In the third part of this Insurance Asset Risk / Russell Investments roundtable, insurers discuss their views on how to integrate environmental, social and governance factors into private market investments.
Adrian Chapman - Group ALM Manager, Legal & General
Ankit Shah - Head of Investments and Treasury, QIC Global
Carolyn Tsalos - Director UK Institutional, Russell Investments
David Walker - senior staff writer and head of projects, Insurance Asset Risk
Jayen Madia - Head of Risk Assets, Axis Capital
Leigh Hazelton - Research Analyst, Private Markets, Russell Investments
Manuel Dusina - Director, Infrastructure & Energy, Scottish Widows
Prasun Mathur - Private Assets Lead, Aviva UK
Simon Blowes - Investment Manager, ReAssure
Chaired by Vincent Huck - Editor, Insurance Asset Risk
Vincent Huck: We often hear there is a lack of available renewable energy assets when it comes to ESG and green investing. Are you finding the private ESG assets you need, or are you finding it difficult to source them?
Jayen Madia: We have looked hard at renewable energy in terms of infrastructure, as well as at infrastructure credit, [and] infrastructure debt. We have found that spreads for the level of risk, overall, have not been attractive enough for us, so we have not made as much investment in that area as we might have wanted to.
Leigh Hazelton: Jayen, when you are looking at renewable, are you looking at operational assets or at building new assets?
Jayen Madia: Typically we are looking more at building new assets, so the construction side, but typically we would look for pre-existing contracts, so not a speculative development but a contracted development, and then financing it with long-term financing.
However, we have found it is a pretty competitive market. Everybody is looking for those assets, so the levels of spread we are getting is, potentially, not enough.
From a pure fundamental analysis of the asset, we have been fearful of long-term depreciation and obsolescence risk of the asset, which we do not think is necessarily priced in, because most people are focused on the first five years with the cashflows that they can get.
Leigh Hazelton: We would second that last point, and that is why our preference is to develop-to-core, then sell on that risk, because we 100% agree that the depreciation risk in renewables is high.
Also, an area that may not be discussed too much, is re‑contracting risk, as PPA lengths are shortening.
In parts of Europe, it is not uncommon to see a ten-year PPA with an asset that can have 25 (or more) years of useful life. Beyond that ten-year point, you are taking risk that you can re-contract that revenue at a similar level when you agree a new PPA. We do not believe that that risk is being appropriately compensated for. It will be a little while before we see what happens to those assets, but eventually there will be a bit of a shock in the market, as there is the potential that assets could re-base to lower revenue streams.
Prasun Mathur: Which sectors you are talking about there, specifically?
Leigh Hazelton: Large-scale solar farms and onshore wind are usually the ones that people focus on, but there is a whole host of different types of renewable energy.
Prasun Mathur: In the US or globally?
Leigh Hazelton: You will probably see it first in the US, because the US PPA market is more mature. Europe is shifting from a subsidy feed-in tariff regime into a PPA market, so that will take longer. Once it happens in the US, I would not be surprised if European investors look at that and think about it.
Manuel Dusina: The European market is still mainly based on subsidy at the moment. Actually, we see also a different way of structuring in US and European markets. In the US, there is a more demarcated time subordination between banks and institutional investors, where the banks let the institutional investors take all the re-contracting and potential merchant risk. In Europe, it is more blended, where, to a certain extent, the parties share that risk, as banks can lend longer than in US
Will Europe go down the US route? On the PPA, yes, there is no alternative, but I do not see the structures proposed in the US, currently working in Europe. There will be some push-back from investors, because they are less keen to take those risks.
Leigh Hazelton: One of the proposals in the European recovery fund that came out today, is that the EU will tender 15 gigawatts of renewable energy capacity in the next two years, which is a significant level of tendering. That may prolong a bit of the reduction in feed-in tariff, but the general direction of travel in Europe is away from feed-in tariffs and subsidies, and towards PPAs. We are trying to monitor how the market is going to price that, because it is not the same risk.
Prasun Mathur: That is going to be challenging as well, because we are looking for long‑dated credit, and corporate PPAs do not necessarily lend [themselves] to long-dated structures.
Leigh Hazelton: You see a lot in Spain at the moment in solar, where a ten-year PPA is the norm. Even a few years ago, you would be looking at a 20-year income stream. It has changed quite dramatically, and the market is starting to morph closer towards what the US is like, but I agree it will not get all the way there.
Simon Blowes: We are very much focused on longer-dated investment-grade investments, and investments in some of the newer unproven technologies in different sectors – hydro is one example –just cannot get to investment grade, in our view, so it does restrict you to proven, operational technologies such as solar, onshore wind and possibly now offshore wind also.
Demand for these investment-grade assets is very high and, as Jayen alluded to, that has driven spreads extremely tight. So, whilst we as investors like to get these kinds of assets on our books, we do still need to get that illiquidity premium over corporate bonds, and that is where we are finding it difficult at the moment, particularly in the renewable energy sector.
Vincent Huck: How are you managing the integration of ESG factors into the investment processes for private markets?
Leigh Hazelton: Data is the main challenge. If you think of businesses that shirk attempting to meet the higher standards of ESG, or assets which are not future-proof, it is pretty well understood in the market that, over time, either those businesses could lose out to competitors, or if it is an asset, could degrade in value quicker than an asset that is future-proof. It is very difficult in the market to point to the data set that will back that up.
A good example is real estate. We see a lot in real estate where you have things like BREEAM or LEED certifications. There is this view that if you achieve a high level of certification, when you go to sell that asset it will be worth more and people will value that sustainability. However, it is difficult to point to the motivation of a buyer, or to be able to run an alternate universe to say, how much would that asset have been worth if it were not sustainable?
Prasun Mathur: Aviva as an enterprise has publicly announced certain green targets, so we are actively looking for opportunities in the ESG-friendly space. So, it is very helpful that there is a lot of tendering of renewables expected in Europe, but the move towards corporate PPAs is not [helpful], because they do not lend themselves to long-term structures. We are looking for average duration of 12 or 13 years at the least, and these corporate PPAs will not support that easily. So, I feel that there is a bit of a disconnect. We intend to deploy capital in green energy, but a move to corporate PPAs makes deployment of that capital in European renewables at attractive commercial terms for us a bit more challenging.
Leigh Hazelton: Another thing we would like to see in the corporate PPA space is a more scientific pricing of risk over time, very similar to what you have seen in real estate and credit, where not all risk is priced to an identical level. Currently, buyers of operational renewable energy that is backed by a corporate PPA seem to put a yield on that, almost irrespective of the credit quality of the counterparty. Some of the logic is that a counterparty is unlikely to default on their electricity bill.
We do need to see some pricing on that differing level of risk, and also on the length of the contract, because we are mindful that the market may not be reflecting a proper delta, in terms of yield and length of contract.
Adrian Chapman: From our group's perspective, our focus has been on achieving the Paris outcome (of limiting the increase in average global temperatures to well below 2 degrees above pre-industrial levels). What that means, practically, is getting a handle on the balance sheet's carbon footprint and agreeing a pathway to support the transition and mitigate its risk. But if data is not there, then what is the appropriate way of measuring the carbon footprint or the carbon intensity of your private assets?
There are obviously different ways of doing that and we are keen to progress industry harmonisation to a standard approach for the carbon footprint-intensity calculation for different asset classes.
Leigh Hazelton: There are certainly entities in and around the industry that are trying to solve that challenge. We firmly believe that in the next few years, the market will get a better grasp on the topic, or we will start moving towards having a better grasp of how you go about analysing that risk.
Manuel Dusina: We have been approached with some opportunities where [the promoters] say, 'This is an ESG investment, so you can price less.' Well, no: credit is credit. We would never trade off 10 basis points on spread, because something is ESG-compliant.
ESG is not only green, ESG is also the S and the G, so you need to put into context the social and governance dimensions, not just the green one, unless of course the institution has a climate target and not an ESG target.
Prasun Mathur: Probably franchise risk is one area often not focused on enough. It is very institution-specific in terms of risk appetites. It does not necessarily have a rational outcome. People are often driven by the thinking of, if you are risking your name being flashed in the front pages, then should you be investing in that opportunity? It is a very irrational risk, and every organisation has varying appetites for it, and it will be useful to understand how that risk has been assessed as part of an ESG strategy or outside it.
Jayen Madia: I was not part of the team that designed our ESG policy, but I think the philosophy for us was that we are going to take a stance on certain issues and that, it will be a sacrifice, but we are doing it for the right reasons.
We are always cognisant of reputational risk and we also make sacrifices on the investment side, forgo certain opportunities to prevent reputational or even potential reputational risk. Litigation finance is one area, or some parts of the life settlements business.
Simon Blowes: ESG is something we consider in detail for each and every new investment, but it can be difficult to quantify and accurately measure, particularly in private debt. We are in the early stages of trying to implement tracking of metrics such as carbon footprint across our investment portfolio. We do have hard limits on coal, oil and other sectors and are also very cognisant of reputational risk. We have stepped back from a number of transactions because of certain attributes of the deal or discoveries in due diligence. ESG is something that is always in our minds, but we have further work to do to hard code all our ideas into our investment thesis.
Vincent Huck: Is any one of you following impact investment strategies and how do they fit into the overall investment portfolio?
Leigh Hazelton: The concept of 'impact', which can be interpreted as meaning that you have to forego return versus values, probably does not accurately represent what 'impact' is.
Impact for a lot of people has morphed out of the third sector, out of philanthropy, endowments and foundations. Maybe at some point in time the balance was more towards values than value. The way we see it - and we are starting to get away a little bit from the term 'impact', because of that connotation - it is another form of thematic investing.
It is the identification of an opportunity that you believe benefits from an attractive market environment , is well structured and has the bones to be a solid risk‑adjusted return going forward, and then you go out and actively seek opportunities that fit within that theme.
Importantly, from our perspective, any strategy or opportunity we look at needs to stand up from a financial point of view.
David Walker: In Europe obviously the regulators are considering different capital charges for ESG investments and there are big regulatory pushes in Europe for ESG. As a US-headquartered company how you would view that? And secondly, how do you weigh up the risk and reward when Europe is going in one direction, and maybe other parts of the world are not pushing so hard from a regulatory point of view?
Manuel Dusina: A lot of players start to question if the market has already priced in climate risk or not yet.
Vincent Huck: And what do you think?
Manuel Dusina: It is starting, but it is just the beginning. If you were to factor in the full [effects of] climate change now, the market could be disrupted given the uncertainties. It should be gradual, in my view.
Leigh Hazelton: We have not met or spoken with many people who can very confidently state how you price in the risk. Maybe there are market participants out there who are confident in doing it, but based on the conversations we have had, we would be surprised if it is already priced in. We just do not get the impression that the market fully grasps how to confidently price in that risk yet.
Part I is available here: Private market allocation in times of COVID-19
Part II is available here: Private equity and infrastructure opportunities