Commentary: Pension funds and the role of the debt market in the fight against climate change

The 2021 United Nations Climate Change Conference, or COP26, that takes place later this year will be of particular significance as it will mark a milestone for the Paris Agreement.

It is here that all nations are expected to commit to enhanced ambition since COP21, under the first iteration of the "rachet" mechanism, which occurs every five years. The goal is to ultimately limit global temperature rises to well below 2 degrees Celsius (ideally 1.5) to avoid "dangerous" climate change, which means reducing greenhouse gas emissions by 50% by 2050 — or achieving net zero carbon emissions by that date.

So far, only a handful of countries have submitted new 2030 targets and on the whole the indications are that they will be insufficient to meet the Paris Agreement. In the absence of government leadership, attention has shifted to the investment community to help drive the agenda forward.

One of the larger cohorts within this community are obviously pension funds, which represent more than $33 trillion in assets. Though we are increasingly finding greater engagement from pension funds on environmental, social, and governance issues like climate change, challenges still exist.

Many pension funds are beginning to get a better grasp of incorporating ESG considerations into their investment practices, but it is important to note that ESG integration is more developed within the equity universe, with pickup proving slower in fixed income. Traditionally, pension funds have been heavy investors in fixed income, with this asset class often accounting for the core investment of their overall portfolio. For example, the average U.K. defined benefit fund has more than half (54%) of its portfolio allocated to bonds.

Though there should be some practices that can be applied from ESG efforts in equities to fixed income, the latter does present some unique characteristics, which mean a nuanced or slightly differentiated approach is needed.

For example, more multidimensional ESG investment analysis is required, which potentially requires several ESG perspectives for a single issuer. There are also fragmented ESG data sources of various quality, and that can result in inconsistent implications for market pricing. Finally, there can also be issues from an engagement perspective given the different legal status of lenders relative to owners (equity investors). That said, it does not mean bondholders do not have stewardship responsibilities or influence.

Clearly, there remains ESG challenges for pension funds' fixed-income assets that need to be overcome, but if they are tackled correctly there is a huge opportunity for pension funds to assert a high level of influence over the direction of capital over the coming decades.

On climate change, we have already seen concern about fossil fuels resulting in calls for divestment as a way to signal they have no place in a low-carbon world. One area that appears to be gaining momentum is to "deny the debt." In essence, it means not providing capital funding in the first place to companies or sovereigns deemed to be fundamentally failing on climate change.

The other, newer angle that is being picked up is the thinking that the impact will be greater if efforts are focused on primary markets as opposed to secondary ones, be it in equity or fixed-income markets.

The logic being that with secondary markets, trading occurs between investors rather than the issuer and the investor, and it is about existing financing, not new financing, which primary markets are about. In short, there is not much opportunity to directly signal to an issuer a concern about climate change or influence change over a company when it's not present.

But by targeting new bond issuance and bank lending in fixed-income markets (i.e., primary capital), you as investors can affect supply/demand dynamics more directly. You can not only potentially impact an issuer's access to capital, you could drive up its cost of capital.

The "deny the debt" concept is about signaling to issuers matters that investors are concerned about. Another approach gaining interest takes the opposite approach, allowing issuers to signal their interest in areas that investors want to allocate funding to, namely tackling climate change.

In recent years, the green bond market has emerged to do just that. In their purest form, these products are designed for investors to direct issuers on how their capital will be used, namely for green projects. Their names would suggest that these issuances are the obvious way to easily and immediately stimulate better climate outcomes. However, they are still very much in their infancy and have some way to go.

Though green bonds were perhaps created with the best intentions, it is important to avoid the charge of "greenwashing" by ensuring a robust assessment of each green bond issuance on a case-by-case basis. This can include providing practical evidence of the impact these projects are having in terms of improved climate outcomes, understanding what the project eligibility criteria is and whether this is in fact "green," as well as how the issuer will ensure the capital is not used for other purposes other than what has been stated.

Furthermore, a holistic analysis may also need to consider the issuer's overall activities and what its non-green issuances are funding — it could very well be the case that "brown" assets are still being funded alongside "green" ones.

All these approaches have a role to play in the climate fight. Indeed, we need all asset classes to participate. But clearly given the scale and urgency of the climate issue, and the lack of international governmental leadership, we can expect to see more on the deny the debt concept especially from asset owners, like pension funds that have set ambitious net zero climate goals. The emphasis on primary capital in either case is logical and necessary — focusing solely on the secondary capital market is not going to get us where we need to be.

This will be part of a broader emphasis on the role of the fixed-income market, where lenders and bondholders play a unique and critical role. The challenge will be whether they will seize the opportunity to act as enablers of the low carbon transition or be a barrier to it. Either way taking an active approach will be key.

My-Linh Ngo is head of ESG investment at BlueBay Asset Management LLP, based in London. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.