A fiduciary argument for impact investing?

14 Jun 2024

Could there be a good faith argument for fiduciaries to allocate a portion of their portfolio to climate impact investments? I argue that there could.

In my paper “Universal Owners and Climate Change” I highlighted some of the limitations to the universal owner arguments that are used to support very ambitious investor climate action. But my intention behind this has always been to try to identify what actions investors can take that are both effective and aligned with fiduciary duties to clients. These are more modest than some of the more expansive claims made for investor agency on this important question. But through being more robustly grounded may end up being more effective and enduring.

In Section 6 of that paper “A positive agenda for investor climate action” I set out the areas that I felt passed these tests. But with one of them, I have to admit, I was flying a bit of a kite. This related to the role of impact investment. When I recently presented my paper to the clients of a major investment bank, this was picked up as a potentially significant proposition, so I was encouraged to pull it out separately in this blog, rather than leaving it languishing on page 46 of a 57 page paper.

I proposed that a climate-concerned asset owner might make a good faith fiduciary argument for a modest portion, say up to 5%, of their portfolio to be allocated to impact investments related to mitigation of climate change. I’ll develop the arguments I made below. But I was very interested that a few days after I published my article (and this is definitely correlation not causation!) the Financial Markets Law Committee published their paper on fiduciary duty in the context of sustainability and climate change where they stated in paragraph 6.11:

“Some investments will be marketed or offered as designed to be positive in their “impact” on sustainability and climate change. Some of these may involve a reduction in financial return to reflect the use to which the investee will put the sums invested in the interests of sustainability or to address the subject of climate change. In principle, these investments may still properly be considered by pension fund trustees in keeping with their duties (and by their investment managers); they do not fall outside what may be considered. But both financial return and risk would be the considerations, and at the level of the investment, at a portfolio level, and at the level of whole economies material to the pension fund.”

The fact that my thoughts might be aligned with such an eminent group of legal experts encourages me to try developing the proposition further.

The challenges with fiduciary arguments at the portfolio level

The problem with impact investments for fiduciaries is that to be impactful, i.e. additional, there has to be a reason why they aren’t being financed already. Typically this will be that they offer lower than market levels of return or higher than market levels of risk. They may be essential for the transition to net zero, but they aren’t commercial according to today’s economic incentives. Fiduciary duty for asset owners acting on behalf of beneficiaries (such as pension fund members) tends to require them to prioritise financial returns over impact, and so the idea of giving up returns (or incurring additional risk) in exchange for impact is anathema to most trustees and their advisors.

A fiduciary argument in favour of impact investment is therefore likely to have to go up a level from the individual asset to the impact on the portfolio as a whole, as indicated by the Financial Markets Law Committee. How might this argument be run? I’ll outline how I came at it below, but it’s perhaps helpful to start with the argument that I think does not work.

Anyone who has read my work will know I’m quite sceptical of the universal owner arguments in favour of 1.5C with limited or no overshoot being the goal asset owners should be pushing for. To be adopted as a fiduciary argument, the asset owner needs to believe in good faith that achieving the goal is beneficial for client portfolio values over the relevant time horizon. Moreover, the asset owner needs to believe that they have some efficacy to achieve the goal and to be very aware of the risks to which beneficiaries are exposed in the event of climate scenarios worse than those targeted.

To believe that 1.5C with limited or no overshoot is beneficial for portfolio values, the asset owner needs to believe that:

• achieving 1.5C with limited or no overshoot is beneficial for the economy - this generally requires belief in a green-growth multiplier but also faith in economic models that model the transition using an implied carbon tax, ignoring the inevitable political shenanigans and inefficiency that such an ambitious transition would give rise to;

• improved GDP translates into improved returns over the timeframe of the investments, notwithstanding the significant shift from consumption to investment in the economy, which while neutral for GDP might be expected to be negative for markets at least in the medium term (GDP and corporate free cashflows are very different things);

• the “cross over point” where the corporate cashflow benefits of climate action exceeds the costs comes early enough to enhance returns over the asset owners time horizon taking into account market rather than ethical discount rates.

Secondly, the investor needs to believe that their actions can significantly contribute to bringing this dramatic transition about and in so doing those actions do not result in investment strategy or engagement choices that expose clients to significant risks in the (likely) event that the 1.5C with limited or no overshoot target is not achieved. The problem is, as I’ve written elsewhere, investment strategies that have the greatest impact in dragging the economy onto an entirely different path are also those likely to expose beneficiaries to greatest costs and risks.

It is not impossible for an asset owner in good faith to believe all of these things. But in my view it’s a stretch and unlikely to form the basis of a widely adopted position. But is there a less ambitious reframing that would be more widely believable? I think so.

Marginal gains

The starting point would be to move from claiming as optimal an absolute climate target that is a long way from the trajectory we are on to an argument that, at the margin, less rather than more climate change is a good thing for beneficiary returns. The path we are on, to warming over 2C, is fraught with risk as has been identified by a number of reports by climate scientists. While the central case for markets might be relatively benign even over quite long timescales, the downside risks are less so. While it is tough, as outlined above, to make the financial case for dramatic investor action, it seems to me plausible to for a marginal cost benefit for marginal reductions in climate risk. It therefore seems credible to contend that paying a modest “premium” for a modest reduction in this downside risk is a reasonable thing for a fiduciary to do. Given the lack of credible climate-related long-term portfolio insurance, the premium is “paid” in the form of a modest impact investment.

I immediately accept that this is the most critical and contentious step in my argument, and if anyone can strengthen or disprove it I’d be very grateful!

Of course, while the potential cost of an impact investment is quantifiable, the reduction in risk is probably not. However, it is, firstly, at least more plausible that at the margin the reduction of climate risk is beneficial for portfolios than it is to argue the case for the portfolio of a dramatic, rapid, and unprecedented economy-wide transformation. And, secondly, it is also more plausible that through a focussed marginal impact investment the asset owner has agency to make a difference to climate change, at the margin, than through attempts to drag the economy far away from its current path.

Modest allocations

If we accept the arguments for marginal benefit and impact set out above, we must also accept the qualitative nature of the arguments. Therefore, modest allocations to an impact strategy would be in order. In my paper I suggested an allocation up to 5%. Why 5%? For no more scientific reason that it is the largest number that still counts as small. It is below most materiality thresholds and it is hard to see a strategy including this level of allocation constructed in a thoughtful and good faith manner giving rise to legal difficulties. Indeed the Financial Markets Law Committee comes to our aid here. They affirm that trustees are within their rights to make reasoned qualitative decisions where there is no clear quantitative yardstick. But this could still release many $bns for impact investments of various types.

It should be noted that decisions with this level of financial impact are routinely taken by trustees and not subject to challenge. For example, all else equal, an increase in fund management fees of 20 basis points has a potential cost of 5% of the portfolio value in net present value terms, but trustee fund choices at this level of difference would not credibly be challenged in the courts, notwithstanding the overwhelming evidence that higher fees tend not to lead to higher returns.

Indeed, currently fiduciaries are taking quite wide ranging decisions with potential unbounded consequences in pursuit of sustainability. For example, portfolio decarbonisation strategies could easily have tracking errors of 20 basis points per year or 5% of portfolio value cumulatively over long periods depending on the climate scenario. A combination of higher fees for “sustainable” funds plus investment strategy distortions arising from “net zero aligned” strategies plausibly expose clients to bigger and much less well defined risks than a clearly bounded and identified allocation of 5% of the portfolio to impact investments. Given its bounded nature, such an allocation would also lend itself much more naturally to obtaining informed agreement from beneficiaries about the potential costs and benefits of the trustees’ approach to sustainability.

Selecting impact investments in the portfolio context

Trustees would need to be thoughtful in the selection of impact investments. I propose three guiding principles for consideration:

1. The impact investments should have the prospect of delivering an acceptable return. While the expected return or risk may be worse than market norms, there should not be an inevitability of non-performance of the investment (so, for example, research grants would be more difficult to justify than high risk venture or blended finance investments).

2. Impact investments should be focussed on the biggest and most scalable problems such that the potential marginal climate benefit is maximised for the marginal impact investment. This might include investments in critical technologies such as low carbon cement and steel, farming, or carbon capture and storage where breakthroughs are required to create scalable technologies, but where the potential climate gains are great.

3. Impact investments should provide a hedge to other parts of the portfolio in particular climate scenarios. For example, an asset owner remaining invested in oil and gas companies faces downside risk in scenarios where the policy transition is much more rapid than expected, yet these might be precisely the scenarios in which innovative solutions to high carbon industrial processes become viable and hence the impact investments deliver the highest returns. The impact investments and retained oil and gas investments might be seen to be uncorrelated diversifiers.

Could not should

Set out above is, I believe, a series of arguments that could be accepted in good faith by a climate-concerned asset owner in support of a modest impact investing allocation. But this is not something that we can say an asset owner should do. The arguments I’ve set out are, I believe, more plausible and robust than arguments for more ambitious investor action based on universal owner theory. Their modesty is their advantage. But they are not so compelling as to say that all asset owners must do this.

Nonetheless, they are arguments that should at least be considered, and may lead to investment strategies that better meet the necessary twin objectives of climate-concerned investors than do many sustainable investing strategies today: the twin objectives of pushing for the world as you would like it to be while investing for beneficiaries based on the world as it is likely to be.

There are different strategies, based on different investment theories, that trustees can reasonably adopt to pursue returns for their clients. Who’s to say that a well constructed, traditionally diversified portfolio coupled with a 5% allocation to impact investments isn’t better for beneficiaries than a costly or distorted “Paris-aligned” investment strategy with dubious efficacy from an impact perspective?

Leaving the last word to the Financial Markets Law Committee:

…provided they approach a decision properly, and for a proper purpose, acting within their powers, and give due consideration, and do not neglect to make decisions when they should, pension fund trustees should not fear liability.

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