Written By: Pádraig Floyd
Pádraig Floyd examines how LGPS investors can best approach the question of responsible investing
You’d have to have been living on the moon to have missed the rapid advance of responsible investing (RI) in recent years. Concerns about the impact of climate change had preoccupied a sizeable minority for the past half century. But they were generally classed as hippies and idealists. But the younger generations – X to some extent, but especially Y and Z – have integrated environmental, social and governance (ESG) matters into their social psyche and ESG themes are at the heart of the zeitgeist.
As a result, things are changing, and fast. Lobbyists are having unprecedented success at influencing corporations to reassess their positions. They are winning hearts and minds of shareholders as the data continues to stack up in favour of RI and highlighting the financial risks associated with not having ESG based policies.
By September 2020, sustainable fund management in Europe had attracted more than US$1 trillion (£750 billion) in assets under management, more than five times US figures and 25 times that invested in Asia.
Ahead of the curve
It is fair to say that while the corporate world of business, finance and pensions has spent the past two years catching up with the new agenda, local authority pension funds were well versed in many of these topics.
Lobbyists and activists alike have taken advantage of the greater transparency of policy and operational matters in the LGPS environment to push their campaigns for some years. But familiarity with the subject does not automatically translate into being in control of these risks.
Corporate pension funds will be required to report on how they are approaching and managing climate change risks in line with the Taskforce for Climate-Related Financial Disclosures (TCFD) framework from later this year. And something similar is in the pipeline for the LGPS.
As far as the body with governance oversight for the LGPS, the Ministry of Housing, Communities and Local Government (MHCLG) is concerned, climate change is “a major systematic financial risk” and it has been working on a disclosure framework for local authority pension funds also.
At the Pension & Lifetime Savings Association’s local authority conference in May, Oliver Watson, a senior policy adviser with MHCLG told delegates that “a core principle [of the framework] is that the quality of the disclosure and the risk management should be as high for a local government fund as for that of a private sector counterpart.”
The requirements of TCFD disclosure cover governance, strategy, risk management, plus metrics and targets. The ministry’s framework will also require disclosures on each of these in addition to an annual report, summarising the approach the scheme has taken.
Local authority pension funds will be expected to establish and maintain oversight of the climate risks and opportunities, and demonstrate the quality of their oversight process.
The funds will also have to quantify risks in the strategy in relation to the scheme, making use of scenario analysis to identify the scheme’s exposure to climate risks.
Risk management will be required to monitor and report upon physical (from rising temperatures) and transitional risks of climate changes. Some of those transitional risks will come from moving towards a world in which carbon reduction is a primary goal.
And finally, comes the metrics – how to measure risk so it may be monitored, disclosed and mitigated.
“We’re open to feedback… on which metrics might be the most useful for LGPS funds to report and make decisions on,” says Watson. “There is, however, likely to be a requirement for a metric to show a fund’s total carbon output, as well as a carbon intensity output – which is actually a total carbon output divided by some financial metric.”
Carbon always seems to be a reasonable measure, as many organisations have been tracking it for years. But that doesn’t necessarily make it a useful benchmark.
“One of the elephants in the room is how do we measure carbon?”, says Richard Tomlinson, chief investment officer at Local Pensions Partnership. “People say enthusiastically that we can make a statement about cutting our carbon content. But how can I go about cutting it, if I don’t know what it is today?”
Tomlinson highlights the biggest problem for schemes trying to make TCFD disclosures. That there are no standards, no benchmarks, no taxonomy that can encourage funds to ensure that when they are making measurements, that they are accurate, or meaningful. Or even measuring carbon, in some cases.
In fact, there is a lack of data in general, with only a little over 50% of listed equities and bonds being captured by some ratings agencies. When it comes to other asset classes, such as property, infrastructure and private equity, the level of disclosure varies wildly.
This debate continues to rage and Tomlinson believes it will be addressed. But it will take time and won’t be resolved by the LGPS throwing money at the problem, because they are not resourced to reinvent the wheel nor have “the commercial imperative to break new ground”, he says.
“I’m a firm believer that markets innovate, and especially in asset management,” adds Tomlinson. “Solutions will start coming forward far faster when there’s money involved or where there’s a political imperative.”
All funds will be required to report under the new regime. MHCLG will not provide a grace period for smaller funds – all must comply from when it starts. But there won’t be any heavy-handed smacking of legs for those whose disclosures don’t pass muster.
“We don’t – at the moment – see it as necessary to impose a system of fines or penalties,” says Watson. “That’s because we regard local democratic accountability as being a sufficient way of fostering really good compliance.”
Making slow progress
Jill Davys, previously assistant director of investments for the West Midlands Pension Fund and now head of Redington’s LGPS service offering, says there has been a lot of work done on disclosure within equities, but bonds have lagged, particularly corporate bonds and private debt.
“Your reporting only covers a percentage of what you’ve got in public equities,” says Davys. “Some fixed income managers have been saying they are more advanced in the last two or three years and are trying to improve the level of information they can provide to institutional investors.”
The task will be difficult, however encouraging the ministry is, as the asset mix is determined by a very different set of parameters within the LGPS.
“Our context is very different from corporate schemes,” say Tomlinson, as their growth portfolio is small, if it exists at all. Their horizon is also considerably shorter, as many will be seeking derisking deals, as soon as they can get their ducks in a row.
“If you view a Gilt as a green asset, happy days,” says Tomlinson. “In our world, we’re investing for the long term. We are open, and our actuarial discount rates are anything between 4% and 5%, so we have to have a portfolio of risk assets.”
“A net zero pledge is really serious for us, as we are going to be sitting with some assets for a long time. So we have to think very carefully about that.”
Asset managers have become more attuned to these requirements and are meeting institutional investors half way. “They are being pretty innovative and building fee structures and modern vehicles that are aligned with long-term investment,” says Tomlinson. And with this they are building the reporting structures, he says, because increasingly they are becoming a hygiene factor. “Unless you can report on this stuff to the right level, with the right competencies, and the right level of disclosure, people will just say it’s a red line for us and we can’t do business with you anymore,” he adds.
Build it and they will rent
While climate has been the catalyst for the wider investment world to get on board with sustainable investing, Local authority pension funds have already been broadening their horizons to meet other objectives.
There has been an increased focus on social factors. Just look at the news section for a taste of the kinds of property funds that have a social objective or impact.
This will continue, says Karen Shackleton, founder, Pensions for Purpose, and not just within housing, which she says is “the low-hanging fruit where you can separate the investment from the impact more easily.” It won’t all be domestic, either. “We’re looking at interesting new impact funds. Also new ideas, such as private education in emerging markets, which offers some interesting opportunities.”
Impact has become an important part of the investment lexicon for many funds. Doing the right thing, or even doing a good thing is not considered a sufficient return on investment. People want to be able to show that investment has provided a financial return while improving the environment in which that money was invested.
Social housing is an excellent “best of both worlds” example. But there are limits, not least about concentration of risk if you are trying to invest in housing within your local authority, region, or, arguably, country.
But much more could be done, according to the findings of a recent white paper from The Good Economy, The Impact Investing Institute and Pensions for Purpose into place-based impact investing.
Impact investments are made with the intention of yielding suitable long-term, risk-adjusted financial returns as well as delivering a positive impact. Place-based impact investments are made with the intention of yielding suitable long-term, risk-adjusted financial returns as well as positive local impact. This addresses the needs of specific places to enhance local economic resilience, prosperity and sustainable development. It’s a palpable win/win, the report suggests.
Tree hugging that delivers results
The paper says the cost of levelling up will exceed £1 trillion over the next decade and that public investment will need to be matched by private funding. It uses the LGPS’s £326 billion fund as an example, saying that local authority pension funds could be the pioneers of this socially responsible investment by expanding its current 1% investment in ways that directly support local and regional economic development and positive place-based impact up to 5%.
The model from the white paper is for local authority pension funds to lead the charge into a new form of long-term, responsible investment in real assets and the real economy that will satisfy financial and sustainability agendas.
The obstacles are considerable, but Mark Hepworth, a director of The Good Economy and co-author of the report acknowledges that innovation is not easy, particularly in the financial arena, but there are enough who believe that this form of long-term, responsible investing is achievable, and want to do things differently.
“We need to put more pressure on the system, right through the different parts of the value chain, from local government and the institutional investor side, and then the consultants are going to start doing things slightly differently,” says Hepworth. “You can’t keep on hiding behind things like information barriers and costs of due diligence as a way of delivering an automatic ‘computer says no’ response.”
“It will be a slow process, but it needs kick starting. And it needs the likes of us all to say: Hang on a second, we can’t be forever held to ransom by a bunch of consultants.”
The genie is out of the bottle
However uncertain the LGPS may be of the financial risks posed by matters covered by the ESG umbrella, there is no going back.
Governance oversight will dictate that funds identify, monitor and explain their risks. There is no doubt that the social impact of investment is high on LAPF agendas, says Davys. Infrastructure allocations are being increased, and there is a definite preference for renewable infrastructure, where possible.
Environmental issues will continue to be a focus, but they won’t be as dominant in the future, says Karen Shackleton. “Health and wellbeing and the build back better domestic agenda as to how we can get the economy back on its feet, will be important themes.” But the debate is no longer focused on divestment, she continued. That train left the station a long time ago. “To me, divestment is the end point, not the starting point,” she says, “but it does require a new way of thinking. We always advise funds to take a step back and think about this holistically and articulate a sense of their investment beliefs that will drive the investment strategy.”