Legally, the need for the trustees of pension schemes to consider environmental, social and governance (ESG) requirements as part of their investment strategy has existed for almost 20 years now. Over that time the thinking about how to best meet those requirements has evolved dramatically. As has the regulation, which has been expanded on many times since the introduction of the Occupational Pension Schemes (Investment) Regulation in 2005.
The most recent of which being the Taskforce for Climate-related Financial Disclosures (TCFD) which requires larger pension schemes to report on the climate risks and opportunities of their investments. When first introduced in 2021 this applied only to the largest schemes (over £5bn). However, this has now been expanded to schemes with more than £1bn in assets and some speculation that in the future this might apply to even smaller schemes.
This is an important area of evolution. The trustees of UK pension schemes, both defined benefit (DB) and defined contribution (DC) have a key role in shaping how businesses incorporate ESG factors into their plans.
One of the key challenges when setting investment strategies for pension schemes is the need for greater asset diversification and inflation-linked income, something brought into focus by the recent spikes in inflation. The intersection of these two requirements gives rise to some interesting real asset strategies, particularly in the world of infrastructure.
The ESG opportunities & challenges
The infrastructure asset class is broad; with projects from energy generation (wind turbines and solar panels) to public transport (rail, roads, airports) and beyond. For this article however, I want to talk a little bit about something a bit more novel.
Timber and agricultural investments, whilst niche, are a growing area of interest. When cultivated appropriately, they can offer pension schemes a sustainable asset class that strengthens ESG credentials and provides long-term, stable and inflation linked cashflows.
In addition, these assets positively contribute to solutions for four of the greatest ESG challenges the world is facing over the next decade:
- climate change
- nature loss
- water scarcity
- rising inequality
Good agricultural investments prevent climate change and nature loss by nurturing biodiversity and helping to create carbon sinks. Meanwhile, switching away from water intensive agriculture like rice to less consuming plants can reduce water scarcity and in some cases, protect communities against flooding. The lack of expensive technology needed also helps with rising inequality, as agricultural investments can be made in developing countries.
However, the potential ESG upside of these investments should be considered against the inherent climate risks. Investment in significant areas of land can be exposed to acute climate events such as wildfires and flooding, as well as longer-term risks due to climate change. Therefore, it’s important to invest in a diverse portfolio, from a geological perspective, to help mitigate these risks and ensure the manager has carried out a detailed climate risk assessment for each underlying investment.
A further challenge for pension trustees is translating these ESG factors into the reporting needed to meet current regulatory requirements. Historically, there have been significant data challenges in terms of accessing accurate and up-to-date ESG information.
However, as regulatory reporting requirements increase, more and more data providers are starting to provide key information on the ESG credentials of various funds and asset classes. Although, the debate continues on what ‘standard’, universal ESG metrics should be, with definitions and regulations constantly evolving.
The financial opportunities & challenges
Whilst the ESG aspects of an investment are important, the financials must also be attractive and withstand scrutiny. Investments such as timber and farmland can offer pension trustees meaningful expected returns, low correlation to more traditional assets and offer some inflation protection on the cashflows generated.
This all seems quite appealing. But one of the downsides of all infrastructure investments is their illiquidity. Something that has been thrust into the spotlight by the events of the gilt crisis in September 2023. It is vital when making any sort of illiquid investment to understand the cashflow needs of your existing portfolio in the context of any hedging positions, pensioner payments and potential liability exercises. Careful consideration should be given to understand the scenarios under which the illiquidity of any positions could become an issue and to understand the implications for the scheme’s cashflow requirements and long-term funding objective.
More DB schemes than ever before are now within reach of their ultimate buy-out objective and long-term investments such as infrastructure are unlikely to be appropriate for schemes considering transacting in the short term. There is, however, an increased interest in a run-on approach (as many as 1 in 5 have been reported as considering run-on as their preferred long-term objective*). For scheme’s considering run-on, infrastructure investments such as timber and agricultural land can offer diversification, improved yields and stable cashflow generation working to solve some of the largest blockers to implementing a successful cashflow matched, run-on strategy.
However, implementing a position like this goes beyond just risk and return. It’s essential to look carefully at all the different elements of managing a DB scheme’s portfolio on a day-to-day basis. We have seen in recent years how quickly the economic environment can change, making it important to ensure commitments are not eating into the portfolio’s liquid positions.
The opportunities for the future
Looking forward, there will be opportunities with population growth and trends towards different types of crops and foods such as tree nuts and insects, which will see farmland diversify. With timber, there is continued growth and trends towards construction and eco construction.
These investments can tick a lot of boxes for pension schemes as part of a diversified portfolio, especially as ESG becomes more important. They can provide long term stable growth, but schemes need be in it for the long term too.
If you’d like to know more about sustainable investments, please speak to Nick Prouvost or one of our sustainability team.
