Ben Caldecott: mainstreaming sustainable finance – large is beautiful

The prize of sustainable finance is making more capital available for activities that have positive social and environmental benefits, while reducing the risks facing individual financial institutions and the financial system as a whole. As a result, policymakers are busy thinking about how to encourage its growth and development.
The UNEP Inquiry into the Design of a Sustainable Financial System, the High-Level Expert Group on Sustainable Finance created by the European Commission, the Green Finance Initiative created by the City of London with backing from the UK Government, and China’s Green Finance Committee are all examples of these attempts to get on top of the issue, often from a policymakers perspective.
Beyond changing signals in the real economy, there are many ways for governments to stimulate the development of related practices and markets. They include supporting data and transparency (e.g. disclosure and asset-level data), clarifying duties and obligations (e.g. fiduciary duty), public sector co-financing (e.g. through MDBs or via purchasing subordinated debt), new rules and standards (e.g. financial conduct, new product guidelines), changing supervisory rules and practice (e.g. Solvency II and Basel III), and providing subsidies directly (e.g. tax incentives for holding particular types of debt or equity) or indirectly (e.g. loan guarantees or concessional finance).

In later blogs, I’ll say more about these choices and the principles that should guide what policymakers decide to do. Here I want to briefly discuss the importance of scale, particularly among asset owners, and what if anything, policymakers can do in this area.

The key factor for the development of sustainable finance is demand for related products and services, particularly from asset owners.

The ecosystem of asset owners is multifaceted, from pension funds (public, private, DB, DC etc.) through to insurance companies (life, general, marine, etc.), sovereign wealth funds (politicised, non-politicised, OECD, non-OECD etc.), and family offices (old money, new money, large, small etc.) – each with a different set of challenges and considerations for asset-liability matching.One generalisation that can be made across all these different groups is that the larger the asset owner, the greater the number of opportunities it has to access different asset classes and markets, as well as develop, operate, and use different types of analysis to improve decision-making.

This is often reflected, particularly in large pension funds and in many sovereign wealth funds, in the greater use of direct investing and the creation of in-house teams and expertise in specific asset classes. While this is not universal and some very large asset owners have major restrictions on what they can and can’t do (for example, the Japan Government Pension Investment Fund – the world’s largest pension fund – places almost all its funds in listed equities managed by external managers), anecdotal evidence would suggest that this is broadly the case.
If larger asset owners are better able to achieve scale and do direct investing and build in-house capabilities, could they also be better placed to manage the risks and opportunities associated with the transition to global environmental sustainability? I would argue that they should be, as they have the scale to acquire the expertise and investments needed to do so.
This is mirrored in the relative weakness of smaller asset owners.

Not only is it more expensive per $ under management for them to acquire expertise and diversity across asset classes, sectors, and geographies, but they often have less expertise in these areas at a board level or in the senior management team. This appears to be the case for many small UK pension funds, who then have to rely on patchy sustainability advice from investment consultants with their multiple conflicts, misaligned incentives, and capability gaps.
If these arguments are correct, and I think they broadly are (though I acknowledge that there is huge diversity among asset owners and many exceptions), then helping smaller asset owners to consolidate and upskill could help create champions able to spur significant demand for products and services related to sustainable finance and investment.

This could complement demand from existing larger asset owners.
Policymakers have largely focused on extending the time horizons facing investors to foreground sustainability concerns in their decision-making, for example, Mark Carney’s ‘Tragedy of the Horizon’. This is critical. But, what I am proposing is a parallel consideration of scale and relatedly, ensuring that asset owners have sufficient capabilities internally to manage these risks and opportunities.

This suggests a greater emphasis on consolidating smaller asset owners, particularly pension funds. I’m not sure efforts to consolidate some of the assets held by UK Local Authority Pension Funds are necessarily the best solution, but at least they move things in the right direction. But what could be considered in other jurisdictions, particularly in countries with many smaller pension funds? What could governments to do encourage their permanent consolidation?

Are there light touch incentives that could do the trick or are bigger structural changes required?

This also suggests that we need a greater emphasis on ensuring smaller pension funds have access to the people and expertise they need to navigate sustainable finance. This could be in the form of training, encouraging boards and senior management to have expertise in sustainability, and making sure that the conflicts of investment consultants, particularly when they act as fiduciary managers,are appropriately managed. I do not know what the ideal size and shape of asset owners should be to ensure that they are best placed to align with sustainability. But I do think they should generally be larger, as this creates opportunities to gain the capabilities required, including diversification, technical competencies, and more effective governance. Promoting consolidation, and where that is not possible, supporting smaller asset owners to increase skill capacity, should be a key area for policymakers to consider when exploring how to permanently support the uptake of sustainable finance.

Policymakers have a key role in shaping the asset owner ecosystem through obligations, standards, regulations, and incentives. It is a policy conversation and consolidation is unlikely to happen by itself.

This is part of a series of blogs on sustainable finance and investment by Ben Caldecott, Director of the Sustainable Finance Programme at the University of Oxford Smith School of Enterprise and the Environment and a Senior Associate at E3G.

Read the earlier parts of the series:

Ben Caldecott: Mainstreaming sustainable finance by moving out of the echo chamber
Ben Caldecott: Mainstreaming sustainable finance part 2 – reasons for optimism?