Has market volatility dampened the case for ESG?

The events of recent weeks have changed the investment environment and could affect pension funds’ appetite for environmental, social and governance strategies, experts warn.

The recent severe bond market volatility has caused many defined benefit schemes to shore up their liability-driven investments collateral pools and reassess their investment strategies, especially in illiquid assets.

At a time when funds have been severely shaken by the volatility and liquidity is a clear focus, could there be less focus on ESG factors and possibly a reduced case for it in the future?

Dalriada Trustees professional trustee Jessie Wilson believes there are opportunities and challenges in different areas for ESG in this fundamentally different investment environment, amid high rates, high inflation and LDI strategies needing significantly more collateral.

“Pension schemes could use this time when they are reassessing where their funding level is, what their appropriate asset allocation should be and what their investment objective is, to factor in an ESG review,” she says.

“There is a huge opportunity for schemes that haven’t focused much on ESG to integrate that further.”

Pension funds that have been burned by LDI will likely be much more liquidity-aware and keen to avoid another situation where they struggle to stump up cash to meet margin calls, or are forced to sell assets that turn out to be less liquid than expected.

“If we roll back [to] a year ago, all asset classes broadly didn’t look appealing, so we saw most investment consultants recommending private [markets] because that’s where the returns were,” Wilson says.

“From today, will the same consultants be as comfortable recommending their private allocations to schemes? I’m guessing not, so therefore there will probably be less weighting in that direction.”

This is despite illiquid assets being probably the “biggest way” of making a genuine positive influence by using ESG investing, she adds.

However, Cartwright senior investment consultant Adam Gregory says the increased focus on liquid assets may mean a shift to more traditional assets – such as listed equities and bonds – that are more comprehensively covered by ESG analysis.

Time horizons

Much will depend on schemes’ time horizons when it comes to appetite for ESG factors. These are often risks – and opportunities – that will play out over many years, meaning those with a longer time horizon will be better suited to address ESG considerations, compared with those focused on short-term matters.

Church Commissioners for England’s net zero lead Sofia Bartholdy says short-term volatility should not get in the way of integrating ESG into investments.

“We believe short-term market disturbances don’t hinder a responsible approach,” she explains.

“Systemic ESG risks such as climate change, biodiversity and social inequality are only going to become more material. This builds a case for ESG integration across the portfolio, especially as we have a long-term investment horizon.”

Time horizons have significantly decreased for some pension schemes that did not have much LDI exposure, since rising gilt yields this year have led to improvements in their funding levels. This is particularly the case for schemes that were more underfunded and had more exposure to growth investments.

Cartwright’s Gregory says: “Many poorly hedged DB schemes will have suddenly found themselves within touching distance of buyout with insurers.

“Since insurers are typically sophisticated investors with stringent regulations and long time horizons, the overall impact should be positive in terms of assets being managed with stronger ESG influence than before.”

However, schemes whose deficits and time horizons have reduced but not enough to reach buyout are likely to loosen their focus on ESG, he adds, whereas public sector pension schemes that have not been impacted by the LDI crisis could see huge opportunities.

Dalriada’s Wilson adds: “We may see attractive buying opportunities for the Local Government Pension Scheme funds, which have long-term time horizons and don’t have the same issues that other schemes have, because they are open.”

Demand from DC schemes

There could be an opportunity for defined contribution schemes to invest in more illiquid assets given reforms designed to encourage them to allocate more to these kinds of investments.

“The ability to enact change and invest in ESG for good returns is heavily on the DC side,” says Wilson, “but with the LDI pensions crisis and cost-of-living crisis hitting headlines, is that going to impact people saving money into pensions?”

The rise in gilt yields makes them a more attractive investment and could comprise a bigger part of DC investment pots, which could move some focus away from ESG.

Gregory says: “To the extent that ESG factors have more influence on equities than government bonds, there may therefore be some subtle shifts in focus. But overall, I expect ESG to continue to be a big priority for those looking after DC schemes.”

Adam Gregory is senior investment consultant and head of responsible investment at Cartwright

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