Investors should be “asset class agnostic” when it comes to impact investing and can’t afford to neglect the fixed income market, according to Oyin Oduya, impact measurement and management practice leader at asset manager Wellington Management. However she told investors at the Sustainability in Practice event at Oxford University last week they should approach labeled bonds with a critical lens due to risks of greenwashing.

S&P Global Ratings predicted in September that green, social, sustainable, and sustainability-linked bonds (GSSSB) will account for 14 to 16 per cent of total bond issuance in 2023. The asset category is forecast to have $900 billion to $1 trillion worth of issuance for the whole year, with green bonds expected to account for 59 per cent of the total GSSSB.

Oduya highlighted that labeled bonds are fundamentally “based on promises” before they are issued. While bond issuers will usually tout regular allocation reports and strong investment frameworks, there are risks that the promises will not be fulfilled in the long-term.

But there’s also the issue created by the independence between the bond and the issuer. “You could have a bond, which is doing something good, issued by an issuer that’s doing something bad,” she said. These are exactly the reasons why Wellington doesn’t focus exclusively on labeled bond, despite their obvious appeal. In fact, the asset category is currently a minority in its global impact bond portfolio.

She suggested that investors stay clear headed on labeled bonds by examining revenue materiality (Wellington’s benchmark for labelled bonds is 90 per cent of use of proceeds going to impact themes), additionality (where the enterprise itself is doing additional works) and measurability (a defined KPI at the time of investing).

According to the Global Impact Investing Network (GIIN), the impact investing market stands just above $1 trillion, a drop in the bucket compared to $100 trillion in global assets under management.

In terms of choosing between public and private assets, Oduya suggested investors note the differences in measurement such as data availability. For example, private markets tend to have scarce data due to a lack of sustainability departments or staff, and investors have to do the work in encouraging them to develop relevant disclosure. But the public markets’ problem can be the exact opposite, because public companies tend to have significantly more resources and an abundance (or an excess) of data.

“Once the money has been invested, the issue we have in public markets is that they are very good at giving you ESG data,” she said. “They’ll be able to give you scope one or two emissions, numbers about the diversity of their board, and how many volunteer days they’ve done that year. But they can’t tell you where their product is being used, how much GHG emissions are being avoided, or how many people are getting access to health care at an affordable cost.”

Oduya conceded that for impact investing to become really institutionalised, investors need to set their sights beyond alternatives to the entire capital markets and recognise that investment performance will be absolutely crucial.

“I’m saddened, but it does come up in meetings where people ask: ‘If you’re an impact fund, does that mean it’s a concessionary strategy? Do you think that if a company has more impact, you can put it in the portfolio even if it has a less attractive financial return?’

“The answer is always we have to have both attractive financial returns and positive impact. It doesn’t make sense for us to have a portfolio which is concessional, but you want to be able to grow, scale and attract investors. Impact is not sustainable in this framework, if it doesn’t make money.”

ESG-momentum matters when it comes to outperformance according to new research by Pictet Asset Management’s head of sustainability Eric Borremans who says investors should sharpen their ESG lens and use active ownership to trigger positive change.

Speaking at Sustainability in Practice at Oxford University he highlighted the new research from the Switzerland-based investor that examines the performance attribution of conventional and ESG indices over long time horizons revealing the importance of governance and engagement.

Borremans said that risk-adjusted returns from ESG fixed income indices are in-line with wider market returns. “That’s good news as it means that investors can build portfolios with stronger ESG credentials without losing money.”

He added that the green economy has had ups and downs but the overall picture remains positive as the sector continues to benefit from supportive policy measures such as the IRA. “Since 2018, companies that derive more than half of their revenue from the green economy, as represented through the FTSE ET 100, have generated superior risk-adjusted returns,” he said.

Still, he noted that the hike in interest rates has had a negative impact on renewable energy projects, contributing to delays and cancellations in offshore wind while other challenges include the outside position of some companies in green indices.

Despite positive returns, Borremans said that investors still question the ESG ratings that underpin the construction of indices with many concerned about the extent to which ratings are a good lens to anticipate investment risks and opportunities.

In 2018 Pictet sharpened its own ESG lens, developing smarter ways to analyse companies that included focusing more on corporate governance. The firm’s analysis explored whether governance was “functional or dysfunctional,” analysed companies’ products and services; operations risk, ESG objectives and whether the footprint it left behind was generated at the expense of society and the environment.

“We asked if the company was facing liabilities because of mismanagement,” he said.

Pictet applied its key questions to thousands of companies and then aggregated the results together. A challenging process that had to unpick multiple issues. “For example, we thought that a weakness in one area could be compensated by strength in another but decided that each issue needed to be looked at in its own right to find outliers.”

The analysis also explored momentum, looking particularly at corporate progress over a 12-month period. It can take years for companies to meaningfully change their products, but governance and the change it can bring can happen quicker, he said. “We found more often than not that incremental changes were triggered by governance.”

Companies with a positive momentum outperformed (about 1 per cent per annum) the universe with lower levels of volatility. In contrast companies with negative momentum underperformed the index (around 1 per cent per annum) with higher volatility. “We came to two conclusions. ESG momentum matters and investors should monitor corporate governance as a key driver to momentum.”

Borremans said that the green economy has performed well despite the 2022 downturn and rising interest rates. “ESG momentum is a critical factor and something we should all be monitoring more closely supported by engagement and active ownership.”

He added that economies and regions will increasingly suffer from extreme weather impacting GDP growth, productivity, resilience and inflation and feeding into sovereign creditworthiness and corporate health.

He said that the growing climate crisis will require a more steady and active governance, especially in asset classes like high yield. High yield is approaching a “maturity wall” with billions of dollars of high yield needing refinancing going forward. Looking at corporate governance as a proxy provides a useful window into how successfully companies are managing this risks.

He also noted the importance of engagement, advising the audience that setting clear targets and incentivizing top management triggers corporate change. “Engagement is not always an easy ride, but it can pay off.”

 

CPP Investments has produced a framework and standardised template to measure the capacity of organisations to remove or abate GHG emissions. Speaking at Sustainability in Practice at the University of Oxford, Richard Manley, the Canadian fund’s chief sustainability officer, managing director and head of sustainable investing, explains how investors can encourage corporate efforts to decarbonize.

Given around one quarter of companies in CPP Investments’ public equity allocation still don’t report Scope 1 and 2 emissions — one of the most fundamental indicators of whether a corporate board is engaging on the climate emergency — there is much to do.

Manley argued that rather than focus on what must be done to reduce emissions, companies should start by looking at what they can do, and what they can do today. He suggested companies look at corners of their business where they have a technically proven ability to decarbonise and told delegates that helping corporates prioritize the highest impact and economic opportunities of decarbonization will give them confidence in their progress on the path to net zero.

Investors can support companies transition by encouraging them to put the details in their business plans, and take possible steps regardless of uncertainties around the carbon price or regulation; unknowns around moonshot technology and offsets.

“It is about the technically feasible stuff. If companies are going to provide forward looking statements they must provide the market with data to show if it is either a slam dunk, or just speculative,” he said.

Manley said  companies have an ability to decarbonize their businesses that many don’t realise. A study by CPP Investments explored transition plans at 12 portfolio companies, and found a playbook from a firm baseline for each. “It’s difficult to chart a course if you don’t know where you are today,” he said. From a firm baseline, it is possible to calculate abatement capacity by, for example, starting with efficiencies and changing the how rather than the what.

“The price on the screen does not reflect the climate risk of businesses we own,” he said, echoing comments shared by other conference delegates that climate risk is systematically undervalued.

Businesses should understand that if they don’t decarbonise, they will lose market share and see their value deteriorate, he continued. Once a company understands it has a value at risk that it can protect through decarbonization, it reframes the discussion.  He urged investors to engage with corporates and their consultants on that basis.

Investors can also add pressure for change by reminding corporates that operate in markets where governments will regulate to decarbonize the economy that executives need to act. “It sits with the responsibility of the director to ensure it gets done.”

Shorter-term goals are more rigorous and provide a more solid foundation. He added that investors can also withhold support for directors if the companies they oversee don’t begin on a journey of identifying and quantifying climate risk.

“We expect boards to provide oversight and counsel to ensure all business risk is covered,” he said. He said investors are frustrated they haven’t seen more action and linked it to poor governance.

Investors can’t control regulation, but he said CPP responds to most public consultations. On another note, he said engagement is easier than divestment. To divest, investors need to believe the company won’t respond to calls for change, and that that if they do, those responses will fail.

Manley added that investment opportunity in so-called grey assets is growing and said the pension will continue to finance the transition. He noted a shortage of potential bids on some grey assets creating an opportunity. “We have an increased conviction in the opportunity to invest in and capitalise on decarbonization.”

Manley concluded with a note on the importance of investors doing themselves what they are asking companies to do. In one initiative, CPP Investments is reducing business travel, aware that not every flight has a business rationale.

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.