Covid hit Britain’s economy hard. The initial lockdown ordered to slow the spread of the pandemic drove the economy to contract by a fifth in April 2020. But with 70% of the population now fully vaccinated and Omicron believed to be milder than other variants attention is turning to reviving GDP.
Build back better is the slogan promoting the government’s plan to boost the economy while making it more resilient to future shocks. But upgrading the UK’s infrastructure and making the country greener is expensive, so the government is turning to institutional investors to close the funding gap.
In what was our first in-person roundtable for almost two years, we brought pension schemes and insurers together with asset managers to discover how they can help the UK to build back better.
The Panel
Ted Frith, chief operating officer, GLIL Infrastructure
Ted Frith has been responsible for all non investment matters at GLIL since joining the infrastructure investor in November 2018. He also has a seat on the executive committee. Prior to this, the Oxford graduate spent three decades working as an investment banker and asset manager at firms including Orion Royal Bank, Midland Montagu, Citibank, Aspect Capital and Dresdner Kleinwort Wasserstein. More recently, Frith ran a third-party marketing business, was a consultant and non-executive director.
Paul Rhodes, Trustee, Reach Pension Plan
Paul Rhodes is a member-nominated trustee for the Reach Pension Plan. A national newspaper journalist for more than 20 years, he has worked on The Scotsman, Daily Express and Daily Mirror. He is currently chief sub-editor of The Daily Star. Rhodes also co-founded the Climate Impact Initiative, which aims to make a climate impact investment option available for all defined contribution savers.
Stuart Trow, Credit strategist, European Bank for Reconstruction & Development
Stuart Trow joined the EBRD following a career on the sell side. As senior credit strategist, his role spans high-grade credit management, emerging market strategy, ad hoc portfolio “firefighting” and the development of credit pricing strategies. He also sits on the bank’s retirement plan investment committee. Trow has head of EU credit research at National Australia Bank on his CV as well as head of market & credit analysis at Norinchukin International. A graduate of the London School of Economics, he has also written several editions of The Bluffer’s Guide to Economics and presents his own financial radio show.
Tom Sumpster, head of private debt direct origination, Phoenix Group
Tom Sumpster brought 20 years of structured finance experience to Phoenix when he joined in March 2021. Prior to that he was head of infrastructure, across equity and debt, at Legal & General Investment Management. An accountant by training, Sumpster has also been a managing director and head of acquisition finance at Royal Bank of Canada, focusing on infrastructure debt. He has held related positions at BayernLB, Dexia, Santander and PwC.
Christine Farquhar, partner and head of credit, Cambridge Associates
Christine Farquhar oversees manager and market research across public, hedge fund and private credit investment strategies. She has more than 30 years of industry experience and has been with the firm since 2007. Prior to her current role, Farquhar managed the firm’s global fixed income research efforts with a particular focus on investment-grade bonds, foreign exchange and income-oriented real estate. Before joining Cambridge Associates, she was head of fixed income research at Hewitt B&W Investment Consulting and was an executive vice president and head of fixed income at Lombard Odier. The economics graduate has headed fixed income, derivatives and alternative asset management for investment managers, including Insight Investment.
Julien Halfon, head of pension & corporate solutions BNP Paribas Asset Management
Based in London, Julien Halfon is responsible for constructing customised solutions for institutional investors, including balance sheet management, multi asset solutions and overlays. He has extensive asset management, investment banking and investment consulting experience gained at Mercer, PSolve, Lazard, Hewitt, Bacon & Woodrow and Goldman Sachs. Halfon began his career as an economist at the French Finance Ministry, before working for the European Commission.
The discussion
What infrastructure projects are you expecting to see as part of the government’s build back better plans?
Ted Frith: We have received a couple of letters from the chancellor, but he is asking the wrong question. Instead of asking how much money we have, he should be highlighting the projects that require financing and how we might go about investing the capital we have already committed to UK infrastructure.
Tom Sumpster: There is a wall of money available to invest in the build back better political theme. A difficulty we face are the regulatory restrictions on how pension funds can make investments. We and GLIL have the capability to invest in the broader financial markets. If the regulator could be more flexible with how they allow us to invest it would provide a wealth of opportunities for large institutional investors to make a statement in sustainable investing and supporting government initiatives.
Christine Farquhar: Aggregation of capital is top-of-mind with a lot of investors. Being a seed investor or gathering money through a fund structure, getting that money to work is the challenge. Assets such as infrastructure and clean energy are financially viable, so the issue is: how can investors direct capital to them safely.
Frith: The UK Infrastructure Bank, which we are engaging with, could play a big role as the broker between the providers of capital and the different risk-profile projects, which range from a couple of million to billions of pounds. You need a broker to manage that process and marry the varying demands of the capital providers.
Sumpster: The European Investment Bank took an early role in renewables when offshore windfarms were not seen as stable investments for pension fund investors. We need to be guided and form partnerships with multilateral organisations and governments because today’s taxpayer is tomorrow’s pensioner, so we are investing for the same person. We need to speak with the UK Infrastructure Bank because we want to co-invest, we want strong partnerships with the public sector and multilateral organisations to ensure we maximise the economic and social value of our investments.
Frith: We are supportive of what the government is trying to achieve. We have made a couple of suggestions that might expedite what they are trying to do.
Julien Halfon: The distribution structures are another hurdle. Defined contribution pension plans have a fee cap and funding SMEs is expensive. A fee cap of 50 basis points means we can only talk to large investors or defined benefit schemes, but not defined contribution plans, which would be the best possible investment for their younger demographic.
At the other end of the spectrum, we see several strange operational limitations, such as defined contribution funds having to make highly liquid investments. Why would you need this if you are saving for 30 years? That creates a lot of frictions when trying to invest in large illiquid projects. If there are restrictions on fees and liquidity, an enormous amount of the population is prevented from investing in something that could benefit them.
We are getting into a situation where mass-market utilities should go to smaller investors who could see the impact of their money. But the set-up is preventing almost anything from happening. On top of that, many providers are not improving their platforms. This blocks innovation and limits defined contribution investment to ultra-liquid assets.
Farquhar: Our database has 600 managers and more than 1,000 dedicated impact strategies. It is not only about infrastructure. We have healthcare, social housing and private credit. Those 1,000 strategies are ready and many are waiting for new capital.
Paul Rhodes: This is a problem we are seeing. How do you get into it? How do you price it? It gets more difficult with funds worth less than £100m. The regulator says they must prove value for money, so their options are often more limited. This is why there is a big move to master trusts. They have the scale to do this, but not everyone wants to be in a master trust. So, how can we work together to create impactful opportunities which are more assessable to defined contribution savers?
Is the EBRD acting as a broker when it comes to build back better?
Stuart Trow: Yes, but not to an ideal extent. As development banks go, we are one of the smaller ones. It would be nice to leverage those strategies and get more people on board, but we can still take on multiple projects. A problem is that because of the nature of infrastructure, it is not a perfect market. Things get lumpy and you do not necessarily get an efficient mix of assets. It can end up one sided with too much wind power, for example. Development banks could play a role, but it needs more guidance. What are we aiming towards? What does a green economy look like in terms of how it is financed and who will be the major players?
Frith: We have seen an effect of doing it piecemeal: you suddenly run out of power. Everyone suspects that if there are as many electric vehicles as they are planning to have by the end of the decade there is nowhere near enough electricity to power them. Are you going to account for that by importing electricity from overseas coal-fired power stations?
Halfon: One of the biggest challenges is that if you immediately close the coal-fired plants, you cannot power the entire grid. There are discussions to be had on how we are going to implement the energy transition. Should it be piecemeal, should we replace everything or build on what is already there? BP and Shell, for example, are repurposing some of their North Sea platforms by building wind farms on them. This is more complicated to do at the country level. Where do you put the wind farms, for example?
People need to think through the implications. The only one who has come close is the Carbon Tracker Initiative, and the numbers are mindboggling. It says that replacing oil would cost between £30trn and £40trn. This is just one sector. This number does not even include what is required for mining. This is something people should keep in mind when going through the energy transition. When directing capital, some hard choices will have to be made. Where? How? Why? Is it cost effective? Should Sellafield be a hub for nuclear or wind farms?
Frith: Politicians are catching up with the financial markets. Previously, there was government rhetoric and environment campaign groups, whereas now money is following opportunities. The financial community has achieved in the last two years, arguably, a lot more than the political rhetoric has in the past 30 to 40 years.
Sumpster: It has and it hasn’t. There has been significant greenwashing over the past five or six years. There is a question over the flexibility of definitions for green bonds and whether the funds are really used for green purposes. The financial community has a loud voice to help influence and change companies’ behaviour.
For example, taking a strong stance around coal use in the UK. Is it necessary for the UK to have coal-fired plants? Possibly in peak periods in the short term, but why isn’t the consumer changing their behaviour as well, by running washing machines in non-peak periods or swapping halogen lights for LCD, for example. Behaviour is changing through consumers, government policy and emission zones in cities.
Financial institutions will avoid investing in or vote against corporates who are not transitioning their behaviour to address climate change. We have a voice, and we intend to make a difference. We are focused on sustainable investing and make sure ESG is front and centre of our investment strategy. We accept that we are going through an energy transition where, ideally, we make increasingly more impact investments, but as we manage a large portfolio on behalf of pensioners, we must be responsible around the economics of going straight to impact. We have sympathy for coal mines in Africa, which bring an energy source to local communities where there is no alternative, but less sympathy in the UK where there is a developed renewables and energy market.
Halfon: The changes in the financial sector have gone a lot deeper than anyone expected. In May, Shell lost a court case over their emissions, while Exxon and Chevron lost votes at their general assemblies. These are big behavioural changes, which were enabled by investors.
At the trustee level, a survey by Mercer 18 months ago found that ESG was considered a factor when making investment decisions by 89% of institutional investors in Europe. There is no upside in breaching ESG guidelines. You do not want to be the person responsible for investing in an oil company if one of their platforms blows up. So, the financial sector is ahead of the curve compared to the population, governments and the industrial world. Everyone is behind. We have moved further and faster than expected. I first noticed an ESG strategy being implemented in a pension fund nine years ago. Now I do not know a scheme that has not created at least an exclusion list, if not changed its entire investment strategy.
Farquhar: It is not just what is in the investment portfolio, they look at the manager too. In the past two years I have not met a pension scheme that did not ask for clarity on a manager’s ESG credentials. Cambridge Associates is committed to net zero. We have made the pledge and are going to make that difference. We are walking that talk and making sure client portfolios have that opportunity to tilt. Yes, there is a transition risk but there are also huge opportunities.
Sumpster: It is not just a one-off test. We see behavioural change through certain performance indicators throughout the life of an investment.
Halfon: We passed the one-off test stage before Covid, but since Covid the acceleration has been massive. Following COP21 in 2015, there were changes in the main mining countries. There have been legal changes in Australia, Canada and Chile, while the Netherlands is moving to impose prefunding for nuclear operators.
Rhodes: There is no value in investing in the status quo. It has to be sustainable. Part of a fiduciary duty is investing in things that not only give our members a return but also a world to retire into. We need to back things that are creating change and will benefit from those changes. It would be ludicrous not to look at what is required.
Frith: I would take it above the ESG debate. Historically, local government pension schemes have made only a few investments in local infrastructure. There is a conflict of interest if elected officials ask their pension scheme for money to build pet projects in their backyard. If Andy Burnham, for example, wants new trams in Manchester, instead of going to the Greater Manchester Pension Fund he should go to the UK Infrastructure Bank and put it on tender. He could open-up the whole system.
We do not know what is replacing the private finance initiatives (PFI) to pay for new schools and hospitals. The UK Investment Bank should be able to provide locally elected officials with access to a new source of capital. There will be areas where the government will need to underwrite or de-risk some proposals, but there will be many projects for which there are willing investors.
Farquhar: You cannot look backwards when making assumptions about long-term returns from markets and private infrastructure. So much is changing. Return to normal will be a new normal, that will need to factor in changes from carbon transition, as well as what is socially acceptable and what is sustainable for the planet. That is quite a challenge.
Frith: We need guidance from government in terms of broad policy. This is something that will be quite dramatic once it gets moving.
Halfon: On the pension side, one of the main UK retailers wanted to securitise their network of shops and the pension fund of another UK retailer bought their bonds. They are doubling the risk on their retail exposure, but at the same time are transforming long leases into something different from their sponsor. There are possibilities to do this in a decentralised way.
Frith: Airports are a good example. Twenty years ago, nobody was looking at airports beyond the odd Australian and Canadian pension fund. They were historically owned by governments or local authorities. You knew airport valuations were getting toppy when pre-pandemic there were Eastern European cities you may never have heard of trying to sell their airports on very high multiples. That serves as a good example of what could happen in other areas of infrastructure.
Halfon: Airports are not airports anymore. The way they are sold now is one part is a transport hub and the other is a commercial hub. Terminal 5 at Heathrow, for example, is a shopping centre similar to Westfield. It has dozens of shops and is a place people commute through, so they could potentially buy something expensive at Terminal 5. In practice, the idea of hubs, outside of airports and a limited number of train stations, has not been optimised. It will be interesting to see what happens with gas stations when we move out of petrol and into electricity. You may have a 45-minute stay while your car is recharging, but people could potentially do that at home.
Farquhar: If you follow Lord Bamford at JCB into green hydrogen, then you repurpose.
Halfon: Exactly. You can grocery shop while filling up.
Frith: It was not long ago that a different gas came down your pipes into your kitchen. The gas works in the town once produced coal-gas. Subsequently, we switched everything over to North Sea Gas, which is methane, which is where we are today. So, it is quite feasible that we may switch over the infrastructure to deliver another gas in the future, perhaps Hydrogen. I have a question. A nascent municipal bond market is apparently emerging in the UK. I can see that playing a role alongside what the UK Infrastructure Bank might do, but is there much going on in that regard?
Sumpster: Not at the moment, but it is, to a certain degree, bringing community funds into play. For the large infrastructure projects there are billions of pounds available from bigger investors. But where can local communities put their money to work? Is the pipeline of opportunities there for them to invest in? It is not as clear as it could be, but the two could work hand in hand. Can we go back to what replaces PFI?
PFI fell away because it hurt the public and private sectors in the pocket and reputationally, partly because it was fixed contracts for far too long. Exceptional profits were being made by the private sector, but equally private sector construction companies were going bust. They shared too much of the pain as the risk allocation wasn’t fair. In the changing world we have today with urbanisation, an aging population, climate change and technology all playing a part, more flexibility is needed in how we finance new developments. Pension capital like ours seeks a stable return with a conservative risk profile.
The larger ambition I have as an investor acting for Phoenix is looking at regeneration projects more broadly than just infrastructure. A local authority or city may take a land mass and think about its infrastructure and real estate requirements, such as developing social housing, commercial buildings and improved transportation links. Historically these would be individual financing opportunities, but why not procure under one big regeneration plan where local communities and other stakeholders can buy into the ambition and improve local communities.
This could invigorate the private sector’s involvement alongside development banks, the UK Infrastructure Bank, Homes England and other public sector bodies all playing a part. The difficulty in the past has been that the public and private sectors have had conflicting needs. Yet there is an opportunity for long-term institutional capital to sit in partnership with the public sector. We do not invest for exceptional profit. We are here to invest pension fund money for a reasonable return whilst taking conservative risks.
Farquhar: You do not need to leap straight to public market bonds. Good managers may also be good at managing portfolios of private bond placements, for example. We have seen that in Switzerland, which has a big, vibrant market with a strong flow of new issues. Some have government guarantees and some are infrastructure based, so the risk profiles are different. There is a well-established market, with a steady flow of money. It is not just talk; money is moving.
Frith: Once you get beyond the greenwashing, the amount to which green bonds have been oversubscribed shows how much capital is out there looking for green-related opportunities, but there will be demand for bonds with other risk profiles, too. Most of our members are well-funded pension schemes and are looking for single digit returns. They are not looking for double digits. Why would they want to take the associated risks?
Halfon: If you earn 3% with a low risk profile nowadays, you should consider yourself happy. Over the past five years, we are roughly at 3% for senior debt, which is safe and should be on the books of most mature schemes, because they must absolutely avoid any shortfall with retirees. Schemes want senior debt or other safe illiquid investments with low fees. Acquiring those risks is expensive and takes time. And yet some investors are not happy with 3%. The fact is that we cannot work miracles. There is a limit to what we can do.
Farquhar: For decades we had long-term assumptions that were fixated on equities returning 3% over bonds. That is a dream now. But if pension funds can capture the attractive illiquidity premia on senior debt, which incidentally came through Covid with loss rates well below 1%, they could get much closer to the returns they need but are unlikely to see in their liquid public portfolios. You cannot have both.
What returns are you earning on green debt?
Trow: It is becoming increasingly evident that people are looking at the greenium to decide if it is worth going through the rigmarole of investing. It is not uniformed; it is supply and demand. If fund managers are trying to match an index, they will snap up any new issuance so the greenium will be around 6 basis points, but I am not sure that gets you to where you want to be.
One of the problems with the current investment horizon is the only way to make money is through capital gain, but we are talking about projects that do not produce capital gains. Investors need income that is sustainable over time, and many do not invest for that anymore because interest rates are so low.
It is all about developing capital gains. We have created an environment where what we need to invest in is unfashionable. Rising asset values tell you the investment is not going to the right place. It is chasing the existing assets rather than creating new ones, which is what green infrastructure is all about. I do not know how you square that circle because we have created an expectation that there will be capital gains to make up for the lack of income from bonds.
Frith: That is cultural in the UK. Other countries have traditional bond investor backgrounds.
Trow: Part of it is also that we have got rid of the expectation that inflation will always rise, but we have replaced it with an expectation that asset prices will always rise. With interest rates so low you are never going to get away from it.
Rhodes: Also, with DC savers it is what you save and how much return you get. For a mature defined benefit scheme 3% may cover their members’ needs, but DC members are locking up their cash for a long period and 3% is not what they expect.
Frith: There is no legal obligation to pay a minimum pension in the DC world, but it needs to be attractive enough for people to put their capital in.
Rhodes: There is research that says some people will accept a lower return of up to 1% for a greener or more socially beneficial investment. There is a space for some plans to take out some of the volatility because it scares savers. They do not want to ride things out, even though, if they do, it will not harm them so much.
This could also help us engage with the saver. If savers know that they helped fund the new tram link in their city or the building they pass on their way to work, it could help drive greater engagement in the pension plan. One of the roles a trustee has is getting people interested, to get them to look beyond simply how much they could have at retirement.
Frith: That is the flip side of not wanting to invest in Shell or Exxon. We are being told what they want us to invest in and moral judgements are coming into it. We had a call this morning with a water company we invest in because our members want to know about sewage outflows into rivers in the UK. It is topical, it is in the media.
Farquhar: If a company pollutes the water system, they get fined. Someone willing to work with such companies could alter their behaviour and help them fund the pipe-works to avoid polluting rivers. The government could do more to incentivise water companies to invest in technology, to make a difference and get paid by the investment rather than fined when they don’t.
Frith: They do get rewards from the regulator if they achieve, ahead of target, transformation in certain environmental projects.
Sumpster: As an equity investor and a shareholder, voting to change the behaviour of senior management in companies can be a powerful tool. On the credit side, are investors willing to take a lower economic return for improved ESG behaviour? Absolutely. We have seen this in investments made where there are reductions in credit spread for meeting or exceeding certain ESG metrics. The credit argument being that you are futureproofing the investment. If a company is not moving with investor sentiment its value could potentially deteriorate.
Has the nature of engagement changed?
Halfon: The financial sector has always engaged with institutional investors, but this engagement is no longer driven only by the fact that the investors have money. Other considerations such as protecting the money and not doing anything with it that will make you blush are taken into account. In the past, engagement was about getting a 15% return whatever the consequences. Now it is making sure we earn the 3% we need in a way that will not embarrass us. We all have mandates to protect the money before everything else.
However, protection now goes with not just telling your clients you have made an 8% higher return than expected but telling them that you have done so without polluting the Thames. The mandates have changed in the past two to three years, more so since Covid. Pension schemes talk about different things today when speaking to asset managers.
Sumpster: People are looking for responsible investors to be the guardians of their money. We must be alert to the changing world we are living in.
Halfon: It is not only climate change, but not being involved in a corruption scandal, harassment or racism.
Sumpster: The benefit of private markets allows investors to get inside companies, form close relationships with them and really understand the assets. It is not just about making an investment decision but protecting it over its life. You must consider other stakeholders. The taxpayer or end user, the government, the regulator, your investors, the senior management of a company – there are many people you have to partner with in the right way to demonstrate that you are a responsible investor.
Rhodes: Look at Danone. Their chief executive was not making enough of a return on investors’ capital, so they got rid of him. People like the fluffy, but it needs to be balanced with making money.
Halfon: I agree, but you have to deliver what you promised. If you do not over promise, you do not have to take too much risk.
Trow: On engagement, the industry is excluding anything that might be a risk, which eventually becomes a race to the bottom. By engaging with plan members, you could buy yourself a license to take a risk. If everyone is engaged and believes it is a good option to invest in a tram system, you have that latitude if it goes pear shaped. We are talking about risk here and you can’t not take any risk.
Halfon: Members are often more prone to risk taking than you assume. They will cut returns for environmental purposes, but I am not sure you are cutting that much because if a company you invested in gets fined for something they have done wrong, they risk making you lose a lot more.
Frith: Part of it is understanding the risks you are taking before deciding if you are happy to take them. You also do not have to fool yourself into low yield investment strategies just because the markets move there. If you are earning 5% on a wind farm that used to pay 10%, are you comfortable owning it because it looks like a low yielding asset and therefore must be lower risk? You could be taking a lot of risk that you do not understand. You have to be careful that you do not confuse a low return, low risk strategy with a low return strategy that has a lot of embedded risk.
Halfon: We have become more risk averse, and changing demographics are a factor. We have an aging society and risk takers are younger. Because of the actuarial norms of discounting liabilities in defined benefit obligations, people do not want volatility they have a very limited risk tolerance at that point, so only they tend to invest in assets that look like gilts.
This is changing in the Netherlands as they move from DB to collective DC. Instead of looking at a pension fund as something that has to be completely immunised against all risk, the younger generation can take some of the risk for the older ones.
Rhodes: Managing illiquids is an issue with DC. If you are in a project that looked good, started out good and you are tied in for a long time but is not working out then you have a problem. People are looking at the premium and asking how is this better than the liquid investments available. Why should we go with this? What is the benefit of allocating a proportion of our defaults to an illiquid asset?
Halfon: Illiquid assets bring more diversification. Your expected return could be maintained, but your risk level falls. The point is, depending on the age of the members, you are not going to go above a 25% to 30% allocation to illiquids, unless the state ensures intermediate liquidity. If you invest 60% in illiquids, for example, and the state guarantees that you could drawdown five-tenths annually, this would allow investors to go more into illiquids, to generate more returns and reduce the immediate need for cash.
Does anyone have a final point to make on this topic?
Frith: The economic impact of investing in infrastructure is enormous, whether it is employment or regional re-development. It is great that our pension funds have allocations to infrastructure, but the wider picture is what it does to economic growth. That is a good story. You should get as much money into infrastructure as you can if you are trying to rev the economy and drive future growth in the UK.
Farquhar: It is not just infrastructure, but sustainable investment, too. Part of it is to protect and ensure good outcomes for people and the planet, but the other part is to underpin growth, education and healthcare.
Trow: Infrastructure is at the heart of that. If something is a good investment for society and the economy, it will pay for itself. If it is not happening from the institutional or the private sector, the government needs to step in as a facilitator and enabler. We are in a situation where we have tried to stimulate the economy with monetary policy, which has just chased asset prices up. We can do fiscal policy, which is just a sugar rush, but the next step is fiscal but doing the stuff we have talked about. If it makes sense, it will pay for itself through tax revenue. If you get the incentives wrong it does not matter how much money you have.
