RI Leaders: Sonja Laud, CIO, LGIM: investing through a climate/energy transition

Legal & General investment head talks about the financial pathway to 2 degrees.

Sonja Laud joined Legal & General Investment Management (LGIM), the largest asset manager of UK defined benefit pensions schemes, in January 2019 as Deputy CIO, and took over as CIO in June. She joined LGIM from Fidelity International, where she was Head of Equity, after stints at Barings, Schroders and DWS.

With LGIM headed by CEO Michelle Scrimgeour, the former Columbia Threadneedle Europe chief, it means the £1.1trn (€1.3trn) investor is unusual – maybe even unique in a mainstream fund manager – in having two women in the top two senior roles at such a large firm.

When RI met Laud, she had just returned from Washington DC where she had attended a meeting on climate finance with Bank of England Governor Mark Carney alongside a mix of ratings agencies, asset managers and asset owners. 

Responsible Investor: Tell us about the climate finance meeting?

Sonja Laud: As we know not every tonne of carbon is necessarily the same. We know there are big gaps in the way they are reported: you can end up with different numbers for the same companies depending on what source you are looking at. The discussion was, ‘how do we make this a more level playing field?’

It has to be mandatory. We have to refine what companies need to report and we have to make sure that there’s sufficient transparency on what it is we want them to report.

There’s scope 1, 2, 3 emissions, and there’s the idea that we have to move away from static to more dynamic reporting: because obviously looking back doesn’t help us. And then it came back to what I think will be a big debate around scenario analysis.

We’ve done a lot of work around this. The Bank of England and the Prudential Regulation Authority (PRA) are aiming to stress test the UK financial system and scenario analysis will be the key ingredient in how we stress test: so what are we testing?

There’s two things: what do we want companies to report on to make our overall ESG scores more impactful and more useful and, secondly, for us as asset owners and asset managers, what do we do with this and how do we make this more useful in our own context in how we invest?

Responsible Investor: What goes into the scenarios, what’s the thinking there?

Sonja Laud: I raised the point about whether we make sure that scenario analysis is uniformly applied? I think we’re quite well prepared as we spend so much time on our energy destination model that at least you have an idea of what the future energy mix will look like in a 2-degree compliant world. It gives you a glide path if you assume an orderly transition.

Now it’s about, ‘what’s the price for carbon?’ Again, you have to make an assumption, and I think most would say between $100 and $200 a tonne. Again there’s the assumption that everyone would be using the same price. There’s no point if someone says its zero and we say it’s at least a $100, $150.

Responsible Investor: Do you use a shadow carbon price in your models?

Sonja Laud: Not yet. This is what we would like to get to, that if you apply different scenarios you can model under different carbon price assumptions and say ‘what would that look like?’ So we can get to a position where we can determine the future earnings at risk.

Responsible Investor: Who’s going to set a carbon price?

Sonja Laud: If it were to be set regionally you probably would get arbitrage – the unintended consequences that, again, would be incredibly difficult to model. I think we have to agree that for the global transition of the energy mix, the assumption has to be that we get a unified global attempt to get there [to a common carbon price] because otherwise it will be incredibly difficult and you will have to make a lot of regional assumptions.

If one country starts a carbon tax/price you will begin to see shifts, impacts and influence on commodity prices elsewhere and that would make the whole modelling incredibly difficult. 

Responsible Investor: People are saying there’s not enough expertise in the market, that this is new…

Sonja Laud: It is new, yes. I think we have established what we would like to measure. Physical risks are easier to grasp and understand, though I’m not sure they are easier to measure; that really requires fundamental data and data analysis.

If you have Google moving its headquarters because it’s on a flood-prone region that’s one thing. If you have a $10bn refinery that’s in the exact same area, that’s a very different thing.

It’s the transition risk that’s incredibly difficult, because here you have to make so many different assumptions. Obviously this is a group exercise for L&G as they are group assets on the balance sheet that will need to be tested. We’ve been very much part of this because of our work with [consulting firm] Baringa and Nick Stansbury (LGIM’s Head of Commodities Research) who looked into this and said ‘they’re not all equal’. Some have flaws in the underlying assumptions, others are better. Hopefully through this first initiative with the PRA we might get to a point where there’s a harmonisation of the modelling, where we’re not having various entities using different models.

Responsible Investor: But that’s investing, though. isn’t it? You have your thesis and someone else has theirs…?

Sonja Laud: As long as we are transparent about what it is so that the results are understandable, transparent and comparable, so that the big impact factors like commodities pricing and carbon pricing are at least comparable.

The Bank of England has set three scenarios: orderly transition, no transition at all and the other one is ‘chaotic’ – so the truth might be in between any one of these three, and as such requires more iterations than three. If we have a focus on 2 degrees then at least we know what has to happen.

Responsible Investor: No one’s really grasped the scale of what you are talking about, the shift that’s going to have to take place.

Sonja Laud: The model tells you to achieve something that we’ve never seen before happening in the real world, just in terms of the magnitude and the timescale that the model’s aiming for. So, yes, the model tells you something that historically has never happened before and that requires a global concerted effort.

The model tells you to achieve something that we’ve never seen before happening in the real world

There are so many input factors you have to consider: global energy demand will continue to grow so you’re doing this in a growing energy demand environment. Coal is all the rage – everybody wants to rid of coal – but that would switch out every light in India. You have to allow countries like India to come up with a transition that looks very different.

Excluding coal from any investment process, or starving it of capital, will probably not achieve what we want it to do. For a country like India, taking away its main energy resource cannot be the ideal outcome.

That’s why the model that we end up with still has some coal in it, acknowledging that there are some areas of the world that will not be able to transition as quickly from their main energy source to something else.

Do we have sufficient policy-maker and regulatory support to make this happen? Is there a greater need for the big asset owners to create 2-degree portfolios? There’s been a rather timid attempt so far. It’s no good if companies report on it but it doesn’t have any impact on the capital allocation and the way we construct portfolios: then we probably will not get there.

Responsible Investor: The asset owner community has never had this kind of scrutiny before. The industry has been slow to look at itself as part of the problem and part of the solution.

Sonja Laud: Greater transparency and clarity about what we want to achieve has to be part of the equation. 

Responsible Investor: This has gone way beyond ‘ESG’, the issues are systemic. Does the industry have the capacity to move that quickly?

Sonja Laud:  Before I answer that: a 2-degree portfolio is ‘E’ only. The ‘G’ is always part of fundamental analysis: most of what you’re looking for is good management and balance sheet strength and good strategy.

But you’re right, can we ask asset owners to move in that direction? Can the average pension fund move away from its [perceived] fiduciary duty? It’s not as straightforward as it might sound as there might be limitations on how far we can go. We might be able to shift these portfolios but it might have consequences for the risk-return portfolio that results from this shift in the capital allocation.

The awareness in itself has to accelerate: in terms of preparedness, understanding in terms of modelling so that clients can come to us and say ‘listen, this is my current set-up, where am I?’

The GPIF [Japan’s Government Pension Investment Fund] is already in a position to say that its current portfolio is not in line with 2 degrees. That’s very important: if we can get to a stage where everybody knows this, that would be a massive step forward; so that there is an acknowledgment and an awareness among the big asset owners.

Responsible Investor: How do we get from here to there. What’s the pathway?

Sonja Laud: So you would look at the carbon intensity in that asset book and identify where the worst offenders are. It is all about, for a big asset owner in particular, the identification first and then it’s risk mitigation —  then it’s identifying opportunities.

We should not forget that a transition of this magnitude will create a lot of opportunity: the whole infrastructure around our energy system. 

And this brings us back to the quality of the data we are getting so we can trust the carbon intensity that this model currently would give you. It goes back to what do we want companies to report on and whether we can ensure that the data quality is reliable enough for us to take decisions.

We should not forget that a transition of this magnitude will create a lot of opportunity

Responsible Investor: You seem a long way ahead of most DB pension trustees on these issues. How do you square that circle?

Sonja Laud: Firstly by being active, to show that we are part of the journey in shaping the modelling and the scenario analysis. For me to sit in front of a trustee and convince them that there is action needed, I need the tools to show them, to visualise where the problem is and to show them that a potential change, or tilt, would not necessarily change the overall risk-return profile of their fund.

Right now, we get lots of requests: ‘Do not change the look and feel of the portfolio but tilt it in a way that has minimum tracking error but the impact on the E, on carbon emissions and carbon intensity.’

Responsible Investor: The relationship with the insurance side of the business is interesting. You’re managing the assets but does the insurance side see things slightly differently?

Sonja Laud: This is where we are in a unique position that we are both asset owner and asset manager. We’re currently looking at stress testing from an asset owner point of view. That’s the beauty of the ecosystem that we have within Legal & General, to use this for clients eventually so that it’s deployed on a much larger asset base than just our own balance sheet. There’s a real connection in terms of, again, risk identification, risk mitigation, and opportunities. The group understands that the work we’re doing here has to be beneficial not only for us as an asset owner but as an asset manager as well.

Responsible Investor: There is a perception out there that investment consultants are a barrier to change?

Sonja Laud: I would hope that they are alongside us for the journey and work alongside us on scenario analysis, once these models are in place that there’s an involvement, an understanding, to take it forward.

Responsible Investor: How do we combat greenwash? Is there a risk of mis-selling?

Sonja Laud: That’s a very important one. That goes back to what we ask companies to report on and whether it is mandatory? The more transparency and comparability we have around what companies are supposed to report is essential in avoiding greenwashing.

Coming back to our destination model: oil is still part of the future, so we can’t disinvest from all fossil fuels because it will not get us to the end-point that we think is the most logical for the global energy system.

Yet, what I do want to be is part of the journey as it’s not a level playing field and some [fossil fuel companies] have embarked on being a more sustainable energy producer with a mix of renewable energy and others couldn’t care less – they’re the ones I want to disinvest from and I want to support the ones up here [i.e. more sustainable]. 

That still means I’m invested in fossil fuels. What my fund register shows is that I own fossil fuels. Is that mis-selling? No, because I’ve done everything I can to be part of the journey and to engage with the companies within the most important sectors within that transition.