Jo Holden, Global Head of Investment Research at Mercer, says ESG is taking a much higher priority for European asset owners.
“In terms of asset allocation, it feels like we’re on the verge of a shift.” The evidence might not yet be conclusive, but signs are growing that Europe’s asset owners are reaching a decisive point in their adoption of sustainable investment, according to Jo Holden, UK-based Global Head of Investment Research at investment consultants Mercer.
Appointed in April, one of Holden’s first tasks in her new position has been to oversee the roll-out of Mercer’s annual European Asset Allocation Insights survey, due for release shortly.
Holden says the survey won’t reveal a seismic shift toward green assets, but it will provide further indications that sustainability is increasingly front of mind for pension funds and other asset owners.
“ESG is taking a much higher priority, particularly in the UK and Europe,” she says. “But we’ve not seen a large-scale shift to ESG topping the list of asset allocation priorities. ESG figures in – but is not yet driving – asset allocation.”
This growing influence is accompanied by an increasing desire among investors to embrace ESG-defined opportunities as well as risks, implying higher capital flows to companies and projects focused on positive social and environmental outcomes. This is harder to achieve through an asset allocation strategy weighted toward assets listed in the public, rather than private markets.
The impending survey will reflect a shift toward private market assets, says Holden, but there are many underlying factors.
“We are seeing an increase to alternatives. Across Europe, the survey will show that equities are pretty much on par with the alternatives now, in terms of allocation,” she says.
“But the reasons for opting for real assets or other private markets are still driven by more traditional investment rationales, such as inflation protection or the need for income or particular levels of return,” says Holden, noting that ESG many be tipping the balance for trustees already weighing up more extensive investments in alternatives.
“ESG is one of many factors that would be considered in decision making, I just don’t necessarily think that it is the key driving factor for all investors.”
Mercer’s 2020 asset allocation survey, based on information from 927 institutional investors across 12 countries, with total assets of over €1.1 trillion, saw a sharp change, with 54% of respondents considering climate risk versus 14% the previous year. More broadly, the survey reflected a decade-long trend away from equities, largely toward alternatives, which is particularly prominent in the UK.
The 2020 survey also indicated that regulatory drivers and financial materiality were the main factors behind consideration of ESG risks, leading 88% of respondents to inclusion of ESG themes in their investment policies and 55% developing a defined set of responsible investment beliefs. Allocations to sustainability-themed investments were the exception, however, rather than the rule.
Holden says the 2021 survey may reveal the biggest shifts at the upper end of the scale by AUM. Historically, larger asset owners have had the more substantial equity asset allocations, due partly to the advantages of scale. But draft data suggests less of a difference in equity allocation based on size this year.
“That surprises me, because those very large funds are dominated by public sector or sovereign wealth funds, which historically have had more in equities. So, it is more than likely that that’s where we’re seeing the biggest increase in alternatives. Also, it is probably the larger investors making alternative allocations more heavily based on ESG reasons than their smaller counterparts,” she says.
Still taking stock
The overall picture is far from uniform, with many nuances to asset owners’ approaches to sustainable investing. Holden says defined benefit schemes considering a buy-out or close to maturity are less likely to make changes for fear of jeopardising pay-outs to beneficiaries. The UK’s defined benefit schemes were targeted this week by Make My Money Matter, the campaign co-founded by filmmaker Richard Curtis, aimed at encouraging pension schemes to support transition to a net-zero economy.
Many investors are still taking stock of the evolving regulatory environment too, says Holden.
Mercer has developed an assessment tool, RITE, for clients to benchmark their ESG performance, which will be able to provide a form of peer review in due course. “Looking at where they are, relative to peers, might move the dial in terms of affirmative action that clients might want to take,” she adds.
For further evidence of changes in investor behaviour, Holden points to developments in manager selection criteria. Once institutional investors have decided which asset classes they want to be in, ESG becomes increasingly influential.
Asset owners are probing deeper on sustainability credentials, reflecting their increasingly sophisticated understanding of the support they will require from asset managers. Holden says the ESG ratings which Mercer offers alongside investment ratings have become “a much fuller part” of clients’ due diligence. Standard questions have been replaced by a deeper dive.
“Trustees in general are a lot better read, have a much broader understanding and know the financial impacts that the answers can have. Anecdotally, we’ve seen a shift to trustees seeing ESG as a long-term risk management factor,” she says.
As an advisor to asset owners, Mercer’s own approach to scrutinising asset managers has also evolved. “The number of questions we could ask managers is infinite, so we have to think really hard about the questions that really make a difference,” Holden says.
Mercer’s analysts need to take a flexible approach, based on an accurate understanding of managers’ strategies or philosophies, to extract the most relevant information on behalf of clients, says Holden, who was previously CIO for the firm’s UK Investments & Retirement business and European Strategic Director of Research.
“It doesn’t make our job any easier, but it makes it more interesting. We’re mindful that managers should be serving our clients not answering our surveys,” she notes.
What does this more calibrated approach tell us about the ability of managers to meet the needs of an increasingly ESG-conscious asset owner client base? In short, Holden says managers that have invested time and / or other resources in their sustainability capabilities tend to stand out. That’s not to say they have all the answers for clients, particularly given the scale and urgency of the challenges.
“As an industry, we haven’t solved the data problem. There are all sorts of approximations we have to make when there are gaps. I’m sure we will collectively come to a place where there are more common standards for data,” she says.
“Particularly for those managers for which ESG hasn’t been a priority in the past, it’s a sizable challenge as asset owners, quite rightly, become much more demanding on ESG.”
Groundswell of target-setting activity
One reason for Holden’s confidence in the future of sustainable investment is the continued roll-out of regulation, such as the UK’s requirements for reporting in line with the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD), and the European Commission’s more sweeping Sustainable Finance Strategy.
Through their reporting requirements, these regulations oblige asset owners to calculate and confront the carbon emissions and other ESG risks in their portfolios, with the intention that transparency will lead to remediation. As many have observed, reporting on and reducing emissions is a larger task for smaller asset owners.
“Size isn’t always directly correlated with governance budget. But smaller to mid-sized pension schemes have a huge amount on their plate,” Holden says, suggesting that the scale of ESG-related requirements could lead to more delegation. “Whether fiduciary managers grow their assets specifically through ESG will be one to watch.”
As well as regulatory drivers, asset owners are being influenced by peer pressure. Earlier this week, RPMI Railpen became the latest large pension scheme to outline its net-zero strategy, while Zurich UK shifted almost US$1 billion of its investment portfolio to a new benchmark designed to deliver a 30% reduction in emissions and enhanced ESG performance versus its parent index.
It’s not just the big names that are taking action, says Holden. “Many of our clients are talking about net-zero targets. But if you make a net-zero commitment without a private markets portfolio, then it’s going to take time to build that up. My sense of being on the verge of a shift reflects the groundswell of clients who are starting to set targets. Even those not yet setting targets are looking to get a better understanding of their position, partly driven by regulation.”
Regulation’s role in stimulating asset owner appetite for sustainable investing shows up in Mercer’s asset allocation survey “year after year after year”, says Holden. “There is no doubt in our minds that it has driven behaviour in a positive sense”, she adds, noting in particular the role of TCFD-aligned reporting in encouraging trustees to better understand climate-related exposures.
The climate-first approach evident in many jurisdictions is of course understandable given the existential risks that drive it, but Holden acknowledges that it has often left social issues “taking a back seat” in the UK and elsewhere. “Managers are focusing their time on offering products that fit the E of ESG, but that’s not what we’re seeing elsewhere. If you look to the US, diversity and inclusion is the big issue, and if you look to Australia, it’s modern slavery,” she says, suggesting that managers with global operations may be particularly well placed to cater for the ebb and flow of demand.
“I don’t think you’d find many asset owners in the UK or Europe saying diversity and inclusion isn’t important, but you’ve got to prioritise what you’re dealing with. Global asset managers have to be all over all of the issues because of their presence in different jurisdictions.”