As demand for investments in the private market continues to grow, there is ever-increasing interest in considering ESG factors to promote greater transparency, for better risk management, and to aim to deliver long-term value
In this article we look at how long-term investors can incorporate ESG analysis to optimise portfolio risk within secure income assets - infrastructure debt, private corporate debt and real estate debt. We also offer real-world examples and consider future developments in this exciting and under-explored area.
Private credit and equity versus public markets: key differences
Through their voting rights, equity investors can influence company policy, operations and decisions. As owners, they have a degree of influence over the day-to-day management of their assets.
In our real assets business, our UK real estate equity portfolio has become a market leader by placing sustainability and ESG as a core part of our asset and investment management process. We have achieved this through setting ambitious environmental, climate and social targets to improve the operational efficiency of our assets and promoting the social value of the communities where our assets are based.
But for secure income assets, also known as private credit, investors' influence is limited by virtue of being a creditor (lender) rather than a shareholder (or owner). These debt investments tend to have a long time horizon - often of ten years or more - while their more illiquid nature means that exiting them before the intended time horizon can be difficult.
As a result, we believe it is just as crucial for secure income investors to assess a company or project's ESG credentials as part of their investment process to ensure that they are comfortable with such long-term exposures.
ESG integration in practice
We seek to ensure the E, S and G are fully considered as part of the wider decision-making process with regard to all investments in private credit. We do this by taking both a top-down and bottom-up approach to assessing ESG risks, which enables us to mitigate downside risks on financial performance.
We analyse long-term ESG trends and their implications for the markets in which we operate; the findings inform our views on sector allocation and asset selection. We also conduct ESG assessments of individual assets, analysing performance against key metrics to flag and address potential risks - and highlight opportunities - by identifying the issues that are, in our view, the most material to our assets across the investment lifecycle.
This approach is reflected in five key steps outlined in the chart below.
Looking ahead, we believe there are plenty of reasons to be excited about opportunities for investments with strong ESG profiles in private credit and to have real world impact.
As renewable energy becomes a greater proportion of our energy mix, it continues to attract support from the government and from private investors. With increasingly ambitious climate change targets, the number and scale of projects has been increasing.
We have lent to three of the world's largest offshore wind farms, which together produce enough energy to power more than two million UK households, and we have funded a collection of solar projects.1 We expect wind and solar projects to remain an important part of our pipeline. Looking further ahead, as our energy system continues to decarbonise, we expect more opportunities to invest in next-generation clean infrastructure such as hydrogen networks and heat pumps.
Social - affordable housing
The UK continues to suffer from a shortage of affordable housing, with 1.3 million households on local authority waiting lists. Private capital will play a key role in ensuring this gap is closed. For example, we recently made a £100m long-term loan to Bromford Housing Group, the largest provider of affordable homes across Central and South West England.
As a strategic partner of Homes England, Bromford has a key part to play in providing social and affordable housing; this partnership should be able to deliver 12,000 new affordable homes by 2028. These homes will serve the communities in which Bromford operates, as well as delivering both real economic growth and social value for the UK.
In addition to more visible clean-energy projects, such as wind turbines and solar panels, we are also looking for opportunities in interconnectors and Offshore Transmission Owners (OFTOs). These are key parts of the system for transmitting the energy back to homes and businesses, and to different countries. Renewable energy output is less predictable than fossil fuels, and interconnectors enable countries to import power to maintain a constant supply and create the greenest, most cost-efficient energy mix possible.
We see this area as a potential opportunity, as these projects tend to be large in scale and international in reach, requiring financing from a broad base of banks and institutional investors. What's more, the assets are a crucial element in bringing low-carbon energy to life; the technology is already established, the need to integrate new energy projects is growing and the infrastructure will be in place for many years to come.
What does the future hold in store?
The quantity and quality of ESG data available to investors in public markets has multiplied over recent years. In private credit, that journey is just beginning. Due to the diverse nature of the asset class, there is currently no market standard for ESG management and disclosure.
We are championing several initiatives, working with industry bodies and borrowers to improve the comparability of datasets and consistency of reporting. For example, in the UK, 1.6 million households, accounting for 3.8 million people, are in need of social housing, which is 500,000 more than recorded on official waiting lists, according to the National Housing Federation. To promote greater disclosure and more transparent ESG standards in the UK social housing sector, we have been involved in the development of an industry-wide framework, the new Sustainability Reporting Standard for the social housing sector, which was launched at the beginning of November 2020.
We are also committed to a number of recognised reporting frameworks and guidelines, including the UN Principles for Responsible Investment, the Task Force on Climate Related Financial Disclosure, the Paris Agreement on Climate Change and the Social Value Portal.
In addition, we anticipate greater focus across the industry on the economic and societal implications of climate change. At LGIM Real Assets, we have set an ambitious commitment to achieve a net-zero carbon target in our real estate equity portfolio by 2050.
By supporting transparency, data availability and disclosures, we aim to improve ESG standards across the private credit market. This should facilitate further qualitative and quantitative ESG analysis of the asset class, leading to better and more sustainable outcomes for investors, in our view.
As the world faces multiple crises - from the pandemic to climate change - we believe that now more than ever before is the time for responsible investing.
Rather than being an obstacle, the private nature of secure income assets means that many are naturally aligned with ESG objectives by virtue of their purpose and function, from clean energy to social housing.
Shuen Chan is head of ESG at LGIM Real Assets
1 Source: LGIM Real Assets, 2020. Please note, these assets are examples of investments that our real assets teams made, and may not be held by LGIM in the future.
Important Information: Past performance is no guarantee of future results. The value of an investment and any income taken from it is not guaranteed and can go down as well as up, you may not get back the amount you originally invested. Views expressed are of LGIM as at December 2020. The Information in this document (a) is for information purposes only and we are not soliciting any action based on it, and (b) is not a recommendation to buy or sell securities or pursue a particular investment strategy; and (c) is not investment, legal, regulatory or tax advice. Legal & General Investment Management Limited. Registered in England and Wales No. 02091894. Registered Office: One Coleman Street, London, EC2R 5AA. Authorised and regulated by the Financial Conduct Authority, No. 119272.