Updated March 2019
Ok so I’m not going to win a prize for insight 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. That’s surprised many people, including me, but maybe it shouldn’t have. In this blog I’m going to share my wider interpretation of this theme.
The key timeline steps are pretty well known at this point: beginning with the UN Principles for Responsible Investing issued in 2006 and followed more recently by: 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).
The agenda at the recent PLSA Investment Conference was packed with ESG themes, and managers keen to talk about everything from ESG factor tilted equity funds, impact investing, renewable energy to engagement policies. All different but related angles on the same broad movement – it isn’t one single idea: ethical, environmental, impact, financial and non-financial risks are all relevant in a mosaic of potential ideas and options. This is one of the challenges of the whole area, it isn’t just one concept that you can take a yes or no view on and go ahead and implement (or not). By nature it is a knottier set of potential considerations and angles with a lot of people feeling their way through it for the first time.
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 skepticism – some of it justified, those who see this as a fad, a distraction, and those that worry about a superficial box-ticking attitude toward compliance with ESG requirements (a risk, for sure, and some will go this way, but not been my experience so far). 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”, and see the scramble to appoint heads of ESG). 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. Its also understandable – and indeed a good thing – that this has given many in the industry a stronger purpose-led focus to their work. Balancing the debate are those who highlight the many diverse risks asset-owners already face – not all of which could or should possibly be separately managed, and the need to prioritise the core investing mission.
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, 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.
It isn’t just in finance where we’re seeing this change – there’s a much wider consumer movement toward a choice for more sustainable practices and brands after all: look at the campaign to stop using plastic straws, for example, preference for electric cars, and sustainable tourism, or the sustainability focused brand message of clothing manufacturers like Patagonia or Picture. Those who think the trend in finance is a fad might reflect on the wider examples.
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 behavioural biases at work here in the past which have made the status quo hard to shift, 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 (eg consultants or managers) pointed to others as being responsible for consideration of environmental and social factors. It’s clear that’s not good enough any more – we can’t all stand there pointing at others’ saying its their job – 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. One clear challenge is that “it” is not one binary choice between clearly defined options, it is a myriad of considerations and possible approaches, so 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. In February 2019 the Church Commissioners were again vocal along with members of the Climate Action 100 Group in welcoming pledges by Gencore to align its business with the pledges of the Paris agreement and not to increase its coal production capacity.
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 maturing DB schemes who tend to invest less in equities 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. This excellent guide from Sackers provides a lot of detail on trustees duties and outlines four possible engagement models.
Universal owners, an idea whose time has come?