Hilkka Komulainen: This is the year we are moving from thinking about target setting to implementation in responsible investing targets, after two years of discussion around climate change.
We've seen a lot of the so-called ‘ESG’ funds that have allocated more to the low carbon Scope 1 and 2 sectors – such as tech – not perform as well as oil prices increase. For the industry, this is an opportunity to rethink what we’re trying to do and the tools we’re using to do it. We're seeing investors move towards a better understanding of the levers they have access to that can mitigate risks like climate change and how different fund strategies relate to it.
"There are upcoming US, UK, and European elections,
which may impact responsible investment including."
For our portfolio, we have to think about various sustainability risks systemically; we're not going to be able to divest our way out of climate risk by making smaller changes in terms of owning this fund versus that fund. We invest through asset managers, and the more focus on climate strategies in the conversation between us owners and managers is one trend I see continuing.
A second trend is that, at the end of 2023 the UK Asset Owners Stewardship Review was published, which demonstrated that there were discrepancies between the stewardship preferences of asset owners and the practice of asset managers – how they were stewarding assets and assessing the sustainability and the prospects of a company, for example. These issues are coming to the fore now.
Finally, there is also the focus on 2024 being a big election year. There are upcoming US, UK, and European elections, which may have significant impacts on responsible investment including through prospective impacts on climate policy and regulation. As investors think through their climate targets, the understanding that you need a supportive policy and regulatory environment to be able to mitigate systemic, risks such as climate change, is also becoming more important.
Hilkka: New topics and understanding of the economic-wide impacts are changing the focus. Investors are talking not just about climate but more about nature risk, biodiversity loss, and the consequences on these areas if we continue on current trajectories.
For passive investors, this means thinking about what levers you have available to mitigate these risks. More people are thinking through the question of, ‘What does a good passive climate strategy look like?’.
Most of the market has implemented ESG tilts and screens in passives. For companies like ours, this means that we’ve divested from a handful of companies based on our screens, and we've shifted away from companies that have lower ESG scores compared to their peers or are in more emissions-intensive sectors.
"There are opportunities around primary debt issuance and targeted
investments into the climate transition in private markets."
We realise this is only going to take us so far in understanding and navigating market-wide sustainability risks. It’ll mean rethinking what ESG looks like in ‘passive’ investing.
In terms of active equities, ESG has been a helpful angle for some active equity funds, which are also being examined on the real-world outcomes of their climate strategies. For example, the questions that arise are around the data points that are relevant: how much the company emitted last year on the basis of its Scope 1 or 2 backwards-looking carbon footprint compared to its future trajectories and preparedness for a low-carbon transition. More broadly, there are opportunities around primary debt issuance and targeted investments into the climate transition in private markets, as well as targeted engagement.
Keeping track of the effectiveness of ESG strategies to address portfolio-wide sustainability goals is becoming more challenging. We're seeing a shift toward ensuring that the companies we invest in, the fund managers that we work with, and/or the vehicles they invest in, are prepared to address future challenges – which include the net zero transition, a world where we will likely see increased physical climate risk, and a broad range of impacts due to the effects of climate change on complex supply chains.
This means we must focus on how we make those business models more sustainable and protect the assets we invest on behalf of beneficiaries or shareholders.
Hilkka: We’ve been tackling an energy crisis – which is forcing us to reconsider what we’re trying to do with responsible investing. We’re no longer in the phase where any fund that has ‘ESG’ in its name is a good thing without understanding the fund strategy and its role in an investor’s portfolio. The investment industry has to work harder to consider its actions because we realise that oil and gas are still a key part of the energy mix, and the transition needs to be orderly and carefully managed.
We need to think in a more nuanced way and understand the challenges and dependencies we have as investors. A couple of years ago, a lot of organisations jumped on the net zero target bandwagon and said, “we want to be part of the change” and the industry has been wonderfully ambitious and optimistic about that. I’d like to commend the industry for doing that, but, at the same time, we need to be much more realistic about how we're going to deliver on the targets set.
We know that we need a lot more private investment to support the climate transition, and there will be investment opportunities in the transition and climate solutions. For us, though, climate solutions will need to continue to develop, scale, and adapt as we go.
Hilkka: The real impact of sustainability challenges on future investment returns is still poorly understood – for example, the impact of climate risk under various scenarios of warming potential and what it means for investment portfolios.
"Yes, we're starting to see more models, but while the industry thrives
on data, the data is still often poor."
This highlights the importance of data and modelling. There has been extensive debate and critique of climate scenarios and models available in the industry, and they’re still not hugely decision-useful, so I would say that their real impact hasn’t yet sunk in. Yes, we're starting to see more models, but while the industry thrives on data, the data is still often poor.
There are opportunities and a lot of effort put into improving the data – such as working to understand the scale of the impact, but the same thing applies to the impact of biodiversity loss and nature degradation, which is even less understood because the measurement, data, and reporting is in its infancy. As part of the effort to combat this lag, we’re seeing the first entities do their Taskforce on Nature-related Financial Disclosures (TNFD) reporting after the TNFD framework launched last year.
Investors are now using different tools to assess and combat risks, which means a subsequent mindset change. For instance, a responsible investor allocates to ESG funds, puts in place exclusions, does TCFD reporting, and votes and engages with companies.
We need to be more authentic about the role each one of these elements plays in understanding how to mitigate portfolio risks and delivering good outcomes.
Hilkka: We have a terminology crisis, yes. The politicisation of terms – such as ESG, responsible investment, and sustainability – and what people associate with them varies significantly depending on the investor, especially when considering regional differences. One clear example is the UK and Europe versus the US.
In my view, this signals a need to return to what ESG means for what we want to achieve, as part of a commitment to supporting long-term customer and shareholder outcomes. Before anything else, fiduciary duty is key. The Financial Markets Law Committee recently published its paper on fiduciary duty and climate change, which offers firm views on the role of sustainability topics as financial factors. Just because models aren’t yet solid enough or data isn’t fully waterproof, doesn’t mean that you can ignore sustainability risks like climate change. That is part of fiduciary duty.
Hilkka: Our UK regulators have been forward-looking in their implementation of a lot of the ESG rules, particularly around reporting. Much of this change began with asset owners and the pensions industry – for example, the Department of Work and Pensions (DWP) – proceeding with their TCFD reporting rules before other parts of the market.
We're still in the embedding phase. For Aegon– as we have a mastertrust in the pensions space – this includes us and those doing TCFD reporting are now coming to their third year. For other parts of the industry, they have just completed their first year, which means that more people are thinking about how to make these processes meaningful and whether in some areas we’re reporting for the sake of reporting, which won’t be beneficial.
"As investors we continue to need more data and transparency
focused on the outcomes."
The UK stewardship regulators have just launched their review of stewardship reporting at the end of February and since the last review in 2019, five years ago, we've been building stewardship practices and disclosure. As investors we continue to need more data and transparency focused on the outcomes and progress made on stewardship practices, but we also need to know how much of it is truly meaningful and decision-useful.
We still don’t always have enough data on disclosure from a company level, as well as from an asset manager level, to be able to support informed decision-making on Responsible Investment practices. This is particularly the case in some of the newer, emerging areas or as market practices evolve. We're no longer talking just about Scope 1 and 2 reporting for emissions from last year or the year before. Instead, we are asking asset managers about how they steward companies’ lobbying activity and about the context and rationale for their voting decisions.
This means that I expect to see more focus on alignment between asset owners and managers going forward. The Financial Markets Law Committee review and their paper on fiduciary duty calls out this piece of understanding and alignment between service providers, asset managers, consultants and asset owners.
We have to be mindful to strike a balance while still trying to improve standards.
