Grasping the nettle of responsibility

Written By: Pádraig Floyd LAPF Investments

Pádraig Floyd discusses how LGPS investment strategies are evolving in response to ESG requirements and expectations

The world is constantly changing, though unfortunately, not all change is necessarily for good. Investors who sought to remove – or at least ameliorate – the impact their investments might have on the environment or society at large were seen at best as well-meaning fools, giving up returns for a better night’s sleep. At worst, they were considered dangerous zealots, who should not have influence over a fund’s investment strategy.

The long journey of an overnight success
The steady growth of strategies targeting environment, social and governance (ESG) over the past decade has normalised the thinking about ethical/responsible/sustainable investment, grounding the logic in protecting portfolios from the risks each of these factors pose.

Still, most ignored ESG, reassured that fiduciary duty was paramount and that governance was already something they were all over.

While climate change was a focus for most lobbyists, everything changed with the momentum behind the MeToo campaign that highlighted the role of women in all parts of society, and the murder of George Floyd, that highlighted how far western liberal democracies had yet to go to deliver equality across their societies. Any conviction that governance (G) was already covered was quickly undermined by the ferocious backlash against the business world from both MeToo and Black Lives Matter. And so ESG was here to stay.

Leading from the front
Abraham Lincoln said that you cannot escape the responsibility of tomorrow by evading it today. This might be considered a strapline for many LAPF investment strategies.

“These funds have been miles ahead of private sector funds – indeed, most of the industry – on these matters for a very long time. But about three years ago, there was a greater focus among LGPS funds and it started to really build momentum,” says Jill Davys, Head of LGPS at Redington and pensions finance and investments manager at the London Borough of Sutton Pension Fund.

“A lot of funds switched emphasis, created new funds or renamed existing ones,” says Davys. “But there’s been some very long-term players in this space who have stayed true to what they do.”

As an open defined benefit fund, the LGPS can afford to take a longer-term view, says Davys. And while there is a delay over regulations on TCFD reporting, she doesn’t believe it will hold many back from pushing forward with their plans. “People now accept that you do not have to give up financial return to achieve ESG objectives. It is a logical step forward that can protect you against some fairly fundamental risks.”

The loss of scepticism about the role of ESG within investment strategies was the biggest shift among those running LGPS funds in recent years, says Dawn Turner, an independent adviser. “And despite blazing a trail, the LGPS is still on a learning curve, as to what ESG actually means in terms of implementation.”

“The goals of pooling are to reduce costs, make more money by spreading the risk around and to reduce transition costs by sticking with managers they select for longer,” says Turner.

“The problem is that the world isn’t moving fast enough, and the managers selected three years might not have everything required to make the right risk returns, to diversify, but also to ensure that companies are going to achieve the Paris alignment target.”

But there’s a lot more work to be done
Many of those at the forefront of responsible investing had done a good job at monitoring and managing risk, with a strong narrative about how they were integrating ESG into their processes, says Rory Sullivan, CEO of Chronos Sustainability. But Sullivan is concerned that many of those who have made major commitments may not have a full grasp of their consequences.

“Many have assumed they can deal with ESG as they’ve dealt with them in the past – some risk management and a bit of corporate PR and job done,” says Sullivan.

“But net zero is so fundamentally about investment. If you make that commitment, it has profound implications for strategic asset allocation, sectorial allocation, risk management, risk mitigation and risk creation.”

Sullivan doesn’t doubt that the commitments – particularly among public funds – are resolute and that those organisations are seeking to effect change. Commitment to net zero suggests that you should identify a 5% to 7% reduction year on year of greenhouse gas emissions in your portfolio, says Sullivan. “You might have 10% low hanging fruit, but you need to have identified that each year for next five to seven years.”

The data problem is particularly troublesome for those who are seeking – or being pressurised – to report on their efforts.

This is not just because there are what Sullivan calls “incoherent datasets”, but that funds are being pushed towards using the available metrics, rather than ones that are useful for investment decision making.

“There’s a kind of unholy confluence of events happening, where people are making big commitments without data.”

Reporting requirements present a distraction
Sullivan says that trustees, advisers and senior management are in a very interesting place with considerable potential for influence. But that they’re going to be hampered by the current narrative around context.

“The reporting requirements, like TCFD, are pushing funds towards accounting-oriented reporting,” says Sullivan. “This is distracting them from the real business of reducing impact – or maximising positive impact – while delivering on their fiduciary duties.

“The obsession with reporting and the push for numbers is just pushing reporting for the sake of reporting and tickboxing, rather than impact,” adds Sullivan.

Sullivan does not suggest that local authority funds would be deflected from investing in asset classes or themes that they see as beneficial. But the increasing pressure from lobbyists, investors and regulators has influenced conversations around responsible investment. At extremes, it has reduced the debate to a binary yes or no, in terms of acceptable or unacceptable strategies.

“We know that coal remains an essential part of the energy mix for many years to come,” says Sullivan, and that the events in Ukraine have had a major impact on Western Europe’s reliance on fossil fuels. Moving towards low carbon energy is the right thing to do, but we can’t do it overnight or even smoothly – and keep the lights on.

Divestment means you give up all your levers to effect change, says Sullivan and if the solution to the climate problem is to make large companies adapt their business models, then that is where investors should be seeking influence.

“We’re moving into a environment where the real world is complex,” adds Sullivan. “The advocacy is overly simplistic and not particularly speaking to the issues we’ve got to deal with in society today.”

Responsibility is about striking a balance
Divestment is clearly a theme among local authority funds. There are some funds that are committed to a just transition, but probably many more don’t talk about it, according to Turner.

“There is a lot of lobbying,” she says, “and trying to explain what they’re currently investing in, what their expectations of those companies are and their position on just transition is much harder than simply saying they’ve got a net zero strategy.”

It’s not only energy that should be focused on, because there is a need to focus on all sectors to reduce carbon emissions and to demonstrate their position across the range of the ESG problems.

It’s about striking a balance, she adds, because divesting from certain sectors will deprive them of investment and could create economic risks simply because we don’t have alternatives already in place.

Hope for levelling up
Clearly, the levelling up agenda offers considerable opportunities for funds to invest in those future alternatives in responsible ways. Some funds – both public and private sector – see impact investing as a way of investing responsibly. They see a potential beyond social housing to support a just transition in communities that have been reliant upon old tech or been starved of investment to develop new industries.

Funds may not even have identified some of these assets explicitly yet, says Davys, but many will already have some in their portfolio that meet those levelling up criteria.

“Funds themselves come under huge pressure on all sorts of angles, but ultimately we are there to pay pensions. But if you can get the financial returns and have a positive impact, whether on the climate, society or in terms of improved governance, why wouldn’t you want to do that?”

And schemes have bigger fish to fry. In a valuation year, they are all too aware of their responsibility to pay their members’ benefits.

“They’re going to be looking for investments that are sustainable not only in ESG terms, but cash flow,” says Davys. “That may lead them towards thinking more about real assets and investments that are inflation linked.

“As awareness of pensions has increased, that may be an easier story to communicate now, not only to lobbyists, but in particular your members.”

The final analysis
Ultimately, funds need to determine the roadmap for their organisation’s ambitions. After all, everyone needs a net zero strategy if we are to avoid the impending disaster predicted by scientists.

That means funds – and pools – need to choose the right managers. That requires assistance from advisers. In fact, greater collaboration all round.

The pools are – quite rightly – focused on their internal clients. But some believe that more could be done to advance the project for all.

Local authority funds could do more in partnership if there was a way to facilitate greater collaboration. It won’t be easy, and it would require funding. But a project focused on filling some of the knowledge gaps around risk and investable assets could be considered, with the support of investment managers who will have access to research that could give the whole sector a huge push forward in understanding what needs to be done to achieve goals that have been determined through responsible investing policies.