The path to a sustainable future for private markets is full of opportunity but also complexity, as Laurence Monnier and Ed Dixon explain.
Understanding the difference between what stakeholders say they are doing and what they are really doing is a complex business. This is particularly the case now, when governments and companies face mounting pressure to clean up their environmental act. Financiers, regulators, investors, lawyers, activists and pressure groups are all asking questions, wanting to know more about who is polluting, recycling, greenwashing and so on.
Investors in private markets have significant influence in shaping the sustainability agenda.
Investors in private markets, who are typically closer to the assets they hold than in public markets, have significant influence in shaping the sustainability agenda.
However, this is not as straightforward as it might appear, with little standardisation on disclosures, challenges in turning brown assets green, and fierce competition causing risk-adjusted returns to dwindle in certain sectors.
To find out more, we talked to Laurence Monnier (LM), head of quantitative research, and Ed Dixon (ED), head of ESG, from Aviva Investors’ real assets team.
How should we define sustainability in real assets? Is it in the eye of the beholder?
LM: For me, sustainability is a given. As a long-term investor, everything we do has to be sustainable. If we are looking to invest for the next 20 years or 30 years and an asset is not sustainable, we should not be looking to participate.
As a long-term investor, everything we do has to be sustainable
Quite separate to that is a debate about the environmental or social impact of one asset over another. Ultimately, though, sustainability is about concentrating on assets aligned with the transition to the greener and fairer economy people want to see.
Is addressing it simply part of your fiduciary duty to clients?
ED: It’s unequivocal, and not only because it is included in the UK’s Stewardship Code. We need an in-depth understanding of the risks and impacts of the assets we manage and ensure the long-term interests of clients and society are fairly represented in our investment process.
This is written into our responsible investment policy and strategy for real assets; we must understand the long-term impacts, and if the assets have impacts that undermine the stability of the industry, the economy and/or society, then they do not represent a good investment.
We need to ensure the interests of clients and society are fairly represented in our investment process
This runs from our investment policy and processes, to our real assets strategy, all the way to the Stewardship Code at the top of the tree.
LM: This has come to the forefront of many investors’ minds in the last two years. Sustainability has always been there, but the intense focus on it is relatively recent, and there are more working groups than most people care to follow.
There is a fair amount of standardisation of disclosures around climate, and alignment is very much on the agenda for discussion by the regulators; everybody is mindful about the importance of moving towards a common view. But it is difficult because there are so many different aspects of sustainability. Different issues keep coming to the fore: biodiversity, climate risk, gender, race and ethnicity, and so on. It would be valuable to standardise, but there are so many aspects that are difficult to capture, and the landscape is changing all the time.
I don’t think you will ever develop a single all-encompassing standard that neatly encapsulates what sustainability is.
How easy is this area to navigate in private markets, bearing in mind some of the frameworks around sustainability disclosures were crafted with public markets in mind?
ED: Some pieces of legislation, like the Sustainable Finance Disclosure Regulation (SFDR), were written for liquid markets. A degree of thought has gone into real estate equity, but virtually none for private equity, private debt or infrastructure. The same could be said for the guidelines from the Task Force on Climate-Related Financial Disclosures (TCFD). The guidelines are adequate for real estate, but somewhat lacking for other (illiquid) asset classes.
A lot of the larger private market managers have come together to try to develop some sort of commonality
As an asset manager working in private markets, you hope you can get some commonality with your peers, but there is no private markets body that ties everything together. The Association of Real Estate Funds has looked at this from a real estate equity perspective and made an effective response to SFDR. But, broadly, there is nothing equivalent for private debt or infrastructure, so a lot of the larger private market managers – including Aviva Investors – have come together to try to develop some sort of commonality.
Asset management is not just about liquids; we need the regulatory and industry bodies to think this through in a lot more detail.
At an asset class level, are there areas where it is particularly hard to shape the sustainability of the asset in which you are investing?
LM: The degree of influence you can have clearly depends on your role. So, if we are lender in a syndicate refinancing bank loans, we may have limited influence, but even there the influence of lenders is growing. Lenders are promoting changes to loan documentation standards, to alter disclosures around environment, social and governance (ESG) issues and what borrowers will have to disclose.
As an industry, lenders have a lot of power. Lenders can also develop a sustainable loans strategy and influence borrowers, as we already do through our real estate sustainable transition loans.
It is true that if you are a major investor who brings the equity cheque you will have more power than if you are a small equity participant or a lender in a syndicate, but lenders do still have a big voice to play in the debate.
We keep hearing about industry-led sustainability initiatives. Is the finance industry finally stepping up?
ED: People on the ground appreciate the change that needs to happen and want to push it forward, but in some cases it is being held back by how quickly their employers or industries are able to go.
Take infrastructure debt, for example. A consortium of lenders, initially led by us, has got together to produce a set of minimum standards, which would mean borrowers have to come forward and disclose certain information at the point a deal is made. We are close to agreement, but to achieve industry wide buy in, at some point an industry body will need to adopt and push it forward.
There is no private markets organisation that ties everyone together; that is needed to make the change
In real estate, we’re starting to work with peers to come up with a better set of minimum standards on green leasing. Broadly, this involves a new concept where sustainability requirements are embedded into the lease to bring direct benefits to the occupier, so they are rewarded for reducing their environmental impact, but we face the same challenge regarding standardisation.
There has been progress in some areas. Take the Better Buildings Partnership (BBP), which established a climate change commitment we have signed up to alongside the majority of our peers. BBP said: ‘We know where the industry needs to be, and we are going to put you on the hook to do this,’ and it has really driven rapid change. It is also working on operational energy ratings and moving that agenda forward with the government. This is forward-thinking, but I am not sure we benefit from the same collectives or industry bodies driving change in private debt.
Overall, there is a groundswell of opinion among the larger players wanting to collaborate to raise standards, but I don’t know how soon the representative bodies will be able to drive the changes through. There is no single private markets organisation that exists to tie everyone together; that is needed to make the change.
LM: I think the industry is stepping up, but maybe we should be asking if it is stepping up in the most effective way. That’s another question. There are the issues we have already touched on – about potentially having too many standards, too many views. The EU has its guidelines, then we have the sustainable and green loan framework, the guidelines for climate disclosures and so on.
I suspect a smaller number of dominant standards will emerge
In addition to BPP, infrastructure investors and private lenders have their own forum to discuss issues, then we have companies and lawyers as well. We also have the Asset Owners Alliance, bringing together all the net-zero owners and the insurance industry, as well as the Net Zero Alliance for asset managers. How will they mesh to create the sustainability standard of tomorrow?
Will it mean aligning with the EU taxonomy, or any other standards? That taxonomy is fine, but how relevant it is for a road project in Benin? The level of interest has led to complications and some overlaps, but it does at least suggest we are going at the right direction. Ultimately, I suspect a smaller number of dominant standards will emerge.
There have been suggestions recently that as disclosure requirements in the public space intensify, the temptation is to move dirtier assets off balance sheet. Is this any cause for concern?
LM: There is a misunderstanding that privately listed companies do not have ESG disclosure requirements. Disclosure may be less advanced in the private sphere, but there are requirements for institutions through the Asset Owners Alliance, through the guidelines set out by the TCFD and now the obligation for UK pension funds to disclose their net-zero alignment.
The need to disclose is getting more attention and therefore taking assets private is not necessarily the way to avoid this
This has been compulsory for insurers in France for a long time. The need to disclose is getting more attention, whether you are public or private, and therefore taking assets private is not necessarily the way to avoid this.
If you think about investors in real assets that manage assets day-to-day, we need to stay close to what is going on. It is not just about making a small disclosure in a footnote; it is about what we may or may not be embedding in a building or piece of infrastructure. It's real.
The other thing to consider is the implications of that choice between retaining an asset and improving it or selling it on to somebody else. This is a real question for us in infrastructure and real estate. If we sell an asset, it is off our balance sheet and improves our own carbon credentials, but it does nothing to improve the planet.
It may be better to keep some of the assets that are not aligned with the net-zero transition today and improve them, so they are much cleaner for everybody’s benefit
All things being equal, it may be better to keep some of the assets that are not aligned with the net-zero transition today and improve them, so they are much cleaner for everybody’s benefit. But as an asset manager, we also have responsibilities to our investors. We manage assets; we are not there to lose money. We need to be mindful of this as we look at which assets to improve and how to do it. If we think the cost of improving the asset is uneconomical, we may be forced to sell on.
Can we return to questions of scale and the importance of disclosure thresholds? Is it not the case that some smaller bodies are exempt from some of the tougher requirements?
LM: Scale is an issue. For example, some smaller infrastructure projects may not have to disclose, but of course larger professional investors in those projects do. The fact the smaller body is exempt does not take away responsibilities from the larger bodies, which are not.
We have responsibilities to our investors. We manage assets; we are not there to lose money
There are concerns that the disclosure requirements are too heavy for some of these smaller bodies. For example, if your asset turnover is less than £1 million a year, you may not be able to afford the consultants or staffing costs required to make your ESG disclosures.
What is your view on the idea expressed by Professor Richard Murphy that countries with net zero established in law have experienced a crystalising event, which should force companies to reveal the costs of transitioning on the balance sheet?
LM: It is a logical proposal, but if you drill into the detail, the question is hard to answer. Take a software company, for example. How will it disclose how much it will cost to be net zero? It depends how it intends to get there! How will it deliver goods? What vehicles will be used? Will they be electric? Will the power come from renewables?
If we want to get to net zero, there are still a lot of unknowns, and a lot of technological change needs to happen. We need to be able to reduce emissions drastically but also capture carbon dioxide from the air, and it is not clear how much that will cost. No-one really understands the cost side now: not the government, not big companies and certainly not small software companies concentrating on their own product lines.
Pushing for disclosure is helpful, but it sometimes distracts from the real issue, which is everyone thinking about what they have within their immediate control to help us achieve net zero. The more time we spend on disclosing things that we don't know very much about, the less time we are likely to spend on doing things that have an impact. That said, the move to make climate disclosure mandatory has contributed positively to the finance industry stepping up to the plate.
Have we got to the point where changing ‘brown’ assets to green ones makes sense, but clients may be concerned about the reputational risk of retaining these assets?
LM: Not in the assets we own personally. As we have been focused on sustainability for a long time, the sectors we invest in are generally green – renewables, full fibre broadband and so on. There are investors with blacklists that prohibit them from investing in certain kinds of assets, like roads, because of the pollution. Should we be doing it? That's a live debate.
It is disingenuous to say: ‘We won't invest in roads anymore’, and then expect an Amazon delivery to come to your door
In my view, it is disingenuous to say: ‘We won't invest in roads anymore’, and then expect an Amazon delivery to come to your door. If we choose not to invest in roads and do not maintain them, what happens then? I think the bigger question is: which roads do we wish to invest in, and what are the conditions that allow us to be comfortable with that? How will the trade-offs between environmental costs and social benefits be made?
Another example of trade-offs is in district heating. On the lending side, there are cases where we lend to district heating, but we have specified we do not wish to see energy inputs from non-clean solutions.
The danger of a pure exclusion approach is that it could create significant moral hazard by leaving assets in the hands of people who are less focused on environmental issues, and that may be detrimental to the clients we serve. Ultimately, we need to make sure our investment strategies are aligned with the transition. We are working to ensure all the assets are aligned rather than restricting the types of assets in which to invest.
You spoke about managers’ responsibility to clients in terms of delivering returns. Where is the greatest evidence of green premia now?
LM: The established renewable sectors such as wind and solar arguably look expensive today for investors focused primarily on financial returns. There has been a real rush to buy and that has driven returns down at a point when investment risks have been increasing as subsidies are removed.
The more renewables you build out, the less each asset is likely to contribute
While renewables have a lot of benefits, if you obtain your energy from 100 per cent intermittent renewable sources, you are likely to have blackouts in January because we currently have no way to store vast amount of energy in an economic and environmentally friendly way. So, the more renewables you build out, the less each asset is likely to contribute. Take, for example, a solar asset in the UK; it only delivers power about ten per cent of the time to the grid, yet every time you build a new asset you use carbon building it, transporting it to the site, installing it and so on.
You must ask yourself if you can go beyond a sector view into an analysis of which assets are good or not good. It is not just a case of understanding if the sector is aligned with the transition, but also asking which specific assets are aligned within the broader asset class. This kind of analysis makes sense from both financial and transition standpoints. And if you own assets that are not aligned, what are you going to do about it?
These are much more nuanced questions than basic sector allocation decisions, but that is what truly sustainable investing is about.