Analysis: German states realign €30bn pension fund assets to stricter ESG standards

Four German states have recently revised their sustainable investment strategies, sticking to stricter ESG standards, a move that has caused shifts to the allocation of public pension assets worth close to €30bn.

The states of North Rhine-Westphalia, Hesse, Baden-Württemberg and Brandenburg, which since 2019 invested around €11bn in jointly developed sustainable stock indices, so-called ESG countries fossil-free indices, switched to a Paris Aligned Benchmark (PAB), lining up with the EU taxonomy and United Nations (UN) Sustainable Development Goals (SDGs) to invest their assets.

As a result, Baden-Württemberg expects reallocations of around 20% in its equities and corporate bonds portfolios, with companies excluded for conducting controversial businesses in certain sectors – for example tobacco companies, manufacturers of harmful products or companies that disregard workers’ rights, a spokesperson said.

“Moreover, orienting [investments] towards a Paris Aligned Benchmark means that the portion of greenhouse gas-intensive sectors in the portfolio tends to increase, while opting [at the same time] for those companies with a credible greenhouse gas reduction path,” the spokesperson added.

Baden-Württemberg operates two pension funds – Versorgungsfonds and Versorgungsrücklage – with assets under management (AUM) of €10bn.

The latest law on sustainable finance passed by the state’s parliament at the beginning of March, aligning investments according to the EU taxonomy, UN SDGs and Paris Agreement goals, applies so far only to equity and bond investments in the Versorgungsfonds.

Assets in the Versorgungsfonds amount instead to €5.7bn, including around €2.4bn invested in sustainable stock indices, affected by the changeover. Assets in the Versorgungsrücklage, instead, amount to around €4.2bn, invested through Spezialfonds in equities and bonds, actively managed by two asset management companies.

The equities portfolio of Brandenburg, the state surrounding the capital Berlin, is now geared towards more ambitious ESG goals than in the past.

“Among other things, [now] Scope 3 emissions are also included in the calculation of the CO₂ intensity of the companies, and companies that are active in the production of tobacco are excluded [from the portfolio],” a spokesperson for the state’s Ministry of Finance and Europe said.

The state’s pension fund in Brandenburg has assets totalling €954.3m, including pension reserves, of which €215m is invested in equities to be aligned with the Paris Agreement.

The equities allocation of the pension funds for the state of North-Rhine Westphalia, with €13.1bn AUM as of the end of December last year, is set to reach 60% of total assets in the future, invested through a PAB standard, a Ministry of Finance spokesperson said.

Bespoke equity indices, the STOXX ESG Countries Eurozone PAB Index and the STOXX ESG Countries Global Ex Eurozone PAB Index, are used by the pension fund to invest in equities and corporate bonds, with the investment strategy of the Pensionsfonds of the state reviewed at regular intervals.

Hesse’s pension fund, with assets worth €5bn, invests only in companies generating less than 1% of their revenues from the exploration and production of coal, their sale, and those of associated products and services. The threshold of the turnover for the exclusion of coal companies has been tightened from 5% to 1%, a spokesperson for the state’s Finance Ministry said.

It targets climate neutrality by 2045 at the latest and, as the other states, will cut the GHG intensity of invested companies by at least 50% under the new strategy, compared with a non-sustainable investment.

Invested companies must reduce their absolute GHG emissions by at least 7% each year, compared with the previous year.

Fixed income and real estate

Stricter ESG standards seem to have a lighter impact on sovereign bond portfolios for the pension funds of the four states, which tend to invest exclusively in euro-denominated bonds.

Only one Finnish government bond had to be sold in the Vesorgungsfonds, and small shifts in terms of government bonds are also expected in the other pension funds (Versorgungsrücklage), the spokesperson for Baden-Württemberg’s Ministry of Finance noted.

The impact of the law on existing government bond portfolios of state pension funds, consisting exclusively of euro-denominated bonds, are therefore minor, he added.

As part of the sustainable investment strategy, however, Baden-Württemberg excludes government bonds linked to controversial activities, and of countries that decided not to ratify important UN conventions, for example on human rights, weapon systems or environment.

“In the case of cluster munitions, EU countries are also excluded, namely Finland, Estonia, Latvia, Poland, Romania and Greece,” the spokesperson added.

The investment of pension assets of the state of Brandenburg in government bonds is based on existing guidelines for the special fund – Sondervermögen – looking mostly at liquidity and returns.

“The primary requirement here is that a bond must have an investment grade rating of at least BBB- or Baa3, when it is purchased. Securities from countries that do not meet this requirement are not eligible for acquisition by the [pension] fund,” the spokesperson explained.

The state of Hesse only invests its pension assets in government bonds of countries that have ratified the Paris Agreement, denominated in euros to avoid foreign currency risks. It is aiming to gradually increase over time its allocation to green, social and sustainable bonds, which currently amounts to 19.7% of its fixed income portfolio, it said in a statement.

The state’s pension fund has approximately €256m, about 4.8% of total assets, invested in government bonds in the euro-zone, as of March this year, and a further €135m invested in bonds issued by the EU, the spokesperson said.

Similarly to Hesse, the pension fund for the state of North Rhine-Westphalia only invests in government bonds denominated in euros, issued either by Germany or by other countries in the euro zone, it said.

In real estate, Hesse will in the future only invest in funds that assess their ESG performance via the GRESB score.

“Physical and transitory [climate] risks must be taken into account both in the selection and acquisition process of new investments [in real estate], and when exercising voting rights. When selecting new investments, it is important that a fund manager works towards reducing the CO₂ footprint of the managed properties, and carries out the analysis required for this, for example [through] the Carbon Risk Real Estate Monitor,” the spokesperson explained.

The state will look at the Paris Agreement and the requirements of the EU on the decarbonisation of buildings to exercise its voting rights, it added.

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