By Hugh Wheelan
Why the time is right for sustainable thinking by pension funds and institutional investors.
When Roger Urwin, global head of investment content at Towers Watson, the investment consultant, turns his mind to a subject, the pensions world listens. Urwin, one of the most influential investment advisors around, has worked with many of the world’s largest retirement schemes. His recent attention to the theme of sustainable investing is notable because of his experience in the reality of pension fund practice and governance. Urwin says his concept of sustainable investing is a blend of long-term investing, integrated environmental, social and governance (ESG) considerations in investment, active ownership and inter-generational solidarity.
Urwin is also an advisory director at MSCI Barra, which earlier this year bought RiskMetrics, the New York-listed risk and ESG research house. For such a high profile advisor to pick up the sustainability theme will be news to many – in different ways. On one side, Towers Watson’s pension fund clients have broadly been reluctant to broach the subject. On the other side, responsible investment practitioners have regularly accused consultants of dragging their heels on ESG issues.
Speaking to Responsible-Investor.com, Urwin concedes that until a year ago when he started working intensely on sustainability-based investing he tended to keep just one step ahead of clients because of a lack of relevant appetite.” He says: “I think this subject is bought rather than sold, and to date asset owners have to come to the conclusion that other things matter more.”
However, in the summer of 2009, Urwin spoke at a World Bank-organised investment conference in Bali and began evolving his thoughts on sustainability. He then crafted a thought paper jointly with Claire Woods of Oxford University on sustainable investing principles for the UNPRI Academic Conference in Ottawa in October, 2009.
“To be honest, I thought the subject of sustainability and ESG in institutional investment wasn’t that deep, but the more I dug the deeper it got and I found it was amazingly deep. And it’s still going deeper.”
Urwin says he was conscious that his own personal values played an important part as he burrowed further. One particular personal bug-bear, he notes, is inter-generational sustainability in pensions.
“Having children makes you tend to agree somewhat with what David Willets (current UK Minister of State for Universities and Science who has previously worked extensively on pensions issues) said, that our generation has stolen our kids’ future and that we need to get it back for them.” The backdrop of the global financial crisis also convinced him that societal values had to make a major return to investment.
Working with Tim Hodgson, head of Towers Watsons’ Thinking Ahead group, on a ‘defining moments’ paper for the crisis, the pair concluded with two major themes. The first was the return of big government, because, Urwin says: “Markets have not proved to be as flexible and adaptable as they should be.” The second was that society wants greater fairness: “Things have become rather unfair, and inter-generationally that is a particularly sensitive issue.”
Urwin says the thinking is designed to give Towers Watson a sense of where social and economic themes are heading and to position the investment consulting business accordingly: “Those two big trends, in our view, both make sustainability an interesting response.”
Drilling down, he points to a series of major challenges underpinning the sustainability theme: adverse demography, climate change, resource depletion, and challenging economics – pointedly the fiscal deficits of developed countries weighing against growth in the next 15-20 years. “Sustainability, to some extent, hits all four of these challenges. Various measures suggest that non-government capital will be responsible for 80-85% of the sustainable development to address tomorrow’s challenges in relation to environmental change and resource degradation. Governments may create an environment that is more conducive to change but the bulk of the challenge will be left to institutional capital, particularly in today’s deficit scenarios.”
Nonetheless, Urwin seeks to be dispassionate about the issue: “Many people in the ESG world are values driven. I think those values are good, but they don’t necessarily have a strong financial orientation. My feeling was that the industry lacked a bit of discipline and framework. For example, we talk about the UNPRI being $20 trillion in assets under management, but the amount of capital truly influenced in that amount is not a great deal, and it’s still actually rather small, so there’s a lot to figure out. The PRI doesn’t do that much at the moment on long-term investing, and inter-generational fairness is not necessarily incorporated in responsible investment at present. The terminology needed to be broadened out.”
In short, he says ‘sustainable’ investing encapsulates the concept of 1987’s UN-backed World Commission on Environment and Development, informally known as the Bruntland Commission, which is that of meeting ‘the needs of the present without compromising the ability of future generations to meet their own needs.’
One clear aspect of this, he says, is a changing economy in relation to energy technology: “Where we had an information technology (IT) revolution, we now have the start of an environmental technology shift (ET). This leads to the question of what fiduciaries and fiduciary capitalism can bring to a changing low carbon, resource sensitive economy.”
He says a logic for institutional investors to be active in the space follows: “If climate change and resource degradation progress at a pace that they likely will given the view of the best available science, then the return on future capital is going to be diminished by virtue of mitigation and adaptation in response to these problems. But, we can put in a hedge to offset that effect via a portfolio of investments that is focused on the adaptation, such as alternative energy, energy efficiency, etc.” Urwin’s expertise is on the practical relationship of institutional investors to the sustainability theme, which to date has been limited to a convinced number of larger players.
He argues that the lack of interest amongst many pension schemes partly reflects the “short-term, consensus model” in operation: “It’s assumed that there is a normal way to do pension fund investing, but the reality is that it is currently one that has very high cost levels from fees and high turnover portfolios.”
A recent research paper written by Urwin and Gordon Clark, a professor at Oxford University and respected author on pensions governance, looking at the financial crisis, concluded that pension scheme governance had little in the way of an innovation DNA: ““The force of creative destruction which should produce survival of the fittest effects on these organisations is very weak: they don’t have the same accountability of corporations.
So fiduciary capitalism is set up in a way that is not exactly fit for today’s conditions. Should pension fund boards, for example, have the same experience and competence as corporate boards? It is a principle that is being pushed in Australia. In most countries pension fund boards are quite a way off that level of competence and struggle to complete their increasingly complex agendas. As a result they do not give the time to consider sustainability.”
Urwin concedes that investment consultants have been notable by their absence in the area, but says this is changing: “What is a consultant there to do? It’s not to unscramble all these problems, but to provide a clearer framework for investors and instigate some new thinking. It isn’t our job to force values on our clients.” He says Towers Watson’s mainstream researchers are now in tune to the ESG theme and have been trained to look at it on an integrated ESG basis: “Managers are signing up to the UNPRI in such numbers, so they are validating the ESG proposition. There is a self-fulfilling aspect here and our manager research people are on top of that.”
Practically, Urwin says his work on sustainability with pension clients is now about working with companies that already have a sense that something important is going on and have some sort of broader sustainability agenda at the company. He points out though that this is not a large portion of Towers Watson’s clients.
What interests Urwin especially, however, is the concept of universal ownership amongst very large pension schemes and sovereign wealth funds: the idea that as an owner of the broad market of equities and bonds there is self interest in global sustainable economic growth. Urwin believes this leads naturally to what he calls ‘ESG beta’.
“It’s interesting because most investors in their belief set think that for every winner there’s a loser, and that’s an important argument at the alpha level. But it’s not the same at the beta (market) level. ESG beta is not talked about very much and people don’t really understand it. But if you think about any company and then consider ESG, as in what is their environmental or ‘E’ vector in its sector, i.e. how is it set up for environmental change, then there is some form of comparative, measurable influence. The same could apply to the ‘S’ component in terms of workforce policies or human capital, but maybe the saliency is rather smaller, and you have to recognize that, but it is there. It’s the same thing for governance. They are just further data points or sources of comparative advantage on assessing companies for an investor who understands the component parts of ESG beta, or the ‘factor’ exposure.”
Urwin compares the issue to a shift in the institutional investment world away from what he calls “rather clunky” factor indices: “You can invest in the S&P value index, which slices the 500 in two and gives you the 250 stocks index (very clunky), or there are providers that will produce a portfolio that is a purer version of value in the long and short space, so that you get a sector neutral exposure to value.”
He predicts a similar index evolution in the ESG space: “For example, you should be able to invest on the ‘E’ factor, on a sector neutral basis, if you believe that companies that are well positioned on the environment will have a tail-wind. Then you can say, well why don’t I put that exposure to work on a ten-year position? Obviously there are some judgment calls about how to price these factors at any given point in time. But fundamentally, I think these characteristics will have abnormal growth potential; their own alpha, if you will. In the environmental space you can invest with good specialist fund managers, or by tracking a tailored index, or a combination of the two. As a universal owner, not only will that be an offset against environmental change but it will also be helpful to climate change mitigation down the line.”
Urwin says he is also increasingly attentive to areas like microfinance where markets can be used as levers for social change. “The relationship between asset owners and global capitalism is really interesting. Institutional investors are big and influential but are not punching their weight relative to some of the things they could achieve, including levers of social change of a positive win/win type. That’s what I’m interested in. I can see private sector capital as being both the engine of growth and a force addressing climate change mitigation and adaptation and the changing balance of economic development that we need in the next 20-30 years. What’s clear is that corporations produce a number of negative externalities that are ultimately unsustainable, which is a problem that markets will have to adapt to. It’s obvious that we need a different sort of economic development and private sector capital is the means by which that could be achieved at a reasonable pace. We could be slow with this change, and if we have asset owners who do not find it easy to adapt we will be slow with it. At the moment, asset managers are not able to do this specialised kind of investment with the mandates they are given.”
Urwin says longer-term mandates from pension funds could reduce manager turnover costs, produce better investment ideas and permit better ESG integration. He says the consultant’s experience of long-term mandates is that the contract is no different than the current norm in terms of the possibility of removing under-performing managers, but that evaluation tries to be more intelligent around long-term results.
He says the consultant has had quite a lot of success with ten-year mandates, and says both top-down and bottom-up research at Towers Watson has shown that the highest performing managers are benchmark insensitive with a long-term orientation. More broadly, he says he is both optimistic and pessimistic that, post credit crisis, the financial markets can be put on a path to sustainable growth: “I do listen to, and sometimes agree with those people that say they are optimistic because human nature has boundless ability to deal with things. But I think people are underestimating the new reality of a tightly coupled financial world in which we’ve dialed in a propensity for financial accidents. The global financial crisis is not properly finished: it’s just morphing into something else. We’ve dealt with the symptoms but not many of the causes.”
Republished from July, 2010 Responsible Investor magazine.