ESG in UK LDI – is it just window dressing?
ESG has become increasingly important over recent years, with discussions shifting from ‘How can I integrate ESG into my equity allocation?’ to ‘How can I integrate ESG across my entire portfolio?’. And, since LDI is often the biggest allocation of defined benefit pension schemes, it couldn’t be ignored. One could be excused for dismissing the topic altogether, arguing that LDI does not lend itself well to ESG analysis or integration. My colleagues know that I, myself, have approached this topic with a healthy dose of skepticism. Since there is certainly an incentive to ‘window dress’, using ESG as a marketing tool rather than to make a meaningful difference to investment processes. Over the last few years, we have been researching this topic to separate the substance from the hype. Below we summarise the major ways in which ESG factors can be incorporated into LDI processes:
Counterparty approval, selection and engagement
This is typically the main way that managers incorporate ESG considerations into LDI. Most LDI portfolios are moderately levered, requiring some repurchase agreements (‘repos’) and swaps. These instruments are traded predominantly with banks, who act as counterparties. Asset managers typically have processes in place to ascertain whether potential counterparties are sufficiently creditworthy to trade with. ESG risk analysis is often included within that counterparty approval process. And, if any ESG related shortcomings are identified, the manager may choose to remove that counterparty from their list, reduce trading with them over time and/or engage with the bank on that topic.
Engagement with regulators
There’s an ever-increasing amount of new regulation, some of which can have a meaningful impact on LDI portfolios and pension scheme beneficiaries. RPI reform, in particular, comes to mind. Several major LDI managers believe that their engagement with regulators to protect the interests of clients (and underlying members) is a Responsible Investment activity.
It’s not uncommon for LDI portfolios to have a money market fund holding, especially if the portfolio is heavily invested in swaps. Since cash funds can be thought of as very high quality, liquid credit products, ESG risk considerations can be incorporated into the investment process as part of the assessment of issuer creditworthiness. Some managers have gone a step further and launched funds that tilt their allocations towards issuers with superior environmental practices, and away from heavy carbon emitters, or even using a portion of their management fee revenue to purchase and retire carbon offsets.
The proceeds of green bonds are used to finance, or re-finance, “green projects” (for instance renewable energy or green buildings). The UK government announced that they intend to issue at least £15bn worth of green gilts in 2021, but at the time of writing there was very little detail available on this. There will no doubt be more analysis and discussion once these are issued and there is more clarity around the use of proceeds, reporting, pricing versus regular gilts, liquidity and ability to use as collateral – all of which are important considerations. But in the meantime, here are our initial thoughts on their relevance within pension schemes’ portfolios.
The firm itself
Finally, your LDI asset manager, as a firm, may be involved in a variety of initiatives related to ESG. Relevant considerations may include being a signatory of the UN Principles for Responsible Investment or having committed to supporting the transition to a low carbon economy.
So, is this all just window dressing?
Based on our research, we’ve concluded that there are genuine channels through which ESG considerations can be integrated into an LDI portfolio. During our meetings with managers, we found that some have limited trading with, or indeed removed, counterparties from their approved panels based on ESG factors. We also saw one LDI manager produce an engagement report outlining what topics are being raised with counterparties and what progress has been made so far.
We view engagement with regulators as a desirable activity, giving clients, who otherwise may not have the necessary time, detailed technical expertise or access to regulators, a representation and voice in the topics that affect them. Whilst we believe cash funds should integrate ESG considerations into their processes, in practice, holdings in these types of funds are not as large as they used to be in the past due to the shift in LDI hedges from a swap to a gilt basis (nowadays, LDI portfolios predominantly hold gilts and repos rather than swaps and cash). Finally, the main allocation in LDI portfolios is typically to UK gilts and this element has not been the focus of ESG integration to date. One possible reason may be that there is no choice of the underlying issuer of the government bonds for UK LDI, as is the case for equity and credit portfolios. However, we may see more developments in this area in the future. For instance, we are aware of sovereign debt ESG scoring models and we may see more reporting on that aspect of LDI portfolios at some point.
Overall, while there is of course incentive to exaggerate the extent or materiality of ESG integration activities, this should not discourage both asset managers and clients from ensuring that we all, collectively, take steps in the right direction. To assist you with this, we’ve pulled together a list of potential questions that you may wish to ask your LDI manager in relation to their ESG integration efforts:
- Do you integrate each of Environmental, Social and Governance risks into your counterparty approval process?
- Have you ever removed a counterparty from your approved list on ESG risk grounds or reduced trading with them due to ESG concerns?
- Can you provide an example of engaging with a counterparty which has resulted in a meaningful change to how that firm addresses ESG risks?
- Do you engage with regulators on regulations relevant to LDI clients? If so, please offer an example.
- Are there any other ways in which you incorporate ESG considerations into your LDI investment process?