Change Institute, sounded a positive note on how investors can help mitigate plunging biodiversity loss.

He said that high-yield agriculture and laboratory-produced foods are key future trends in a modern economy that will support sustainability.

“Plant-based, laboratory meat products hold potential for the planet. If we were to substitute meat products, we could reclaim two thirds of agriculture and give it back to nature.”

Obersteiner detailed a research programme that could support investor analysis of companies doing most to restore nature. Research into palm oil production in Indonesia used satellite images to map the plantations, estimate yields by analysing the age of the plantations, and identify illegal plantations. Continued, detailed research was able to identify the wider ecosystem of supply chains connected to the plantations; trace which multinational corporations own the plantations and calculate profit and loss subject to international policy changes like EU anti-deforestation laws. It was also able to identify the banks (mostly Indonesian) financing the industrial conglomerates.

The technology has also been used to map soy and beef farming in Brazil, gathering information that helps reveal the financial backing of illegal farming. “We can find out which banks are invested in which farms,” he said. Similarly, the research reveals these illegal farms links to the wider supply chains, and export markets in Europe and China.

Obersteiner said the research is accessible to investment teams because it is easy and quick to gather. “Looking to the future, it will be possible to provide this stress-testing analysis on all assets.” He added that the research could also play into forecasting models – the closure of illegal farming and plantations would mean prices could spike – and also provide information on entire supply chains.

The discussion turned to the challenges of investing to protect biodiversity in listed markets. The vast majority of corporate activity harms nature, said fellow panellist Lucian Peppelenbos, climate and biodiversity strategist, at Dutch asset manager Robeco. Rough estimates reveal that only a fraction of the universe of around 40,000 listed companies do no harm to nature. “Finding nature-positive companies to invest in is very difficult,” he told conference delegates.

Not only is channelling capital into wholly nature positive companies close to impossible. It is just as challenging finding companies that will help “bend the curve” on biodiversity.

Peppelenbos advised that investors have a better chance to reduce nature loss by reducing damage and destruction in a pragmatic approach, rather than attempt to become nature positive.

reducing nature loss

Investors need to be ready for the new biodiversity framework from the Taskforce on Nature-related Financial Disclosures (TNFD) that sets out 11 core metrics around risk management and disclosure for business and financial institutions to mitigate nature-related risks and restore damaged ecosystems.

But one of the challenges for investors wanting to integrate biodiversity comes with knowing what is material, as well as the absence of broad based models or a transition models for nature. Those challenges present a contrast with  climate change, where the focus is on reducing emissions.

“How much waste do we still accept from the pharmaceutical industry? How much land conversion from agriculture?” asked Peppelenbos. “We need to reduce the complexity and we can’t wait five years.”

His suggested pragmatic approach involves integrating data at a sector level to give a clear picture of which sectors are putting the environment under most pressure. A second building bloc ascertains the underlying drivers of biodiversity loss.

“Nature can restore [itself] as long as we create the right enabling conditions,” he said.

Different industries have different negative impacts. For example, a key source of biodiversity loss in the paper industry comes from change in land use. “Companies can mitigate here by recycling and sustainable sourcing,” he said. KPIs also help measure progress at a company level and classify companies into leaders to laggards. Similarly, in the chemical sector companies can be split into leaders and laggards regarding water and land use, and their use of renewables to create an investable universe.

Robeco’s research reviews KPIs and sets thresholds. The biodiversity team meet with companies and are creating industry guidance in a research paper that will be open access later next year.

“The long-term direction is clear, and it’s clear politicians need to legislate towards the green economy. With a pragmatic approach we can make biodiversity investible,” he concluded.

Being joined-up is an interesting phrase. Its use grew up in government where it was a beacon to draw on best practices and behaviours in coordination between wings of government, collaboration between key members of government and coherence of thinking in the policy setting process.

All fine aspirations. All devilishly difficult. In the main, joined-up government is an oxymoron.

In this article, we apply those three C’s to the investment industry and specifically the asset owners. We suggest the joined-up term involves getting the fullest benefits from coordination, combinations and coherence across people, teams, organisations and ideas. The investment enterprise at its core has a mission to add value to capital by combining the efforts of separate groups of people in the pursuit of return. Monk and Rook in their investor identity paper put it this way: ‘All investors produce returns in the same general way: they take capital, people, processes and information as inputs and combine them to generate investment returns, which increases financial capital’.

The complexity of the investment industry is clear from just how many groups of people make up the ecosystem of an asset owner – board, executive team, support teams, asset managers, other providers, investee entities, regulators, end investors – these make up most of it, but there are more, the ripples carry on.

So, are there some general conclusions about how to optimise these combinations and bring greater value creation to the asset owner? Essentially, can the asset owner become better joined-up?

It turns out that there are several ways to produce larger combinatorial benefits, but they all involve the deployment of the soft and subtle organisational alpha that is generated from a mosaic of governance, culture, talent, and technology.

The key piece of this mosaic is the alignment of the organisation to one set of specific goals. In this area the approach that secures alignment is one where improvements to the total portfolio is the arbiter of success. This is not the traditional way things are done – the strategic asset allocation (SAA) approach with its policy benchmark introduces biases and the drag from tracking errors. Instead, you need a common framework best described as the total portfolio approach (TPA) that has all investments and groups compete for capital with their best ideas for the total portfolio.

Securing the best organisational alpha for asset owners will depend heavily on four combinations:

  • the board and executive management combination
  • the combination within the asset owner of specialist teams (asset classes, strategy, risk, etc) and support functions working in full alignment
  • the asset owner and asset manager combinations
  • the asset owner and asset manager combination with investee entities employing stewardship and engagement activities.

Each of these areas is difficult. Combinations require significant levels of trust, co-operation, and shared understanding of goals. The organisational incentives may pull in another direction away from the goals. Organisations tend towards one dominant in-group and multiple out-groups and silo behaviours are widespread as a result.

This is accentuated when the out-groups have intrinsic alignment differences as commonly occurs. We also see cognitive errors in how asset owners see collaboration with its merits under-recognised. Some of the blind spots comes from the difficulties in measuring and attributing the outcomes of collaborative actions.

Joined-up in sustainability

But when something is hard it is often very rewarding to do it well. This turns out to be the case with being joined-up, and particularly in how sustainability can be joined-up.

First, there is the rightsizing of sustainability ambition with commitments to the primary goal of maximising returns per unit of risk. Being joined-up here involves the shared vision of the materiality of sustainability factors to financial outcomes.

Secondly, there is the step-up in ambition that some asset owners choose in employing universal ownership strategies where having impact on the wider ecosystem is instrumental to better long-term financial outcomes. We refer to this as 3D investing in which risk, return and real-world impact are joined-up in a competition for capital that integrates sustainability impacts across the SDGs.

The challenge with this is that we have “super wicked” problems needing holistic thinking and cross-agency coordination to tackle the complexity and apparent intractability of the many pressing societal issues captured in the SDGs and most significantly in dealing with climate change.

Joined-up in climate

Notwithstanding this challenge, being joined-up works well with climate.

The first leg is the net zero investing strategy that reduces real-world emissions. Allocation of primary capital to climate solutions plays a part. Stewardship and engagement with higher emissions companies also plays a part in helping accelerate the energy system shift. Systemic stewardship and engagement – across high-emitting industries and on public policy – plays a particular part in guiding collective action.

The second leg is linking the climate impacts with the financial outcomes over time. The returns asset owners need can only come from a system that works and the theory of change thesis is that this allocation and engagement strategy will mitigate the considerable risks to the financial system from a changing climate system. The beauty of this is that this sustainability impact strategy has fiduciary integrity by being instrumental to better financial outcomes.

Climate change is the mother of all super-wicked problems. Finding any decent contributions to a solution is a cause for celebration.

We have an understandable desire in our ecosystem to see simple causes and effects, but the interconnectedness of all things makes that unrealistic. Hence this need to be hyper joined-up in thinking and action. OK, I’ve made things more complicated in seeing our world through an ecosystem lens. But if we can simplify this and progress this to the point where our whole industry frames things using this mindset our anxiety-laden future should not be so chequered after all.

 

PGGM, the €228 billion asset manager for the Netherland’s second-largest pension fund PFZW, is working with US hedge fund manager Bridgewater to help restructure its portfolio to incorporate impact.

The research partnership will integrate a 3D approach incorporating risk, return and impact at PGGM that goes beyond its existing SDG alignment and particular focus on healthcare and climate themes. Still in the early throes of the partnership, the investors are collaborating on analytical detail and wrestling with the tough issues that go into building these new portfolios.

Arjen Pasma, chief fiduciary manager, PGGM, and Carsten Stendevad, CIO, sustainability at Bridgewater, took to the stage at Sustainability in Practice, the University of Oxford, to detail the strategy in action that will ultimately change the look of PGGM’s portfolio, most notably reducing the number of public market stocks.

“We will look very different in five years’ time,” said Pasma, who said the approach applies across public and private markets and the bar for claiming impact is high “There will be fewer names in the portfolio. Research involves a lot more than just buying a company.”

The importance of beliefs

In a catalyst to the new strategy, PGGM recently re-wrote its investment beliefs in a process that has shifted its focus away from exclusions, targets and risk and return optimization. Instead it has begun honing-in on the assets in the portfolio and conducted deep dive analysis on how to make the portfolio more sustainable.

The new approach is already addressing previous challenges – like the fact exclusions “don’t work” in the 30 per cent allocation to private markets. “For every single line in the portfolio, we want to know why it’s there and that we’ve evaluated the risk,” said Pasma.

Carving out beliefs sharpens strategy and helps navigate uncertainties. For example, investors need a strategy on whether or not to finance transition assets. Are they  prepared to invest in high emitting companies if they are reducing their emissions and are on a credible pathway? This type of analysis involves a long journey and comparing notes in a concrete and practical process. Elsewhere, beliefs help decide whether to focus on climate or social issues – or both.

“There is no right way of doing it, but you need to understand all downstream choices,” said Stendevad.

Beliefs also provide a framework to respond to difficult questions around performance. Investing for risk, return and impact requires a more rigorous investment process and frequent trade-offs in contrast to less complex ESG strategies shaped around exclusions.  It also involves having to defend strategies – like a decision to continue to invest in fossil fuels. “How do you measure that trade off? It’s a scary journey that might lose folks,” he continued.

Bridgewater conducts some its research in a top-down approach. This  seeks to analyse the impact of climate policy on markets and economies, for example the IRA and European climate regulation. Elsewhere, the team are looking at how China will balance growth and climate policies.  “Net zero won’t happen by itself. It will happen because policy makers make choices and our job is to try and understand how climate policies help the world and will change how economies work,” said Stendevad.

In a next step, Bridgewater is building out a detailed understanding of sustainability at an industry and company level, exploring how integrating sustainability interacts with impact, risk and return. “We want to take all this understanding and incorporate it into our fundamental investment processes. Any portfolio manager should be able to say this is my return, here is how it fits my risk dynamics, and this is how this company is aligned with sustainability. That is the north star but in practice it is difficult.”

The research partnership also seeks to understand which companies will impact the world most and aims to get under the hood of bank lending to fossil fuels – and to what extent banks are financing the transition.

“It’s not easy to to assess banks’ balance sheets and understand if they are aligned to net zero but only by breaking apart bank balance sheets, will we see if banks are putting money to sustainable outcomes,” said Stendevad.

In another strand, the research also seeks to assess to what extent sustainability endeavour is supported at CIO level. Strategy often flounders without leadership, and sustainability has to come from the top of the house.

Global investors have committed to net zero, but implementation around those commitments is slow with little action on the ground.

“We are seeing lots of commitments but not much implementation,” said Carola van Lamoen, head of sustainable investing at asset manager Robeco, opening Sustainability in Practice at the University of Oxford where attendees have collective assets under management of $8.5 trillion and include some 64 global asset owners.

“Around 50 per cent of our total assets under management are under net zero commitments. But that doesn’t mean these investors have introduced targets on a mandate level.”

Implementations and action on the ground include engagement and voting; working with partners and clients to identify companies with the biggest carbon emissions, and accelerating real world transition. Van Lameon added that joining forces with other asset owners through organizations like Climate Action 100+ as well as sovereign engagement is another way to act on net zero promises.

Sustainable strategy at £60 billion Border to Coast, the LGPS pool managing assets on behalf of 11 partner funds, has come under particular scrutiny because it manages money for public sector employees. Positively, being in the public eye has helped accelerate integration of sustainability – visible in new targets and the investor’s focus on investing in “well managed companies for better long-term outcomes.”

However, it has also bought the fund in contact with politics, including picket lines outside the investment office and press coverage of its investment process. “The emotion that comes with this is challenging and we have to remind ourselves why we do it,” said Rachel Elwell, chief executive of Border to Coast, reiterating: “We believe climate change will have a material financial impact on the portfolio so we must understand the risks.”

She added that integrating sustainability is challenging because it’s difficult for investors to gage what is within their control. “There is a risk that asset owners have oversold what they can deliver,” she warned. She said all progress depends on being in conjunction with policy makers. “We are seeing some splitting of strong coalitions in financial services because the government hasn’t kept up with leadership. There is a need for investors to engage with governments to help them understand their role.”

In a step change in its sustainability strategy, PSP Investments, which invests C$230.5 billion on behalf of Canadian public sector pension plans, has introduced a climate strategy set around short-term targets. This includes goals around investing in green and transition investments, and reducing carbon in the portfolio. The strategy involves mapping investments, data gathering, looking at the carbon intensity of investments and companies’ transition readiness. “Do portfolio companies have a plan and is it science-based?” asked Herman Bril, PSP’s managing director and head of sustainability.

Green asset mapping

Brill advised attendees to map their green assets to understand “where they are today, and where they will be in the future.” Moving forward, this should take into account regulation, changes in accounting methodologies, and the fact data will improve. “Every five years refresh and update strategy,” he advised. “Realise what you have learnt and how to move forward; move forward step-by-step.”

These moving pieces make hard targets difficult. Governments, companies, consumers and the accounting world need to align to long-term net zero targets, he said. “In reality we need all the levers to change,” he said.

Moveover, it is difficult for universal owners to effect change if the world is not decarbonizing. A short-term focus helps ensure delivering on actions rather than simply making false promises. In another approach, PSP Investments also changed its narrative around ESG, swapping talk of responsible investment to framing all discussions in the context of sustainability and climate innovation. This allowed the institution to move away from ESG and compliance. “The investment opportunity is massive. We are not an impact investor, but an investor with impact.”

Brill noted that it is easier to integrate sustainability in private investments because of the ability to steer corporate strategy via a board seat and direct engagement. PSP splits its portfolio 50:50 between public and private assets.

PSP prides itself on being strong and smart, staying on course and working with its board rather than try to influence the vicissitudes of short-term politics – something he said was unmanageable. “We invest 50-years forward,” he said.

Chris Mansi, global delegated CIO of Willis Towers Watson, a delegated asset manager for institutional funds, said that integrating sustainability is a multi-year process and progress will have challenges to be addressed on the way. WTW regularly reviews sustainability targets for client funds, breaking these goals down into short-term actions. He flagged that integrating sustainability requires a “financial underpinning” alongside assessment of impact and said that in most circumstances WTW did not support divestment as a means of achieving sustainability goals. “[Sustainable investment] requires ongoing review of where we are and how we make decisions.”

Indeed, many pension fund have set targets that they hope to achieve, but the reality is they may not. Panellists agreed that fiduciary duty in the context of net zero “needs consideration” particularly since the world “is off track,” the politicization of ESG is also slowing progress and integrating sustainability appears to be in decline. Some managers (particularly those based in the US) are reneging on commitments and trustees that used to commit to energy transition are now more reluctant because the political and social landscape has changed.

The conversation also focused on how divestment is no longer the right strategy – and that it is not possible to divest your way to net zero emissions. In fact, asset owners are finding themselves increasingly central to the debate on how to finance emission reductions.

Van Lamoen concluded that investors are allocating to transition assets, rewriting their strategic ambitions, beefing up stewardship and engagement. Despite the challenges, she stressed the important progress that has been made towards decarbonization, the introduction of more forward analytics and the role of engagement whilst signs of government inaction include the Inflation Reduction Act in the US and  Europe regulation that is also driving change.

The key question for pension investors today is whether risk premiums are the same as they were a few years ago when interest rates were much lower – or in the past when economic growth was much faster.

So says Timo Löyttyniemi, CEO at VER, the €21.6 State Pension Fund of Finland, established in 1990. In a recent research note, he writes how many investors expect returns to fall slightly in the coming years, but warns the economic backdrop can quickly change.

Interest rates were so low a couple of years ago that low return expectations had a real basis. Now that interest rates have risen by 2-3 percentage points, the key question is whether this rise in rates will be directly reflected in improved overall returns or whether risk premiums will be lower than before.

“The assumptions concerning these developments will be key questions to be pondered by many pension investors this autumn,” he writes.

“Risk premiums may vary depending on interest rates, the overall market sentiment and market prices. Even if the calculations were completely revised in response to these developments, the new assumptions could also prove wrong.”

Underlying return assumption are based on the yields of each asset class above the risk-free rate, he continues.

“The risk-free rate is the short-term interest rate, which in the euro area is currently around 4 percentage points.”

When investors make their return calculations they must determine how much equity investments, corporate bonds, high yield loans, private equity, real estate investments and other similar asset classes will yield above this said bond rate, he explains.

“When these are then weighted by asset class, we obtain the expected return for the entire portfolio. For pension investors today, it could be from 4 per cent to 6 per cent, or 2 per cent to 4 per cent in real terms over the long term (more than 10 years), depending on the pension fund, the composition of the portfolio and the assumptions used.”

Return expectations

The long-term return assumption (expectation or target) is probably the most important assumption made by a pension investor. It is determined, explains Löyttyniemi, by investors making a wide range of assumptions concerning returns, volatilities and correlations in respect of the various asset classes.

“While the return assumption seldom hits the bull’s-eye in the short term, it often proves more or less accurate over periods exceeding ten years. This means that while it is advisable to disregard it in the short term, it may well be used as a basis for the pension system in the long term. Reliability is not perfect but could be sufficient if other adjustment measures are available.”

As for pension liability calculations, he says they are complex and involve a huge number of assumptions relating to age, retirement and mortality rates. Perhaps one of the most important assumptions concerns the discount rate. “It may be a fixed rate or can be derived from market rates, in which case it varies in response to market rate fluctuations,” he says.

“In this respect, individual countries have made different choices. In Finland, the rate is fixed whereas in the Netherlands the discount rate is currently based on market rates.”

One challenge arises if interest rate assumptions prove wrong.

“If interest rates are sufficiently low, the risks of incorrect assumptions are probably lower as pension liabilities are higher in terms of current value and no false notions have arisen. Choosing a highly volatile market interest rate, on the other hand, forces you to invest at least partly in line with the corresponding interest rate behaviour.”

investment beliefs

Löyttyniemi explains that long-term investors base their decision on key assumptions and investment beliefs are a key part of the decision-making process. “Investment beliefs are important because they usually serve as a guideline for long-term policies and investment allocations,” he says.

Investment beliefs are used to draw up assumptions. Which in turn serve as a basis for various calculations, usually to optimise portfolio structures and the relative weightings of asset classes. “For example, one assumption could be the belief that a more sustainable company produces better returns or risks are lower,” he says.

“It can also be assumed that the carbon neutrality goals and schedules of governments and companies will be fulfilled. If these assumptions are not fulfilled, the investor can easily make wrong decisions and in that case investment returns may suffer. Of course, if there has been more talk than action in terms of responsibility, no damage has been caused by following the indices.”

Pension investors do not modify their portfolios overnight, concludes Löyttyniemi.

When changes to portfolio structures are made incrementally, the assumptions made or beliefs used in any given year do not result in undue risks or deviations. However, small changes accumulate to transform into big ones.

Many assumptions are confirmed over the long term rather than in the short term. But any correction to assumptions is also costly.