2022 Perspectives for the Public Sector

8 comparing ‘E’ against ‘S’ against ‘G’. A further complication is that, as yet, there are no ESG factors (such as company size or volatility) to identify the source of return (as there is for non-ESG investments). A new way to approach ESG Rather than adding an ESG approach to existing portfolio construction techniques, a growing number of sophisticated asset owners — and even some asset managers — are taking a new approach: they start with an ESG outcome in mind. For example, they may choose to focus on water scarcity and then look across the entire capital structure, including equities, bonds and other asset classes, to identify potential investments that are relevant to addressing this sustainability challenge. Once this investable universe has been defined, various financial and risk filters can be applied to determine allocations. This approach does not overcome the challenge of comparing the efficacy or performance of ESG outcomes because necessarily, such performance means different things to different people. While key performance indicators, which are often present in green and other sustainability-linked bonds, are a step in the right direction and can be mapped to UN Sustainable Development Goals, there is still no uniformly accepted way to objectively measure ESG performance. However, to some extent this is unimportant. Different investors will place varying levels of importance on ESG (and, indeed, on its various components). For some, ESG is simply a hygiene factor; investment in certain sectors might be ruled out. For others, having a demonstrable impact is the primary objective. Investors therefore need to establish a framework that clearly defines their ESG objectives and parameters, before applying these to their portfolio construction. In this sense, ESG is a fundamental challenge to traditional portfolio construction because it is by definition subjective and therefore idiosyncratic. It requires a much more tailored approach to performance assessment than has historically been the case with purely financial metrics. Nevertheless, some of the key concepts that underpin contemporary portfolio construction remain relevant in the new ESG era, albeit in a different form. ESG indices (or negative screening) can be seen both as a risk avoidance tool (they should prevent investment in assets which, over the longer term, will decline in value) and a way of achieving broad ESG exposure – or green beta. Equally, green alpha can be thought of as delivering specific ESG outcomes. It can prove valuable to have different investment policies relating to green alpha and green beta. The negative screening associated with green beta may exclude some investment choices that could have positive ESG outcomes. For example, many patents associated with renewables and battery storage are currently held by oil companies. Investments in such companies could generate controversy but in the long term, their intellectual property could deliver both financial and ESG alpha. Transitioning to a nuanced ESG-led approach The world’s leading public sector pension funds are already at the forefront of the ESG revolution. However, the challenges associated with transitioning to an ESG-led approach to portfolio construction are significant and expectations regarding the pace of change are growing. Asset owners may need support to reformulate their portfolio construction techniques for the ESG era, and – crucially – to establish reliable, transparent and verifiable means to monitor and measure ESG performance. As desired ESG outcomes are specific to asset owners, there is no one-size-fits-all approach when it comes to ESG portfolio construction. It can therefore Integrating ESG into Existing Portfolio Construction Frameworks It is essential for public pension funds to keep abreast of developments in the ESG investment world. Historically, ESG investment has been predominantly focused on equities. This is rapidly changing, with an increased emphasis on bonds and private assets.