Politicians in a variety of different places understandably want to harness the capital of institutional investors. Dutch and UK politicians in particular have made no secret of their desire for local pension funds to invest for domestic ends.  

In an open letter last month, the UK’s prime minister and chancellor of the exchequer called on British institutional investors to invest more to support economic recovery and to promote green growth.

Desirable targets include SME lending, infrastructure projects, such as housing and transport but also renewable energy, or venture capital that could fund new technological solutions to greening industrial processes. 

Yet the response from the industry to calls from politicians to pension funds ‘do something’ in these areas is often a weary ‘but we are already’.

August’s report from the UN Intergovernmental Panel on Climate Change highlighted the urgency of the climate crisis and this autumn’s delayed COP 26 conference has already created an unprecedented focus on the challenge of decarbonisation and the role investors can play.

The COP 26 conference itself is only likely to highlight the importance of efficient and innovative use of capital to transition the world away from carbon-intensive economic activity and processes and towards innovative, greener alternatives as part of nationally determined contributions under the COP framework.

Europe’s expansive stock of pension and other institutional capital is an understandably attractive catalyst for the direction of capital away from carbon-intensive debt and equity financing and towards more sustainable alternatives. 

The reality is that many large European pension funds have been well aware of the carbon and energy transition risks in their portfolios for years and have been actively directing their capital to reduce these risks and towards more sustainable activities. For structural reasons, private market assets in areas like infrastructure, but also private equity and debt, are in demand as pension funds mature and seek to diversify.

In public equities, greater use of shareholder voting power and influence, by both pension funds and asset managers, is already influencing company boards in sectors like energy to transition their business models and investment plans away from fossil fuels. Bond holders also have considerable engagement leverage.

The EU has explicitly put institutional investment at the heart of its new Sustainable Finance Strategy, underpinning the European Green Deal. The new strategy, announced in July, has ambitions to facilitate access to transition finance, for instance with green bond standards aligned to the green taxonomy, and to increase the financial sector’s contribution to sustainability.

Liam Kennedy - Policy underpins action

In the field of pension regulation, the UK has enshrined the principle of carbon-risk mitigation targets in the Pensions Act 2021. Although these are yet to be fleshed out in regulations the direction of travel is clear.

A fairly widely applicable generalisation about pensions is that politics and regulation is the top-level driver of broad asset allocation of any funded pension framework. 

The same politicians who call for greater pension investment in renewables, SMEs or whatever, often simultaneously want to ensure as much security as possible for the ultimate beneficiaries of those long-term assets, be they DB pension members or life insurance policy holders. Unwinding the balance between risk and protection is fraught with complications.

In the UK, the political failure to reform the DB pension system over the years has led to the creation of a vast silo of assets in schemes closed to new membership and future accrual, which is becoming more akin to a closed annuity book as scheme populations age. 

While private markets investments are desirable and already a firm part of the asset allocation roster, the reality for trustees of many of these schemes is that their investment horizons are shrinking, with an insurance buy-in or even a full buyout as an increasingly viable end goal. 

This, along with the size and complexity of investing in some long-term assets, like infrastructure, means scale is of the essence – something lacking in the UK’s DB sector. 

Investment structures like Europe’s ELTIF (European Long-term Investment Fund) and the UK’s proposed Long-Term Asset Fund could be suitable to foster long-term investment in private assets, including in DC pensions if well designed. 

If they really have an eye to the future, European politicians will ensure the sustainable growth of funded DC pension asset pools that can invest in a well-designed range of public and private market investment opportunities in the service of long-term capital growth and towards greening the economy. 

Liam Kennedy, Editor