Features

The ESG Interview: Sticking Plasters or Sledgehammers?

Pensions for Purpose CEO Charlotte O’Leary says UK pension funds must overcome barriers to embrace impact investing opportunities.

Investment teams and trustees at UK pension funds are increasingly keen to achieve greater ‘on-the-ground’ impact through their investment strategies, says Charlotte O’Leary, CEO of Pensions for Purpose, which works with pension funds and asset managers to steer more capital toward impact investment projects. But she recognises that both parties must overcome some structural and psychological barriers to better align funds’ investments with their values.

For those frustrated by the pace of change, says O’Leary, it can feel like sticking plasters on a broken system. “Within the impact investment space, I sense a tension between taking a ‘softly, softly’ approach, and going in with a sledgehammer, because of the need to transform the way we think about this.”

Individual schemes’ investment priorities notwithstanding, regulatory developments are driving UK pension funds to incorporate ESG factors into their investment strategies on a more systematic basis, even if the new rules are not yet being policed rigorously.

The Pensions Regulator has required incremental change, asking scheme trustees to demonstrate consideration of ESG risks in their Statements of Investment Principles. The Pension Schemes Act 2021 went further, requiring schemes above £5 billion in assets to report in line with the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD), from October. The UK Department for Work and Pensions is conducting a consultation on incorporating social considerations into pension funds’ investment strategies, which closes in June.

O’Leary suggests the progress of funds in meeting these regulatory requirements is uneven, but says there is strong appetite for change.

“Many pension funds are taking the opportunity to go further. They’re saying, ‘We don’t just want to be doing the minimum on ESG, i.e. only looking at risks; we want to look at opportunities as well, and contribute to solutions’,” she says.

“We’re also seeing pension funds embed UN Sustainable Development Goals (SDGs) into their strategies. And rather looking at one part of their portfolio, they want to see how all of their investments are impacting SDGs, whether negatively or positively.”

Top-down and bottom-up

Alongside regulation, this growing appetite for impact is a response to a number of forces. While the views of beneficiaries can undoubtedly be a factor, O’Leary points to mounting external pressures on large public pension funds, for example to divest fossil fuel holdings, while company-sponsored schemes, including The Co-op Group, are revising investment policies as part of company-wide commitments to sustainable business strategies, such as net-zero emissions goals.

Heightened awareness of poor business practices, such as Boohoo’s under-payment of textile workers, and of the scope to challenge investee companies through collective investor action, via initiatives like ClimateAction100+, are also driving change. O’Leary sees a combination of top-down and bottom-up factors encouraging pension funds to look more seriously at social and environmental impact. “They see it as risk and opportunity. The other side is market risk. We know that climate risk is not priced in,” she says.

Larger pension schemes with the resources to recruit experienced, qualified ESG-literate investment teams are proactively working with asset managers and investee companies, getting to grips with new regulations and utilising new tools and techniques to define and achieve their sustainable investment objectives.

But O’Leary says the UK pension fund sector is highly fragmented, noting that many are not of sufficient size to influence investee firms or asset managers, often obliged to invest in pooled funds where their requirements can be drowned out or diluted.

“We have a lot of pension funds setting individual targets, but we need collective action. We need consolidation in all parts of the market.”

Setting the framework

Due to these resource constraints, smaller funds can struggle to secure the in-house expertise needed to understand and deploy the frameworks being developed to support and execute impact investing strategies. On the surface, there is no shortage of support. The Impact Management Project and Operating Principles for Impact Management have offered frameworks for measuring impact, while the Principles for Responsible Investment has issued guidance specific to SDGs.

But this only goes so far. The 17 SDGs and their 169 underlying targets do not map easily onto traditional measures, meaning the market has interpreted investment impact on them differently, sometimes double-counting the positive and ignoring the negative.

Rather than poring over the minutiae of impact metrics and methodologies, O’Leary says scheme trustees should take a principles-based approach, setting objectives, governance and metrics at a high level, and ensuring these are factored into selection criteria and incentives frameworks for investment consultants and asset managers. An example of this approach in action is the four Impact Investing Principles for Pensions developed by the Impact Investing Institute in partnership with Pensions for Purpose, which now runs adopter forums to support take-up of the principles.

“It is no good asking the asset owner to understand an incredibly detailed impact measurement framework,” says O’Leary. “The onus for coming up with the measurement framework should be with the investment consultants and the asset managers, but there needs to be transparency in how that’s done. That’s why we came up with a good governance framework that’s far more about rigour, in terms of how you appoint people to make sure they align with your objectives, rather than having all the answers.”

Breaking free from the past

Noting the typical length of schemes’ relationships with investment consultants, O’Leary sees this nexus as critical to achieving sustainable and impact investment objectives and advises that up-front due diligence by trustees will pay dividends in the long run. Under the auspices of the Investment Consultants Sustainability Working Group, UK consultants have taken a non-compete approach to developing minimum standards. This is “a game-changer” for pension funds, says O’Leary, who believes they have a key role in combatting several of those aforementioned barriers.

In the first instance, O’Leary suggests investment consultants can give pension schemes the confidence needed to break free from the underlying assumptions that have guided past and present practice, to achieve meaningful impact alongside the returns needed to meet their long-term liabilities. Institutional investors as a group have allocated incrementally more to alternative investment strategies in recent years, but many pension schemes remain wedded to long-established 60/40 asset allocation models.

“UK pension funds haven’t moved very far away from that traditional asset allocation. But it is something that investment consultants are tackling. Even if you put together SDG-based objectives, you can only do so much if your asset allocation strategy constrains your exposure to infrastructure or renewables, for example. You need that wider view to actually contribute to solutions,” says O’Leary.

To date, most of the appeal of the private markets sector – spanning not just equity, but also debt, real estate and infrastructure assets – stems from superior returns over the public markets, even if that argument is increasingly challenged.

From an impact perspective, O’Leary points to the greater level of control which private market funds can exert over portfolio companies, through larger ownership stakes, versus long-only funds. She concedes that private markets and pension funds might not yet be natural bedfellows, but says channels for collaboration are offering a widening array of options.

“All pension funds which aren’t looking at a buy-out in the next five years or so can look at a greater exposure to private investments. There also needs to be more collaborative effort between other types of investors, working with managers to create product. Investment consultants provide platforms as well as direct investment and co-investment programmes, but that will have to ramp up to cater for the demand,” she asserts.

Investment consultants also have a role in helping pension schemes to adapt timeless principles, such as risk diversification, to new challenges and opportunities, such as stranded assets and impact-weighted accounting principles. “There’s a lot of new thinking out there,” says O’Leary, referring to paradigm-shifting books such as ‘Beyond Modern Portfolio Theory’ by Jon Lukomnik and James Hawley or ‘Doughnut Economics’ by Kate Raworth.

Adjusting incentives

Second, O’Leary suggests investment consultants can facilitate some of the changes needed on the other side of the sustainable and impact investing eco-system. In particular, she asserts that adjustments to asset managers’ fee structures and incentives will deliver on individual client goals more effectively, but also accelerate the gradual broadening in the availability of investment solutions tailored to asset owners’ evolving priorities.

Long-established fee structures, based on AUM among long-only firms or the ‘two and 20’ rule in private markets, can and should be challenged, says O’Leary. With the advice of investment consultants, these can be replaced by a ‘balanced scorecard’ approach, whereby the manager is rewarded according to performance across a range of pre-agreed criteria.

Some impact-focused boutiques are already building impact performance into incentivization structures, she says. “But this has to be pushed by the asset owners because very few asset managers are going to be willing to take on costs and put in new processes. It has to be driven by the asset owners.”

Despite the cost, embracing new approaches can help reinforce the credibility of asset managers as they reposition themselves in a market increasingly informed by a wider mix of priorities.

“Ultimately, it comes back to objectives. If you are saying, as an asset manager, that you’re using the SDGs to report on outcomes, then that has to form part of a balanced scorecard approach when reviewing performance and fees,” she says, adding that the same principle can apply to other impact management frameworks.

Innovation and opportunity

This closer alignment between supplier incentives and client objectives may be a painful adjustment for asset management houses in the short term, but it should help them address some of the long-term challenges that have been eroding their business models for well over a decade.

O’Leary, who has worked for global fund powerhouses and more niche operators in both the traditional and alternative sectors, says it’s not surprising that active managers view ESG investing as a business opportunity. The seismic, and very likely permanent, migration of investment flows to passive vehicles, such as exchange-traded funds, leaves them little choice, she argues.

Driven by the need to differentiate, O’Leary sees evidence that asset managers are exploring the many new opportunities, citing innovations around themes such as green bonds, social housing and regional projects like the recently launched Place-Based Impact Investing Project as examples.

“It’s creating opportunity for them. You will start to see product being developed. Asset managers are talking to us about creating social impact products and working with niche providers as well to introduce social affordable housing and place-based impact investment products focused on infrastructure. It is happening, but it’s about the rate and the scale.”

The practical information hub for asset owners looking to invest successfully and sustainably for the long term. As best practice evolves, we will share the news, insights and data to guide asset owners on their individual journey to ESG integration.

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