Benchmarks are highlighted in the CFA Institute paper, Net Zero in the Balance: A guide to transformational thinking as among the historical norms in finance practice that make investing in climate challenging. MSCI Institute’s Linda-Eling Lee talks to Top1000funds.com about the complexities and evolution of climate benchmarks including the use of balanced scorecard-toolkits that are improving the technology.

Benchmarks, incentives and time frames are highlighted in the CFA Institute paper, Net Zero in the Balance: A guide to transformational thinking as among the historical norms in finance practice that make investing in climate challenging.

The paper stresses the importance of mindset shifts and transformative thinking, highlighting some strategies for success, such as balanced scorecards, total portfolio thinking, universal ownership and stewardship.

In the five years to April 2023, investment in net-zero benchmarks increased from $10 billion to $100 billion, reflecting the growing alignment of investor portfolios to climate goals. This was driven in large part by the European Commission, which had set out the criteria for an official EU Paris-aligned benchmark focusing on emissions reductions. But one unintended consequence of that structure for investors was the potential for portfolios to reduce emissions on paper, while having no impact in the real world.

Linda-Eling Lee, founding director and head of the MSCI Sustainability Institute, says this remains a concern for investors, and the challenges of benchmarks and portfolio construction related to climate goals is not about performance or risk, but an ongoing determination to align portfolios to real-world outcomes.

“It’s not that hard to decarbonise your portfolio but it is difficult to see how that reflects the real economy around that,” Lee says.

“This has been a preoccupation and challenge everyone is trying to work through.”

To this end, last year MSCI developed an attribution tool and a framework to allow investors to better understand the changes in a portfolio’s carbon footprint and what was due to a company’s real world decarbonisation efforts, a portfolio manager’s investment decisions, or changes in the company’s financing.

Challenges of benchmarks

To comply with the EU focus on emissions reduction, benchmarks tend to overweight sectors such as communications, technology and healthcare, which are less material in the real world to reducing climate change. The simplicity of this approach overlooks the potential for high-emitting companies to deploy capital to low-carbon solutions, and the potential for investors to influence that transition through stewardship.

But Lee says benchmarks should be considered a tool, not a constraint.

There has already been “quite a lot of progress” in incorporating toolkits and balanced scorecard-type measures in benchmarks, she says, shifting the focus away from backward-looking data. One example is MSCI’s Climate Action Index series, which uses a balanced-scorecard approach.

“Climate benchmarks do prioritise forward-looking measures…and are about balancing the different objectives,” Lee says in an interview with Top1000funds.com.

“A lot of asset owners are moving towards variations of benchmarks and reflect quite different priorities.”

Some of this progress is related to the evolution of climate investing, from being focused on reduced emissions to a focus on transition finance.

“If you look at the newer transition-related benchmarks they use a balanced scorecard-toolkit way of looking at constructing the benchmark,” Lee says.

“In the conversations we are having, asset owners have been quite open to changes in benchmarks that incorporate these aspects. Like any technology, it will continue to get better.”

In addition, some level of standardised best practice, and groups like IIGC working with the industry on the principles of a climate or net zero aligned benchmarks, act as building blocks for index providers who can then customise to reflect different objectives and preferences of investors.

Beyond Europe

Europe’s leadership on climate investing is evidenced by the level of engagement from investors and the fact European companies are decarbonising quicker than those in other jurisdictions. MSCI data shows that 14 per cent of EU-domiciled companies are aligned to a net-zero pathway, compared with just 3 per cent outside the EU.

But Lee points out that Europe is only a small sub-set of the global conversation and, if alignment between the portfolio and the real world is the aspiration, investors also need to focus on where the decarbonisation needs to happen.

More than three quarters of the global coal-power generation capacity is in Asia Pacific, a region that also has less disclosure of transition plans by listed companies.

More than 90 per cent of large, listed companies in developed markets have disclosed their Scope 1 and 2 emissions, compared with 65 per cent in emerging markets. And about half of smaller listed companies have done the same. Transition capital flows to companies with better plans – typically, large companies in developed markets.

Lee says that both policy and capital needs to be focused on decarbonising the most impactful assets, and this will require an open mind and thinking beyond the norm – something that systems thinking can also provide, according to Roger Urwin, author of the CFA Institute report. Urwin says the features of climate risk present challenges to investors that their imaginations and toolkits have not previously tackled.

In part the problem lies in climate-focused capital chasing a dwindling number of fast-decarbonising companies, but these companies represent a smaller fraction of global greenhouse gas emissions. For example, an investment strategy designed to track a Paris-aligned benchmark must, by EU regulation, reduce average emissions by at least 7 per cent annually. This means only about one-third of the original investment universe of global companies are eligible to be included in such a strategy. And split by region, only 28 per cent of emerging markets companies are eligible compared to 62 per cent of companies in Europe.

“I worry about the movement towards more disclosure and more resourcing for disclosure,” Lee says.

“You will always have larger companies in developed markets benefit from that, and that gap is growing.”

The data challenge

The quality and volume of data has always been a concern for investors when it comes to climate. But investors need to understand that the data challenge is perennial, according to MSCI’s Lee.

“There has to be a recognition, and an embrace, of the fact that you will never get all the data you want. There is no data nirvana,” she says.

And while the amount and quality of information has improved, it is not keeping up with the demand for even more forward-looking data. The answer to that, Lee says, is for investors to look beyond company disclosures.

“I feel like in the beginning investors were asking companies for disclosure because it was a sign of transparency, but that assumes companies had the information and didn’t want to disclosure it,” she says.

“I feel like we have reached the limit of that.”

The second wave has been investors asking companies for information and data as a means, rather than the end of disclosure. This is a way of getting companies to think about their transition plans and how they can actually implement them.

“This works because it gets companies to do things that they would not normally do,” she says.

“But the disclosure itself is not that useful because it is not comparable.

“There is so much more technology and data about companies now, we can get things like asset locations and map them to different hazards or biodiversity risks. And we have the ability to model companies on emissions or water and project that forward, and this is what investors really need.

“There is a noise aspect to this data, but investors need to embrace that.”

The MSCI Sustainability Institute, which Lee founded about a year ago is driving better connections between capital market providers, academics, companies, and policy makers to help solve investors’ problems, including the need for more dynamic and more forward-looking data.

One clear initiative by the institute is bringing academics closer to the concerns of investors and focusing on the future, not on the past.

“We are trying to help them understand the real questions investors have today so academics can work on those that are relevant,” Lee says.

“Pricing and mispricing will evolve over time, and we have little information on that today.”

In helping academics solve these problems MSCI has given 300 academics licences to use all of its climate data. And just last month it launched the world’s first climate finance e-journal on SSRN, to be co-edited by Peter Tufano, Baker Foundation Professor at Harvard Business School, senior advisor to the Harvard Salata Institute for Climate and Sustainability and former Dean of the Said Business School at Oxford University.

Engagement leads to more companies introducing KPIs; corporate Scope 3 emission reporting often results in companies reporting more emissions than they have and measuring nature-related risks is extremely complex. Just some of the key take homes from Japan’s $1.7 trillion (¥245.98 trillion) Government Pension Investment Fund (GPIF) 2023 ESG Report.

As a universal owner (82.3 per cent of the portfolio is passive) GPIF is exposed to climate and biodiversity risk across the portfolio. Specific ESG strategies include a ¥17.8 trillion allocation tracking ESG indexes and ¥1.6 trillion invested in green bonds. The giant portfolio that is roughly split four ways between foreign and domestic equity and bonds.

Engagement works

The report finds that engagement has led to companies introducing more KPIs to support ESG targets. For example, GPIF found its engagement on climate change and board structure resulted in an increase in decarbonization targets and the number of independent outside directors at companies.

“Analysis revealed that active engagement by asset managers likely made substantial contributions to overall market sustainability, corporate value and investment returns or improved market beta.

We believe both asset owners and asset managers should continue their efforts to achieve more effective engagement activities,” states the report.

Problems with Scope 3

GPIF flags that Scope 3 disclosure will make it more difficult to analyse portfolio emissions over time and states that data vendors and investors tend to overestimate companies’ Scope 3 emissions, often arriving at larger figures for emissions than the companies have.

“It is important for companies to proactively disclose information to ensure that they are properly valued,” GPIF writes.

The report goes on to stress the importance of cost-effective, beneficial disclosures that are not too burdensome.

“We have a high hope for the development of ISSB and SSBJ standards.”

The ISSB standards require companies to disclose material sustainability-related information to help investors make investment decisions based on the single materiality approach.

New climate index

GPIF has moved approximately $20 billion to a new ESG-themed domestic equities index due to concerns over a “large tracking error” with  the former index, MSCI Japan ESG Select Leaders Index which was in place since 2017.

The new index, the MSCI Nihonkabu ESG Select Leaders Index aims “to reduce the risk of tracking error from TOPIX, the policy benchmark, while retaining the basic characteristic of an ESG index including stocks with a high ESG rating.”

As of March 2024, the tracking error of the former index was 2.3 per cent while that of the new index was limited to 1.2 per cent

ESG in alternatives

GPIF has a tiny allocation to alternatives, capped under 5 per cent and currently just 1.4 per cent of total AUM. However, the pension fund insists on ESG integration amongst its alternative managers where a lack of standardization adds complexity. GPIF interviews managers,  requests they answer due diligence questionnaires and uses third-party consultants.

The pension fund references the enduring challenges in measuring emissions in private equity where “only a few” private equity funds report on portfolio companies’ emissions.

GPIF estimates portfolio company emissions using the enterprise value (EV) metric, on that basis “that EV and GHG emissions have a certain degree of positive correlation in the case of listed companies.”

The estimated carbon footprint of the overall private equity allocation was 2.32 million tons in a reflection of the tiny allocation. The carbon footprint of GPIF’s entire equities portfolio was 464.03 million tons. The allocation to private equity industrials had the largest carbon footprint.

GPIF marks a 4 per cent increase in the number of funds in its real estate portfolio which participated in GRESB Real Estate Assessment and says 83 per cent of the funds in the real estate portfolio now use the framework.

Nature dependencies

GPIF documents the challenges of nature reporting and disclosure in accordance with TNFD Framework.

“We feel that measuring nature-related risks is extremely complex and that many unresolved issues remain.”

Using the TNFD, GPIF found  “materials” and “transportation” had the highest nature-related risks in terms of both dependencies and impacts on the domestic equities portfolio, while energy and food, beverage & tobacco were identified for the foreign equities portfolio.

Elsewhere the investor found that research showed that TOPIX companies that have endorsed the TNFD recommendations have better disclosure rates than those that have not.

 

In the past two years, the Future Fund has made around $70 billion worth of changes in the portfolio that its director of research and insights, Craig Thorburn, said can be traced back to stubbornly high inflation.  

The Australian sovereign wealth fund stood at A$225 billion ($149 billion) at the end of the 2024 financial year. In its latest position paper on geopolitics, it outlined its bias towards “owning inflation” as a way to mitigate risks that come with changing trade dynamics, a rise in strategic competition, and growing populism. 

These portfolio changes were made between July 2022 and the end of June in 2024 across multiple asset classes, Thorburn said, and one of the most prominent decisions was to increase gold exposure as a part of the currency mix. 

“We own two currency baskets – a developed one and an emerging market currency basket,” Thorburn told a CFA Society investment conference in Melbourne.  

“One is primarily for diversification benefits; and the other is for a little bit of that, as well as return benefits against the Aussie dollar. 

“We added gold into that mix to ensure that diversification benefit as it relates to our developed-market currency basket, so beyond only, say, US dollars or Japanese yen or euro, we also own some gold as well.” 

The fund also started incorporating commodities exposures in its portfolio, which Thorburn said has been “a material uplift…to deal with this secular inflation driver”.

Some of the changes relate to a reduction in bond exposure, as Thorburn said that asset class’s long-term diversification benefits are not as evident as they once were. The Future Fund has been reinforcing this view with various position papers since 2022, suggesting that bonds can no longer sufficiently offset the equity risks.  

“There are scenarios where we do believe that bonds can provide that diversification benefit – that’s probably in a more benign, or what I would call business cycle recession,” Thorburn said. 

“But unfortunately, there are other scenarios that are very different going forward that we are contemplating.”  

Alternatives such as hedge funds are attractive as diversifiers, which the Future Fund attributed as one of its key return drivers in the last financial year.  

“On top of that, the duration exposure that we hold is actually through assets like infrastructure and property, and we do ensure that they do have that inflation linkage,” he said.  

“In the case of property and infrastructure, one of the advantages – should it be contracted – is that you can actually get that inflation exposure through the contract. 

“It’s not enough to just own those assets. You’ve got to ensure that that inflation pass-through is actually through the contract.” 

While the changes were made in preparation of increasing geopolitical conflicts, Thorburn made it clear that the goal is not to “trade conflicts” but to position the portfolio to not only survive them but also thrive in their recovery. 

“We are not trading conflict. We are not smart enough to do that. In fact, history shows that if you try and do that, you’re probably going to destroy wealth,” he said. 

“I would argue…macro has always mattered, even when it looked like it didn’t. Geopolitics is one of those external factors that has actually mattered, but over the last 30 or so years, probably because of the Great Moderation and the great peace dividend, it looked like it didn’t. 

“But unfortunately, in our view, it [the pronounced impact of geopolitical conflicts] is back.” 

The Asia Pacific region is home to more than half the world’s population, four of the largest economies (China, Japan, India and South Korea) and Asian innovation is at the forefront of green finance and technology. The list of reasons to invest in APAC is compelling and institutional investors in the region are increasingly tapping the opportunities.

Among its benefits the region provides unparalleled diversification due to a diverse and dynamic mix of emerging and developed economies, in a landscape where Christy Tan, managing director, investment strategist, at Franklin Templeton says countries are divided by a ‘Wallace line.’

This, she says, is in marked contrast to North America or Europe which are characterised by more homogenised markets and similarities in demand for products, lifestyles, technology and even infrastructure.

“There is a huge difference in the way that opportunities and challenges present themselves across APAC even though these countries are geographically close,” she says.

Local monetary policy, specific trade flows within the region and domestic consumption patterns influence APAC equity markets in unique ways, she continues. It’s manifest in APAC equity sector weightings differing from those in the US and providing opportunities in sectors underweighted in the US like financials, consumer discretionary sectors and manufacturing.

Diversification is also evident in the different levels of income, volatility, efficiency – and ultimately returns – across the region.

“If you are looking to improve return expectations, we see most opportunities in India, Taiwan, Japan and the Philippines. If you are trying to reduce valuation multiples in the portfolio, South Korea and China are undervalued,” she says.

Elsewhere, different countries are emerging as global leaders in specific sectors like cashless payment innovation in China.

At the NZ$77.1 billion New Zealand Superannuation Fund, a passive reference portfolio split 80:20 between equities and bonds guides the Auckland-based sovereign investor’s risk-on approach. A total portfolio strategy eschews any country-level approach apart from an overweight to New Zealand where acting CIO Alex Bacchus counts the largest investments in private forestry and agriculture alongside a sizeable allocation to public markets.

However, NZ Super does run an active return strategy that strategically tilts to take positions at a country and regional level across equities, rates, currency and credit based on the team’s views of long-term fair value.

In Asia, this most recently manifest in an overweight to the Japanese yen (reduced since the yen has strengthened) that was also long Japanese equities. The strategy also played into improved governance amongst Japanese corporates where Bacchus notes regulation is pushing companies to return more money to shareholders.

“We don’t try and forecast what is going to happen in the next few months, but take positions based on our long-term view of valuations,” he says.

Michael Hasenstab, executive vice president and chief investment officer for Templeton Global Macro, also flags currency opportunities in Japan as an example of the region’s diversification. Although he is wary of Japanese fixed income because of potential upward pressure on bond yields, he argues the yen continues to stand out from a structural perspective.

“We expect the Japanese yen to potentially benefit as corporate behaviour and the labor market shift to more productive structures, reflation takes hold, monetary policy normalizes, and reshoring takes advantage of Japan’s strategic and comparative advantages.”

Another example is Thailand’s $34 billion Government Pension Fund which runs an active, top-down investment strategy that also avoids allocating to any specific country. But Man Juttijudata, senior director, strategic and tactical asset allocation who is responsible for GPF’s active investment strategy, says the region’s diversification benefits play an increasingly important role.

For example, he recently parred down the allocation to Thai equity in favour of a wider emerging market allocation.

“We try to reduce our home bias. We first stepped outside Thailand with our allocation to developed markets, but we found we still had a large domestic allocation so allocated more to emerging markets. We only have a very small allocation to Thai equity today.”

Juttijudata adds that GPF is innately comfortable stepping into India or frontier markets like Vietnam and is planning to increase private equity investment in Thailand and the Philippines.

“We are Thai, we are already risky,” he reflects. Still, he is mindful of the challenges in the region, particularly the lack of regulation around infrastructure, and most of GPF’s public and direct real estate and infrastructure investment is either in Europe or Australia.

Attractive income streams

Fixed income provides the same diversification benefits as equity or a particular currency exposure. Australia is a favourite allocation for investment grade sovereign investors on one hand. On the other, those same investors can tap into duration and yield advantages in other countries – albeit with an eye on the oftentimes lack of liquidity and the need for more hedging instruments.

Hasenstab believes that the region’s low debt levels relative to developed markets where debt burdens rose during the pandemic also make a compelling reason to invest. China and India have relatively high fiscal balances, but many other emerging Asian countries have significantly smaller deficits or possibly even surpluses – for example, the IMF projects small fiscal surpluses for Korea from next year.

This provides an opportunity for investors seeking to diversify away from markets where fundamentals may mean more shaky returns for bonds, or where there are concerns about potential supply of bonds into the markets because of large deficits, he says.

On a cautionary note, NZ Super’s Bacchus warns that economies in APAC are not immune from developed market sovereign debt and the global debt imbalance.

“Many of these countries are tied to the US dollar, and debt levels in the West can influence what happens in Asia,” he says. “It hasn’t been an issue yet, but at some point it might be.”

GDP, growth and trade

Perhaps the other standout reason to invest in APAC is the region’s growth. Although Chinese growth remains challenged, Australia, South Korea and Indonesia have demonstrated consistently high growth rates whilst countries including Singapore, Philippines and India stand out for their high variability in GDP growth.

The region is significantly more vibrant than the mature western economies, argues Hasenstab who points to IMF expectations that Asian growth will hit 5.0 per cent in 2025 compared to 2.2 per cent for the US and 1.2 per cent for the EU.

Positively, NZ Super’s Bacchus also observes the pickup in Indian growth versus China, noting how emerging market indices have now rebalanced with more exposure to India than China.

“Equity returns in China have been low compared to India which is doing amazingly well.”

Index investors are mindful of the fact APAC has a reasonably small market cap relative to its GDP, potentially limiting opportunities. However, Bacchus counters a GDP-weighted portfolio approach can face issues relating to access and liquidity, and that globalization means economies and countries will always interact to some extent.

Tan says the region’s “healthy” consumption levels make APAC economies less reliant on exports for growth. And APAC is also benefiting from reshoring and friendshoring strategies, as well as “China plus one” where some supply risk is diversified away from China. Hasenstab argues the integration of supply chains leads to greater exports, but also “drives fixed investments in facilities as well.”

He cites Malaysia as an example of being well positioned to benefit from reshoring trends in another nod to the region’s extraordinary variety. “Malaysia is marketing itself as a neutral player geopolitically, hoping to continue to attract investment both from China and from the western-aligned bloc,” he concludes.

Published in partnership with Franklin Templeton Investments

Texas Teachers records the highest quarterly return in its 85-year history – 333 basis points of alpha – with US and Indian equities fuelling the excess return. Known for its active management the fund has made a number of recent changes to the portfolio including removing China and reducing allocations to private equity.

The Teacher Retirement System of Texas (TRS) the $203.7 billion Austin-based pension fund  posted the highest alpha in its 85-year history in the second quarter of 2024, ending the quarter with a 1-year return of 9 per cent and +333 basis points of excess returns.

“Morale is quite high,” said chief investment officer Jase Auby, speaking during the fund’s mid-September investment committee meeting.

The strong one-year market returns at the pension fund have been supported by US equities, the largest asset class in the fund and accounting for 21.2 per cent of the return. Returns in Indian equities have also driven performance.

“India continues to outperform and is the top performing major equity market for the past year and all the 2020s,” said Auby.

He added that in contrast to India, China has performed badly in recent years.

TRS only has a half weighting to China in its emerging market benchmark and the fund’s new asset allocation removes China in totality. Although the public equity benchmark allocation is zero, TRS’s active strategies are able to make out-of-benchmark allocations to China although these exposures are small.

Auby said it is still unclear whether the US will enter a recession. One indicator that suggests it could is unemployment levels. The Sahm Rule, highly predictive of recession, was triggered last month by nonfarm payrolls. However, he countered that one of the reasons recession has been forestalled so far is the strength of the US consumer, indicative in strong retail sales.

“The US consumer continues to spend with surplus funds got through covid to power the economy,” he said.

New strategic asset allocation

The TRS board recently approved a new strategic asset allocation at the fund that aims to increase resilience to potential financial market shifts. Headline changes in the new SAA, conducted every five years, include lowering the target to private equity to 12 per cent from 14 per cent.

TRS will also shift some allocations in the global equity and stable value portfolios within its diversification framework, as well as reduce the allocation to the risk parity portfolio.

Elsewhere the fund has created a new 6 per cent allocation to inflation-linked bonds within the government bonds sleeve to both reduce duration and sensitivity to inflation. The asset allocation to nominal government bonds will be cut from 16 per cent to 10 per cent.

An eye on corporate earnings

Auby explained how corporate earnings –  a company’s net income after tax  – and often referred to as the bottom line, offer one of the most important indications of stock market growth or decline ahead.

The reason that the US stock market continues to outperform all other regions is strong corporate earnings. Although earnings declined during the pandemic the market is now predicting double digit earnings for US corporates at this time. He said that European indices have underperformed because corporate earnings are lower compared to other regions.

US outperformance is due to America’s booming tech sector, and the fact the US has the highest concentration of tech companies reporting strong earnings compared to any other region.

“Nvidia contributed 2.1 per cent of the total 10 per cent earnings growth over the last year for the S&P 500,” he said, referencing the star performer whose earnings analysts now view with as much importance as economic data.

TRS incorporates earnings into its equity strategy in a number of different ways.

In depth fundamental research finds companies set to beat earnings growth to tap excess alpha. Other strategies include quality analysis that brackets companies according to the quality of their earnings in different buckets.

“If you invest in the quality factor you are investing in the best and it gives you the highest return,” said Auby. “Quality is a statistical measure of earnings stability, strength of balance sheet and those higher profit margins; three things shown over time to outperform market.”

Natural capital holds more risk and opportunity than climate change, but where do investors start? Top1000funds.com takes a deep dive exploring the investors that are making inroads to nature-proofing their portfolios.

Natural capital, the store of the world’s natural resources spanning soil to flora, fauna and minerals underpins the global economy providing the world’s food, medicines and built environment. Investors are waking up to the systemic risk and opportunity in its rapid depletion that has the potential to be even bigger than catastrophic climate change. But many struggle with where to start nature-proofing their portfolios.

Getting started

Don’t view natural capital as an asset class, says Brian Kernohan, chief sustainability officer at Manulife Investment Management. The global asset manager, which traces its first investment in timber and agriculture back 40 years, approaches nature on a spectrum that places climate investments alongside traditional inflation-proof real assets and less familiar investments in the circular economy.

“Don’t think about that spectrum as defined buckets, think of it as a wide range of opportunities. A spectrum gives the ability to be creative and build strategies in a blended approach,” he says, using investments like wooden buildings that combine real estate and the circular economy as an example.

The other essential ingredient to getting started is stewardship.

“Investing in nature involves active management to conserve the asset and ensure it persists,” he explains.

Some asset owners are grasping with the concept of a spectrum and blending approach. They are steeling for a wave of nature-related investment products to hit public markets and are exploring bespoke mandates with managers. Examples of other points on the spectrum they are comfortable with include low risk blue and green bonds issued by development banks.

But they struggle to conceive how they can integrate and scale nature investments outside obvious real assets.

Take AP7, the SEK1.3 trillion Swedish buffer fund, which recently got the green light to invest more in illiquid assets. Johan Florén, head of ESG says the fund will develop its allocation to nature in this corner of the portfolio rather than its SEK1.2 trillion equity holdings.

“Illiquids have the best opportunities if you want to contribute,” he says.

Manulife Investment Management’s Kernohan believes one solution lies in supply chain analysis. It’s an area Brightwell, asset manager for the £46.9 billion BT Pension Scheme which has just begun exploring how to integrate nature as part of its thinking on climate and net zero goals also believes is a significant part of the puzzle.

“Supply chains could potentially unlock 80-90 per cent of the nature risk within a portfolio as well as shine light on other sustainability issues such as modern slavery and climate emissions,” says Emma Douglas, who leads on Brightwell’s sustainable investment and stewardship activities.

But accessing corporate supply chain data is a huge task. Douglas believes many corporates still don’t have full transparency of their own supply chains and have only just got to grips with climate reporting; progress in private equity is even slower.

Investors also need systemic processes to analyse supply chain risk.

But the wheels of change are starting to turn. In 2023, AP7 reported on biodiversity across its portfolio for the first time using the Taskforce on Nature-related Financial Disclosures (TNFD) disclosure recommendations, pulling what data it could from the 3,000 companies in its portfolio in a top-down approach that revealed high risk in every sector. Florén is also ploughing his energy into corporate engagement via investor-led group Nature 100+ to push companies to report in line with the recommendations.

He is convinced that although TNFD reporting is still voluntary it will trickle down into corporate reporting standards and is likely to be incorporated into EU legislation in the future. Kernohan also believes companies will increasingly use natural capital accounting methods alongside financial accounting to understand the impact and dependencies on nature.

He says the need to measure nature in the same way that investors have come to measure emissions is perhaps the most important lesson the industry has garnered from climate investment.

“We know we can’t manage what we can’t measure. Climate and carbon have taught us we need an accounting system of the thing we are trying to manage,” says Kernohan.

A different playbook to climate

But commentators also stress important differences between nature and climate investment.

Integrating climate into investment strategies involves reducing one key global metric (carbon) but biodiversity risk is local and involves multiple metrics.

For this reason, and in another distinction from climate, Douglas believes investors in nature should not jump to attach targets before deepening their understanding.

“The metric and target approach investors have adopted to reduce portfolio emissions needs to be adapted to nature but shouldn’t be the first port of call,” she says.

Too narrow targets set too early on could just create more problems, she continues, particularly if investors don’t collaborate with academics. For example, optimising on one (tree planting) could trigger negative consequences (forest monocultures with a negative externality for the local ecosystem) elsewhere.

“If you destroy an existing habitat by planting trees, are you adding to anything?” she asks. Targets can encourage divestment and put a strait jacket on progress, and she also questions investors’ ability to achieve some of the targets they set. “Is it even possible to have a portfolio that is free from modern slavery?”

Putting a price on nature

But for all the distinctions between nature and climate investment, just as in climate, investors will never integrate nature into their portfolios at scale if it equates to lower returns.

The problem is that biodiversity loss is still taken for granted. Valuing nature to a point where the market prices it into a risk adjusted return, coming up with a value proposition for flora and fauna or peat land for example, still feels years away.

Rather than wait for the world to try and solve this complex problem, Kernohan suggests investors put capital to work in one tangible project at a time. This way they can tick off low hanging fruit and find opportunities with real and immediate impact.

Witness how mangrove wetlands on a coastline provide protection from storm surges and hurricanes, he suggests. “You can value mangroves that come with their own biodiversity as a trade off against the catastrophic loss caused by a hurricane. What is the price we incurred by not having nature protect us?”

He is also encouraged by progress in the carbon market where a forest can now be managed for wood and paper outputs, or as a carbon store. “Three years ago, carbon wasn’t valued highly enough to compete as an investment, but this has now changed,” he says.

In another example, the UK government’s high-profile dispute with global investors about the value of water suggests that pricing nature is finally climbing the political agenda.

Investors including C$133 billion Ontario Municipal Employees Retirement System (OMERS) and £75 billion British Universities Superannuation Scheme (USS) cut their losses in troubled UK water utility Thames Water because of demands from Britain’s regulatory authority, OfWat, that they reduce their returns below the cost of capital.

It’s a similar story in Sweden, where Florén argues investors can’t make enough profit because Swedish regulation decrees water infrastructure can only be self-financing. Meanwhile, waste and over-consumption increase because water is cheap.

“The population is not used to paying for water,” he says. “When things are free there is too little investment and over consumption. If there is no financial interest, problems are difficult to solve, and this is also visible in the tragedy of the commons.”

Regulatory risk

The issue reveals how regulatory risk is now a key risk for investors in natural capital. USS recently said its losses in Thames water have shaped its approach to other regulated utilities, calling on the government to recognise the need for investment, and strike a fair balance between risk and returns over the long term.

Moreover, because the concept of investing in nature is new, regulatory frameworks are bound to evolve and change. As the EV sector shows, regulatory course corrections are inherent at the intersection of government and new sectors and concepts, says Manulife Investment Management’s Kernohan.

“Investors will have to consider the risks that the government introduces in the way they manage the regulation,” he says.

Yet in a Catch-22, regulation is also essential: the market won’t find a value for nature without it.

In some ways the regulatory landscape is starting to evolve. AP7’s Florén welcomes the EU ETS, the world’s first carbon market, and notices a new regulatory impetus coming out of Europe from tree planting to river restoration.

Other investors agree.

“If governments send the right signal, the market will respond,” says Douglas, who stresses regulators should incentivise not punish.

Regulation, says Kernohan, could involve policymakers taking stock of natural capital at a government level to understand if it is increasing or decreasing.

“Perhaps they could do it in the same way as they measure GDP,” he concludes, reflecting on what the future could look like.

“Governments could create a metric that is an indicator of natural capital wealth and allows it to track natural capital. Natural capital underpins economies, but it has become an externality and an input to growth whereby nature actually declines at the expense of a single financial metric, GDP.”