Sovereign wealth funds: the future of ESG investing?

Attacked for political investing, could sovereign wealth funds actually be the most important future trend in ESG finance?

by Afshin Mehrpouya | July 22nd, 2008

In the face of credit crisis write-downs and scarce liquidity, Sovereign Wealth Funds (SWFs) especially from China, Singapore and Middle East have taken huge stakes in several western financial institutions such as Barclays, UBS, Citigroup, and Merrill Lynch. Such large and visible transactions, while being very helpful to the cash constrained western financial sector, have raised concerns about the lack of transparency at SWFs and the possibility that their investments are being made for political reasons. One key area, however, which has received less coverage, is the environmental, social and governance (ESG) implications of SWF investments. Given their scale and scope, the policies of SWFs will increasingly be one of the key defining factors in the ESG behaviour of the companies they invest in.
Already by the end of 2007, the total money in SWFs was estimated at $3 trillion. This is forecast to reach $10-12 trillion by 2012, or over 15% of the global equity market capitalisation.
Sovereign wealth funds (SWFs) are predominantly defined as funds controlled by national governments invested in international securities, against which the government does not have any liability.
This is their key differentiator from pension funds. SWFs are usually sourced from commodity exports especially oil (e.g. Middle East SWFs and Russia) and non-commodity trade surplus (e.g. China and Singapore SWFs). Some SWFs such as Kuwait Investment Authority (KIA) and Abu Dhabi Investment Authority (ADIA) were launched a few decades ago.
By contrast, several countries with large reserves that were historically invested only in foreign currencies and sovereign debt have recently announced their interest in launching SWFs (e.g. Japan, Saudi Arabia, China and Russia).
As demonstrated in the table (see downloads – left hand column), SWFs are emerging global players and at very different stages of adoption of ESG policies. The leader in this area is the Norwegian Global Pension Fund which actively engages in improvement of the ESG behavior of its investees. In addition it has a negative screening and divestment policy, which, for example, led to its divestment from Wal-Mart, the US supermarket giant, due to labour issues. Funds such as the Norwegian and New Zealand SWFs cite both higher returns and national values as the reasons for their ESG focus.
Chinese Investment Corporation (CIC) is another example of emerging SWF interest in ESG. Gao Xiqing, CIC’s president and chief investment officer, recently announced that, the CIC will invest in environment friendly technologies and negatively screen its portfolio for arms and gambling.
Nonetheless, all SWFs including Norway’s (which is currently reviewing its environmental & social policy) significantly lag behind the best practices in parallel institutions such as pensions funds.

“The policies of SWFs will increasingly be one of the key defining factors in the ESG behaviour of the companies they invest in.”

For example, none has actually invested part of its capital in environment related investments. In addition, even in the best cases, engagement activities and proxy voting disclosure of SWFs are not as comprehensive as their pension fund counterparts and the overall level of integration of ESG risk evaluation in investment practices seems to be low.
Yet, given the dominantly long term investment horizon of SWFs and their sources of capital, SWFs are well-positioned to benefit from increased attention to environmental and social risks and opportunities in their investments.
Below are a few of the drivers for increased environmental and social focus of SWFs:

• For SWFs sourced from oil exports, investment in renewable energy can be an effective hedge against possible future oil crises or resource exhaustion
• In many cases such as Norway, the country’s constitutional commitment to principles such as the preservation of the environment and respect for human rights is diffused in the management of the fund; another example is a carbon emissions portfolio audit especially for SWFs in countries that have Kyoto protocol commitments*
• SWFs are long term investors, hence they can reap the proven higher long-term returns of environmental, social risk adjusted portfolios and ESG engagement
• In the face of media and regulatory pressure about the nature and objectives of SWF investments, adoption of responsible investment mandate can help SWFs appease such concerns

Depending on national values, type of government, level of media coverage, size of the fund and its source of capital, the above drivers affect different SWFs at different levels. Consequently, not all the funds are expected to equally respond to these drivers. One factor that has limited the potential ESG role of SWFs, especially in engagement, is that many of them such as CIC and GIC choose to be passive investors.
This decision is an attempt to allay concerns about the possibility of them using active investment to pursue political goals. Pressure from regulatory bodies, the investment community and initiatives such as IMF governance and transparency codes for SWFs (GAPP – Generally Accepted Principles and Practices) can help such SWFs move towards transparent & independent active investment management in the future.
Financial services firms can be another important ESG driver for SWFs. Given that many SWFs are currently seeking training from international financial firms and also tend to outsource part of their fund management to them, such firms are well positioned to assist SWFs in realizing the potential benefits of activities in this area.
International investment communities and codes such as the UN Principles of Responsible Investments (UN PRI) and the UN Global Compact can also play a key role in this diffusion. Such codes can serve as a source of guidelines and investment community dialogue for SWFs. So far, Norwegian and New Zealand SWFs are the only signatories of UN PRI.
Finally, for diffusion of best practices among SWFs, research firms who can analyze, compare and publish the ESG practices of SWFs can play an important role. Innovest Strategic Value Advisors has recently carried out an analysis of governance platforms and ESG practices of SWFs. Such efforts can contribute to a better understanding of the risks and opportunities associated with investments of the SWFs.
Current oil price trends and non-commodity trade patterns guarantee that SWFs will play a central role in the capital markets. They have expanded and come into the spotlight at a time when the world is facing critical challenges such as climate change, water scarcity, fossil fuel price hikes, rising food prices, etc. Considering their national mandates and their investment style, there are a wide range of economic and strategic incentives for SWFs to adopt a strategy with regards to such risks. It remains to be seen whether they will leverage such issues to achieve higher long-term returns and be a positive environmental and social force or whether they will continue to be laggards in this area.
Afshin Mehrpouya is a senior analyst at Innovest Strategic Value Advisors