Pension funds ‘overwhelmed’ by inconsistent transitional rules

Access to capital, the long-term risk-return perspective and the nature of investments in infrastructure and energy projects mean that pension funds play an integral role in increasing the financing of the transition. With their ability to bring together the necessary actors, including investors, fund managers and governments, pension funds need to use their influence and capital to drive sustainable capital markets.

This was a call to action from participants at the OMFIF roundtable on the role of pension funds in transitional financing. The event brought together representatives from banks, pension funds, asset owners and managers, and private financial institutions to explore what needs to be done to scale up transitional financing.

“How can we bring everyone to the table and build trust at the same time? How can we see this as an opportunity for innovation but also as a public good?” one participant asked. They emphasized that it is important not only to have the “right” people at the table, but also to understand and accommodate everyone’s needs and risk tolerance. “We need to get comfortable with this new type of risk.”

The roundtable agreed that “transformation financing encompasses both the long term and the short term sprint.” Pension funds need to adopt a range of sustainable products and tools to raise the capital needed to drive the transformation.

Regional differences

There is a big divergence between European, Asian and North American approaches to financing transitions. In the US and Canada, investors expect a clear promise of return or at least a subsidy, such as the Inflation Reduction Act. In Europe and Asia, financing transitions is based on taxonomies and frameworks.

The number of frameworks and regulations currently in place in Europe was identified as a “real pain point” for markets. Participants acknowledged that while these frameworks are essential to starting the conversation that “will later trigger big changes,” there are downsides to having to meet so many different requirements. One audience member noted that many pension funds had already started taking serious steps in their transformations, but that regulation had held them back. They said: “We risk hitting the targets but missing the point.”

On the other hand, funds in North America are subject to very few regulations or requirements, which means they often don’t know where to start. Meanwhile, emerging markets are “falling into a big black hole” because they don’t have the same resources to meet disclosure requirements as developed countries. “Are we just not investing in them?” asked one participant. To close this gap, clear, simple and consistent guidelines that are easy to understand and apply are needed.

There is also a risk that overly prescriptive taxonomies in Europe could make all balanced portfolios look the same. Latin America was presented as an example of how to avoid this. Each major Latin American country is working on its own taxonomy, tailored to its specific needs and priorities, rather than simply copying the European model. However, there was some skepticism among participants about whether this would actually increase capital flows to these countries.

Change focus

One pension fund participant said that funds are most likely to look at investing in green assets to decarbonise their portfolios. But there is a need to change things “from the inside out”. One way is to invest in raw materials such as steel and plastics – highly polluting industries – to start changing their processes and reducing emissions.

The roundtable participants said there is a reluctance to pursue this strategy because of the immediate increase in investors’ carbon footprints. But they also pointed to a greater focus on “intentionality,” meaning investors are starting to care more about the impact of their investments, which are doing good, rather than just about profit.

While the lack of clarity and consistency in transition standards persists, it is clear that sovereign and pension funds are starting to seriously engage with net zero emissions targets. Funds are taking ‘active ownership’ of lower-emission assets, implementing transition plans, green strategies and requirements, and divesting their portfolios. Clear and simple guidance that is consistent across regions will be key to scaling up transition finance over the next few years.

Emma McGarthy is Director of the Sustainable Policy Institute and Sarah Moloney is Deputy Editor of OMFIF.