Universal Owners: A New Culture of Weighing Externalities?

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Ok so there aren’t any prizes here in 2019 for observing that consideration of ESG (Environment, Social and Governance factors) has become a big theme in the institutional investment space in the UK, the theme has been around for a number of years but has really gathered momentum in the last 12 months placing it front and centre of many trustee board conversations.

Many an asset manager conference presentation has detailed the key catalysts and steps on that road so far (IPCC 2017 report, environment agency letter to the UK’s 25 largest pension schemes and subsequent replies, adoption of climate risks into guidance from The Pensions Regulator). A UK government consultation took place in 2018, with the resulting paper “Clarifying and Strengthening Investment Duties”. which will require the trustees of many schemes to make a written statement on their approach to sustainable investments. A good summary of current, historical and future regulation can be found in this paper from the Pensions Policy Institute (PPI).

What is a Universal Owner?

Roger Urwin writing for the Thinking Ahead Institute says:

Universal Owners are investors who own the externalities associated with their portfolio companies, their response being to manage the value AND utility of members’ wealth by addressing financial and non-financial considerations with both “within-the-system and change-the-system” actions.

Source: Thinking Ahead Institute Asset Owner 100 Survey 2018

There are three avenues that Universal Owners may take to manage the risks associated with such externalities: active ownership, seeking to influence public policy and using an investment strategy influenced by ESG considerations.

Now there is some scepticism – some of it justified, and those that worry about a superficial box-ticking attitude toward compliance with ESG requirements. And it has been amusing to see some of the virtue-signalling going on from the asset management community (interesting to hear how many asset managers have discovered that ESG is “in their DNA”). But equally some assessments of ESG risks have genuinely been integrated into the way managers invest for a while, without being highlighted as such, especially those that relate to financial risks.

I think the bigger picture can be understood by considering the larger context of the social compact for how asset owners weigh the externalities associated with their investment  alongside things like risk and return when they make investment decisions. And this is where the concept of Universal Owners comes in. Externalities is an economics term for things that impose a cost or benefit on someone who did not choose to incurr that cost or benefit. A key consideration is that these are not always or often accurately reflected in market prices – pollution of the environment is a very obvious one. Sometimes regulation can nudge or lead a change in social conscience but more often than not it reflects it (or somewhere between the two) and I think that is what we have been seeing.

It is certainly a difficult job for the fiduciaries of large asset pools with many beneficiaries to appropriately weigh different considerations in order to determine how to invest. Until recently I’m not sure the social compact in the UK really supported giving serious weight to non-financial externalities when making investment decisions. It arguably had in some other countries such as the Netherlands or Nordics but that is a classic reflection of different cultures (I never felt it was quite right to say that the Netherlands was “ahead of the UK” on ESG, just that it’s culture set a different context for asset owners to incorporate into portfolios). This recent study from Maastricht University provides an excellent example of this through a field survey of >3,000 (Dutch) members of a pension fund, where real investment decisions were on the line the study showed 67% individuals favored more sustainable investments, even when other factors such as expected returns, political inclination and income level were controlled for and factors such as investment beliefs, information and confusion were ruled out. More of this sort of work might be the way forward in allowing Universal Owners to gauge the true preferences of their underlying members,

I think it is fair to say that has now shifted in the UK and there is a fascinating debate to be had around how these externalities such as effect on the environment or society should be factored in. I think to really put our finger on the issue here we should focus on non-financial externalities as anything that has a direct financial impact should really be factored anyway into a raw financial evaluation, and there’s no need for a big debate about it.

There have certainly been a few behavioral biases at work here in the past, which rightly need to be ended: for example for many years I think there has been a kind of “social loafing” where many people in the “value chain” delivering institutional investment solutions pointed to others as being responsible for consideration of environmental and social factors. It’s clear that’s not good enough any more and that ultimate responsibility ought to rest with the Asset Owner but there is the clear expectation that their investment consultant will be able to offer relevant advice and their asset managers will be forthcoming as to their approach with regard to ESG factors.

It is early days in how these factors will be weighed and I think these issues sit at the investment belief and principle level for many, which means that different groups of decision makers will need to articulate their beliefs and form their own principles. Hardest of all I think is where the rubber hits the road for defined benefit trustees where they are tasked with delivering fixed benefits. Here there will be very specific choices between investments and, for example, investment in a renewal energy project that later delivers poor returns and leaves the fund short of money to pay benefits is unlikely to be viewed favourably by beneficiaries despite the positive environmental impact. Decision makers will be using “new muscles” in processing and enacting these decisions so its understandable it will feel alien and the there’s a lot to be worked out.

One early example of Universal Owners in action were the successful shareholder resolutions put forward by the New York in late 2018 Pensions Fund and the Church of England endowment which were successful in pressuring Exxon Mobil to disclose greenhouse gas reduction targets.

Various initiatives are coming to the fore to support this trend – the announcement of the Founding Members of the Climate Investing Leadership Initiative  including asset owners such as AXA, Macquarie, HSBC and The Government Investment Fund of Japan is a clear step toward the concept of Universal Owners becoming mainstream. My own experience suggests that in practice the difficulty of getting investment into sustainable projects can be as much on the supply side (the supply of suitable assets) than on the demand side (encouraging investors to invest). I have seen examples of plenty of appetite from investors, but a lack of capacity or ability to deploy assets and return levels that compensate for the risk – after all investors still ought to demand a reasonable return from sustainable projects. Often too much demand to invest in a fixed number of projects – particularly investment interest from leveraged players – can drive down returns below what is reasonable. I think this is a key challenge going forward, as much as making the case to investors as to why they should look at such projects.

One of the most visible initiatives so far has involved launching ESG or sustainability focused factor equity funds for example by Schroders  and LGIM which are often aimed at DC pension schemes, but this isn’t always the case as the collaboration between Merseyside Pension Fund and State Street to invest £400m of the DB scheme’s £9bn of assets in a sustainable equity fund shows.

There is also thinking to be done on how ESG principles apply beyond the traditional long-only equity focused world. Equities is in some ways the easiest to understand and apply, and there are more common standards, but for DB schemes often the least helpful. Thinking needs to be done on how this applies to fixed income, derivatives and absolute return strategies. Examples like this from Muzinich are encouraging. In many ways debt investors who might regularly underwrite large chunks of a company’s ongoing financing are in as good or perhaps better position to influence policy than equity holders. There is plenty of thought leadership available on impact investments (one angle on ESG) from organisations including Pensions For Purpose.

It leaves a significant role for advisers in helping clients to articulate their beliefs, turn them into actionable principles that can actually be brought to bear on real-life tough decisions. This will certainly be a must-have capability for investment consultants from 2019 onwards, and the onus is also on asset managers to demonstrate clearly how ESG considerations are fitting into their investment process.

Universal owners, an idea whose time has come?

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