If there is to be a successful transition to a net- zero global economy, trillions of dollars need to be invested in renewable energy generation, electricity transmission and storage systems, and energy efficiency. The need is for fresh money. At scale.
The (not so) Modern Portfolio Theory of Harry Markowitz and William Sharpe revolved around two dimensions, risk and return. Now, in an ESG world and with the threat of climate change, we have a third dimension, sustainability and impact. This has profound implications for the way we should be managing money and building portfolios. We can no longer just optimise portfolios relative to some broad market benchmark.
While at first sight this appears to introduce considerable additional complexity, it is in fact liberating. We get to recognise that risk is not just the standard deviation of relative returns; in a very real sense it is also the risks presented by climate change (among many other ESG concerns).
Regulatory regimes, while well intended, encourage asset owners to act in a pro-cyclical manner. With multiple powerful vested interests, governments struggle to provide the incentives necessary to turn the economic ship in time. Yet we have already gone through at least two global energy transitions in the past, from wood to coal, and from coal to oil, gas and electricity, including from nuclear. We also know that transitions can happen quickly, recently and most notably in the area of technology. Only 20 years ago, it would have been close to impossible to have imagined how technology has changed almost every aspect of our lives.
Most accept that global warming is happening due to human activity and the effects of carbon in the atmosphere. It seems inevitable that we will move to a carbon-neutral global economy or face disaster. Whether we do so in time to avoid the worst effects of global warming is another matter, but the fact that the transition will eventually take place already has significant investment implications. If we are focusing on our liabilities, rather than on a market benchmark, we have the freedom, some might say the responsibility, to factor climate change into our decision making.
There are four elements to a solution:
- Fundamental changes to the best-practice model for long-term pools of capital;
- A rethink of what we mean by risk. Inadequate cash flow to meet liabilities is the greatest risk that pools of capital face. Having predictable cash flows of all forms large enough to meet expected liabilities for the next several years minimises the risk of having to sell assets at depressed prices;
- A supportive regulatory regime; and National and international governments coming together with the private sector in a public/private partnership to tackle climate change.
A UK example
Large pension schemes (greater than £5bn) must now report on climate risk, and schemes greater than £1bn must do so from October 2022. From October 2019 pension schemes must already include in their Statement of Investment Principles an outline of how ESG considerations are taken into account in the selection, retention and realisation of investments. ESG and climate change are now firmly on the agenda for all major pools of capital.
At the same time the defined benefit (DB) market is rapidly maturing and schemes’ asset allocations are moving progressively into fixed income investments which, where possible, match their liabilities. Meanwhile an increasing number of defined contribution (DC) participants are reaching retirement and need progressive investments for the decumulation period of their lives. This provides the potential for a public/private partnership to raise the large amounts needed to address climate change at an affordable rate, while providing tangible benefits for pension funds, both DB and DC.
A potential solution: a new form of security
A new security would have the following characteristics:
- 25 years of payments, increasing by inflation, or by a fixed percentage, or by nominal GDP;
- No final return of principal.
- The cash flows look like a fixed-term annuity directly matching the cash needs of a retiree, and would have a duration of around 18 years.
- For DB funds, a security with these characteristics would fit very well with their liability profile.
For DC participants, the security could either be sold in the wholesale market or provided through the goovernment backed National Savings & Investments. Provision through the wholesale market would allow financial institutions to acquire these securities as part of a more comprehensive retirement package including, for example, an element of life insurance to cover the longevity risk beyond the age of 90. Purchasing longevity risk cover at, say, age 65 for the 90-plus years should be relatively inexpensive as the issuing insurance company would have the use of the premium for 25 years.
In the event of early death, any surviving spouse or their estate would continue to benefit.
Further, it is possible to achieve this while keeping the debt off the government’s already stretched balance sheet. Going carbon neutral will necessarily involve a public/private partnership with the government establishing the impact, quality, governance and pricing structures, and the private sector building and operating the assets. If the private sector issued bonds of this type but with the benefit of a government guarantee, pricing should continue to be closely linked to the Gilt curve.
Beyond net zero
If we think of the broader ESG agenda, there is an opportunity to make progress on the 17 Sustainable Development Goals (SDGs), adopted by all United Nations member states in 2015. They sit low on government agendas. The way we measure our economy, GDP, is positively Victorian and contributes to this lack of attention to the SDGs. We capitalise plant and equipment and write it off over a number of years but, in what is supposed to be a knowledge-based economy, we think nothing of education. More importantly, we measure our gross production, not net production after accounting for the negative externalities we create – CO2 emissions, for example. We should replace GDP with NDP (net domestic product) by deducting from gross production the economic value of the negative externalities we create for each of the 17 SDGs. Doing so would do much to move the SDGs up the political agenda, something we should all favour.
The same fixed-term securities could also be used to scale up the capital so desperately required to give substance to the aspirations of the SDGs. In combination, they describe a planet of peace, prosperity and opportunity for all.
Alan Brown is chair of Artemis Investment Management and former CIO of Schroders