Portfolios constructed using a cashflow-driven approach can prove to be a good fit for meeting ESG regulatory requirements and mitigating risk, says David Curtis.
The launch of the government's Green Finance Strategy has pushed ESG up trustees' agendas and, from 2020, trustees will need to report in line with the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD).
Across the board, the focus on environmental and impact issues has ramped up. Most agree that institutional investors have a key role to play in developing a sophisticated investment response to ESG-related risks - without compromising returns or increasing risk.
Against this backdrop, the bar has already been raised for pension schemes to re-evaluate the scope of financial considerations deemed material, including - but not limited to - ESG factors.
To date, many schemes might have associated ESG with screening, while viewing seemingly non-financial decisions as drive by values rather than valuation. But, from October, trustees will have to evidence how they are factoring ESG risks and stewardship - how they engage with investee firms and exercise voting rights - into their investment decision making.
Thinking long term
From a purely practical perspective, as we near the 1 October deadline, many trustees will be considering how to meet new reporting requirements, which are only set to get tougher once TCFD guidelines gain a statutory footing next year.
With many schemes taking a strategic view on how to deliver programmatic cashflows over the next 30 years, it is only natural for schemes to question how to both integrate and report on ESG factors. Trustees must think long-term about both the structural shifts and more idiosyncratic corporate events impacting asset values and, ultimately, threatening the sustainability of pension payments. ESG investing is no different; put simply, taking a view on ESG risks is not a philosophical decision, but part and parcel of good investing.
The long-term nature of cashflow-driven investments (CDI) lends itself to the adoption of ESG considerations, providing a practical solution to demonstrating an ESG approach. Through CDI, trustees can meet their regulatory requirements while delivering long-term income streams via credit investing.
CDI portfolios are typically characterised by low portfolio turnover and constructed on the basis of a long-term investment horizon. This underscores the need to consider ESG factors during the initial credit selection process of a CDI strategy. In sterling-denominated credit, almost 30% of the market is accounted for by the top 20 issuers. This leaves schemes particularly exposed to idiosyncratic corporate events, making engagement and ESG monitoring even more important.
Integration via CDI
In long-duration portfolios such as those constructed under a CDI strategy, it's almost inevitable that schemes will take on some utility exposure. Aside from divesting the sector from the portfolio, investment managers have the opportunity to assess issuers within the sector on their ESG credentials and look at which are best equipped to transition to a low-carbon economy.
Third-party data can be a useful input to our view of issuers' ESG credentials but should be regarded as just one factor in both the decision to invest and ongoing oversight. For issuers in the utilities sector, for example, assessment of long-term ESG risks should consider not only what the issuer's current exposure to coal is, but also factor in the regulatory context and potential physical climate risks to utility infrastructure, including flooding and fires, relative to the broader valuation.
When investors think about climate and environmental risks, many automatically think of oil, energy and utilities. However, unidentified risks of unethical business practices and poor governance - such as misstatement of financials - also face all issuers' long-term fundamentals. Conversely, greater reliance on sustainable sources of energy may deem an issuer less vulnerable to sharp swings in fossil fuel prices or future regulatory requirements that curb use of these energy sources.
Our clients are often surprised by the acute risks that climate change presents to issuers in the financial sector. Banks and insurance companies' risk models may not be adjusting relative to the changing environment and the risks of stranded assets, an area that will be examined by upcoming ‘green stress testing'. Ultimately, the approaches to ESG and credit risks are part of the same fundamental analysis.
As trustees consider how they are going to meet a rising regulatory bar on ESG, CDI portfolios can help schemes formalise their approach, mitigate risks and maximise investment opportunities.
David Curtis is head of UK institutional business at Goldman Sachs Asset Management
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