Hermes asks what’s next in sustainable investment

This article is sponsored by Hermes Infrastructure

In 2020, government, society and industry experienced an almighty earthquake in the form of the coronavirus pandemic. The ongoing social and economic fallout has accelerated discussions in several areas that already had momentum before the crisis, including responsible capitalism, the purpose of business, transparency, inequality and the urgency of the climate emergency. During 2020 and 2021, a plethora of regulatory, industry and policy initiatives responding to these, and other issues, will either launch or come into force.

In the context of such a dramatically changing landscape, it is important to consider where we are now before opining on what’s next in sustainable investment. In many respects we are experiencing the evolution of a new normal: a modernised social contract, sharpened focus on climate change and deeper cognisance of social and environmental impacts. We expect the ability to recognise and embrace the paradigm shifts underway will determine not only what’s next, but who thrives.

Legitimacy, trust and accountability

Sustainability in essential infrastructure should be considered in its broadest sense. As private infrastructure investors, we own businesses that provide vital social, economic or environmental services, stewarding critical assets not only for current users, but also for the next generation. In infrastructure, a fundamental prerequisite for sustainable investment at all is that private finance is perceived to be legitimate.

The 2017-19 nationalisation debate in the UK represented an existential crisis for private infrastructure investors. While the immediacy of the debate has subsided, its shadow still influences policy and behaviour. The UK government may have a multi-billion pound infrastructure funding need to create jobs, deliver the path to net zero and our digital transformation, but is wary of proposing improved models for private finance or partnership at risk of sparking voter disquiet.

Economic regulators attempt to address historic, perceived unfairness using their currently limited toolkit, while arms of government send sometimes contradictory messages around promoting long-term investment while limiting consumer bills. For so long as the legitimacy question remains, the potential of private investors to contribute to the achievement of social and environmental goals may go unrealised.

The drivers for negative sentiment towards private ownership of essential infrastructure have been much discussed, with consensus landing on a lack of public trust. Trust in institutions is based on two attributes: competence and ethics.

In Endelman’s 2020 trust survey, business as an institution ranked highest of all institutions in competence terms. This implies the public assumes the private sector could run infrastructure assets better than the government but that the trust gap is an ethical one. Mistrust is said to be driven by a sense of unfairness and, in infrastructure, by a lack of accountability on the part of the private sector.

In this light, headlines focused on executive pay, tax practices, shareholder returns and what is regarded as remote, foreign ownership, make sense. It also becomes obvious that advocating the benefits of private infrastructure provision solely in competence terms, risks missing the point.

The new social contract

Post-covid, many organisations have highlighted a need for a new social contract, in return for the support businesses received in furlough payments and government-backed loans. In April 2020, the Financial Times devoted a series to the topic, advocating ‘radical reforms’ focused on fairness and equality.

In March 2020, the Social Market Foundation recommended using the pandemic as an opportunity to set out new shared norms for the conduct of business and its obligations to others. The SMF’s illustrative content majors on areas that directly address perceptions of unfairness – company purpose, accountability, diversity, transparency, tax justice and fair remuneration.

Discussion of governance in essential infrastructure is often focused on boards of infrastructure companies. It also generally avoids ‘political’ matters. In 2017, Federated Hermes Infrastructure made the case for an enhanced governance regime for essential infrastructure, including board-focused improvements such as independent representation, aligning compensation to environmental, social and governance metrics, the establishment of stakeholder committees and enhanced non-financial reporting, which has influenced a number of studies since.

But both in content and subject, the world has moved on. The market spotlight has been turned firmly upwards, to the owners of assets. It is also increasingly acknowledged, including notably by KPMG, that infrastructure ‘governance’ discussions must include previously taboo topics that drive to the heart of perceived unfairness, including responsible tax.

How quickly trust can be rebuilt, if at all, will depend upon the readiness of investors to embrace the new reality. Buying into the new social contract may be added to competence as a government screening criteria for new project or private finance initiative/public-private partnerships (allowing government to actually form them), public procurement, or infrastructure M&A. Or the industry may initiate a convincing enough transformation itself.

It is certainly not beyond some asset owners and managers to live up to a holistic set of principles. We would like to think doing so would be consistent with Federated Hermes International’s focus on holistic returns. However, making commitments to, for example: be available and accountable to all stakeholders; promote fair remuneration ratios; disclose ownership structures, sources of funds and the diversity and qualifications of management teams, may prove challenging for some institutions. Standing behind them will require authentic – not box ticking – intellectual, financial and operational commitment.

What’s next, is continuing the conversation.

Climate change and impact

Aside from governance and legitimacy, we are also witnessing an accelerated focus on climate change and impact reporting.

Rather than distract investor attention away from climate change, the pandemic has sharpened focus on the risk. The UK government is considering making a task force on climate-related financial disclosures mandatory for pension schemes, including their carbon footprint and how the value of assets or liabilities would be affected by different temperature rise scenarios. The UK’s Financial Conduct Authority is challenging listed companies, while the Prudential Regulation Authority will be stress testing banks and insurers in 2021.

Paris Agreement-aligned investment strategies and asset allocation are also fast-moving topics. As well as new legally binding net zero targets during 2020, some investors have expressly aligned investment activity with no greater than two-degree warming and are considering net zero targets more ambitious than governments are.

New tools are being developed to support investors in these ambitions. In August, the Institutional Investors Group on Climate Change and its members, including the international business of Federated Hermes, published a comprehensive framework for aligning investment portfolios with the Paris Agreement goals, that will soon be tailored for infrastructure. The EU Taxonomy provides a unified classification system for green and sustainable economic activities, setting technical screening criteria across a range of
sectors.

This is already having an impact. In March, Cadent Gas issued the UK’s first Taxonomy-aligned transition bond to invest in the retrofit of its gas distribution networks. Investors are already considering what proportion of their portfolios are Taxonomy eligible, in advance of disclosure requirements coming into force in 2021.

Despite the obvious relevance of physical and transition risk to infrastructure assets, the quality of assessment and disclosure among the biggest investors and managers is said to be variable. We have seen such variation in our portfolio companies, with regulated utilities being more sophisticated than most.

If managers are to support the new normal, risk frameworks, scenario planning, data and reporting will need to become more robust, consistent and credible, quickly. In addition, it may not be long before institutional investors regard Paris alignment as a pre-condition to making a fund investment.

Heightened understanding of the connectivity between citizens, business and society has seen environmental and social impact reporting extend beyond impact funds and approach mainstream. Whether expressed as a contribution towards a Sustainable Development Goal, using an internationally agreed metric, or just in plain English, investors (and their beneficiaries) increasingly wish to know the real-world impact of their assets and many managers are voluntarily reporting in this way.

While positive in many ways, the risk of a proliferation of voluntary impact reporting is that selective positive impact is prioritised in a way that hinders the assessment and resolution of more challenging ESG issues. As recently flagged in the media, sustainability is in how a company makes money, not how it spends it. Those businesses reporting ‘social impact’ via charitable donations to food banks may still have failed to pay suppliers during lockdown or have fundamentally unsustainable employment practices. We remain cognisant of this in our engagement and reporting to investors.

What’s next may be a coming of age in impact infrastructure investment. While impact reporting becomes mainstream, we see a place for dedicated impact funds, currently less common in our asset class, that target net positive environmental or social outcomes.

In infrastructure, impact funds have tended to concentrate around energy transition, many focusing exclusively on renewable generation. We see a gap for diversified infrastructure impact funds that dynamically target innovative investments, and drive transformational change across sectors, thereby contributing to creating the circular, low carbon and inclusive economy we all need.

The role of managers

The pandemic has presented us the opportunity to reflect on our roles in society and whether we are collectively up to the task. At Federated Hermes Infrastructure, our clients are increasingly, positively challenging our ambition, commitment and ability to deliver on their environmental and social expectations. We welcome these discussions.

When meeting mainstream expectations means engaging with the public and wider stakeholders on trust, accurately assessing and mitigating climate, environmental and social risks, accepting accountability for positive and negative impacts and innovating for positive change, best-in-class infrastructure fund management requires more than financial and operational skills. It requires a diversity of experience, commitment and perspective to genuinely engage with and serve our beneficiaries and wider society.

The organisational vision to embrace change and access to deep technical resource, such as Federated Hermes International’s responsibility office and EOS at Federated Hermes with around £1 trillion ($1.3 trillion; €1.1 trillion) under advice, will become increasingly valuable, if not essential, in the new normal. Times are changing and to see what’s next, we must move with the times.