CPPIB’s green investment chief: ‘decarbonising a portfolio at scale is almost impossible’

As Net Zero Investor continues its scrutiny of net zero investment efforts and climate finance strategies of Canada's largest pension funds, the next stop is The Canada Pension Plan Investment Board, generally known as CPP Investments as this publication sits down with Richard Manley, CPPIB's chief sustainability officer.

Operating as CPP Investments, CPPIB is was set up in 1997 and managed, at the end of June, just over CA$575 billion, making it one of the larger retirement schemes in the world. 

Time for Net Zero Investor to sit down with Richard Manley, chief sustainability officer, managing director and head of sustainable investing, leading the pension giant's team responsible for integrating climate risks and net zero opportunities across CPPIB's investment portfolio.

Prior to joining CPP Investments in 2019, Manley spent 18 years at Goldman Sachs, where he was most recently global head of thematic equity and ESG Research. Before that, he worked at Merrill Lynch, Donaldson, Lufkin and Jenrette, and Paribas Capital Markets.

Many pension funds in Canada, Scandinavia, Germany, Switzerland and the Benelux make bold and prestigious net zero claims, although their actual allocations to climate finance-related projects remain fairly modest. Would you say your strategy and approach are different?

Our investment mandate is very clear, to maximize returns without undue risk of loss. In developing our net zero commitment, we had to ensure that our approach to long-term decarbonisation of the fund wouldn’t place us at odds with our mandate, today or in 2049. As soon as we then started to reflect upon the implications of seeking to decarbonise a portfolio, it became quickly clear that decarbonizing a portfolio at scale on a sustainable basis is almost impossible, unless you see a commensurate reduction in emissions in real economy.

So how did you alter or sharpen your strategic focus based on that notion?

Well that realisation led us to focus on a few important constraints that would shape our approach. The first was understanding the underlying pace of decarbonization of the real economy which could become a binding constraint on the ability of the financial sector to decarbonize loan books and investment portfolios. If the real economy decarbonizes ahead of expectation financial assets will also decarbonize ahead of expectation, however if emissions in the real economy continue to rise, the only way to decarbonize portfolios will be to divest.

Second, were the levers we actually control that can influence decarbonization. There is a perception that the financial sector is a silver bullet to drive decarbonization in the real economy, but the reality is that financial market participants have limited capacity to force change in investee companies or creditors. We can influence portfolio design - the asset classes we invest in, and security selection - the individual investments we make. We can exercise our governance rights to hold directors accountable for integrating consideration of climate risk into company strategy and in certain asset classes we can negotiate contractual terms to secure climate related outcomes, but we don’t have any other levers to play with.

Lastly, we sought to understand the other variables that we don’t control that will shape whether, when and how the real economy attains net zero. Will consumer and corporate consumption habits change? If people continue to do carbon intensive activities, then the burden placed on the real economy to offset those emissions will be larger. Will technology advance in a way that becomes a tailwind for industries to decarbonize or will innovation stall? Will we see the development of market infrastructure (like reporting standards) that provides executives the insights they need to make better choices and more informed decisions? And similarly, will we see the development of carbon markets to provide an economic incentive to decarbonize? 

Lastly, the two final variables - will the companies fulfil their commitments to decarbonize, and will the policy environment provided by regulators around the world be conducive to moving forward with ambition? Our approach is guided by our mandate to deliver superior risk adjusted returns, grounded in a real appreciation of the underlying constraints we face, and guided by belief that we cannot deliver paper decarbonisation without supporting decarbonisation in the real economy?

Rather than give specific decarbonisation targets in the short term where we have limited influence to shape emissions in the real economy, we committed to grow the amount of assets we own that are green and transitioning to become green over time. We committed to holding our portfolio company boards to account, to decarbonizing our own operations, to invest to support the transition of grey sectors where the return opportunities presented themselves and to report on our progress.

Canadian pension groups often team up in pushing for a particular agenda or endorsing a certain strategy or viewpoint. Given this collective harmony, how do you see the role of asset owners in driving net zero investment?

Asset owners are a key market participant by virtue of the fact that they are the apex of the capital pyramid. Whether they invest directly or delegate assets to fund managers, their voice is considerable, and importantly their objective clear, delivering the return outcomes that are expected by their beneficiaries. Asset owners can engage proactively with their managers to ensure that managers are increasingly 'climate-aware by-design' to ensure they are integrating consideration of climate as a risk and an opportunity into their development of products, into portfolio design, into security selection, and how they negotiate and how they hold portfolio companies to account.

Asset owners can also engage with policymakers to share their perspectives, feedback and the challenges that they encounter in deploying capital to support the fundamental decarbonisation of the real economy.

The other opportunity is engaging proactively in the development of market infrastructure and shaping market convention to ensure that all financial investments and contracts over time, become 'climate-aware by-design'. For example, it's still surprising to see how many lease agreements are being negotiated by companies that have a public commitment to decarbonize their operations, where their procurement teams are actively seeking to draw lines through the Green Lease provisions of contracts. 

If it becomes market convention to only sign green leases or regulators say that all leases need to be green, landlords will immediately know the emissions of their tenants and tenants the emissions associated with services provide by their landlord. Let's not forget the built space is 40% of emissions. This would be one very easy change in convention that could yield a considerable uplift in decision-useful insights for tenants and landlords across the economy and an example of where an asset owner can use its voice and use its influence to shape the agenda.

Speaking of green policies, how do you 'green' your investment portfolio in practice? What do you look out for?

One way is simply to invest in new green assets. Certainly, when we look across the real estate portfolio today, it's very hard to identify any developments underway that do not meet green building criteria.

The second way is to identify parts of the portfolio where conducting an Abatement Capacity Assessment - to determine the ability to decarbonize the business allows us to work with the management team to develop a comprehensive transition plan that allows us to convert a business or asset that was intrinsically grey to intrinsically green over the lifecycle of our investment.

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The third is to identify assets in the market that have derated by virtue of them being grey assets and determine whether we can make that investment and deliver competitive returns through the post-acquisition decarbonisation of that business. There are a few transactions that we've done in that ilk to date. I would anticipate we will see more of those transactions over time. The biggest impediment to doing net zero transactions at scale today is often the seller’s expectation of the sale price does not fully reflect the investment required to deliver their decarbonisation.

Renewables and clean energy are the most logical pro-net zero investment spot, but many investors cite risks and obstacles. Where does CPP Investments stand?

We are already a considerable investor in renewables and clean energy. The competitive landscape for these assets has transformed over the last few years. A combination of these technologies being de-risked and competitive with conventional generating assets has increased corporate appetite for green power and attracted a lot more capital to an asset class where grid infrastructure and permitting still constrain the supply of new projects. 

This landscape has gone from being relatively less competitive where developers were able to generate compelling returns aided by favourable auction dynamics or feed-in tariffs and a tailwind from falling technology costs to one where we have some very competitive tenders resulting in stabilised (operational) assets that trading on forward returns considerably lower than was the case three to five years ago. 

As a result of underlying cost inflation in materials and labour and supply chain constraints, we've moved from an industry that previously had a technology tailwind that was insulating developers from cost-inflation, to a situation now where people are seeing very real cost overruns and delays, on more aggressive project assumptions that is starting to result in situations that we've seen recently in Europe and in the US, where developers have delayed or walked away from the development of green projects. We continue to invest with a focus on identifying those opportunities that we believe deliver superior risk-adjusted returns.

Some pension funds, like the Church of England Pension Board in the UK, are abandoning oil and gas investments altogether. Where do you stand, what is realistic, in your view?

We know that conventional energy will remain a critical component of primary energy supply for decades to come. The opportunity is to ensure that hydrocarbons that can’t be substituted in the near-term are delivered to the market with the smallest possible emissions footprint by stopping fugitive methane release and taking scope 1 and 2 CO2 emissions to zero.

Oil and gas producers could deliver a much cleaner molecule to market by comprehensively decarbonizing the production, processing and transmission processes in the value chain. If the oil and gas industry can do this, the airline or gas-fired power plant will only incur emissions associated with combustion, not the whole value chain. This is a real opportunity for the industry to dramatically slow global warming from continued hydrocarbon consumption until long-term substitutes are developed and deployed at scale.

One investment in our portfolio is targeting a 90% reduction in Scope 1 & 2 CO2 equivalents associated with production by the end of the decade, tied to proactive management of methane release and electrification of the production process.

In a related development, recently we saw some of the world's largest LNG consumers indicate that over time they want to see all cargoes disclose the upstream emissions associated with the volume shipped. That could become a mechanism by which buyers start to discriminate in terms of the price they are willing to pay for cargoes that have the lowest upstream emissions associated with the production. The only way that utility customer buying these volumes can drive down its upstream Scope 3 is by burning gas produced with lower or no fugitive methane, and the lowest or no emissions associated with production, transmission and liquefaction.

As soon as we start to see buyers discriminate in favour of lower emission cargoes, like we see tenants discriminate in favour of lower emission buildings, it will likely create a “green premium” to an inherently “grey benchmark”. As more producers respond to the economic incentive to green, and the global LNG market becomes a lower emission benchmark, at some point in the future, we would anticipate the emergence of a grey discount where producers and shippers who are unable to deliver leak-free and emission free cargoes will suffer a price penalty in the international energy markets.

You touched on engagement and stewardship earlier but let's dive a bit deeper. How hard does CPP Investments push, pressure and lobby, and when?

It's absolutely critical and a foundational pillar of how we communicate and reinforce our expectations of directors and executives of the businesses in our portfolio. In all our engagement with portfolio companies we are proactive in a spelling out our respect for the triad - the discrete roles, rights and responsibilities accruing to us as owners, directors as members of the board and executives as the management team. I also reiterate the fact that the executive is accountable to the board and the board is accountable to the owners and that we will use our right to appoint directors to reinforce our expectations where we conclude directors are failing to demonstrate they are acting in the best interests of our companies.

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As it pertains to climate, our expectations are very clear. Governments in most of the markets we invest in - and most of the markets our portfolio companies operate in - have committed to comprehensively decarbonize their economy by the middle of the century. 

Therefore, it is our expectation that boards, acting in the best interest of our companies, will be ensuring that the executive understands the risks and opportunities presented by the prospective regulatory environment and then determine how to most economically and efficiently decarbonize their business to align the business and its long-term success with the direction of travel in the economies they operate in.

We don't prescribe what the scenario should look like. We believe that the board and the executive, armed within insights that are non-public about the technical and economic feasibility of the different levers available to decarbonise the business, should retain the responsibility for setting strategy. But when we believe directors are not pushing hard enough to hold the executive to account appropriately, we will withhold support for their continued reappointment.

Finally, anything else you'd like to share with our readers?

Despite the challenges to decarbonization created by geopolitics, inflation, higher rates and slower growth we are having a more informed debate about how to decarbonise the economy. Two years ago, there was a lot of focus on paper decarbonisation or simply reducing financed emissions by divesting. A combination of people doing the work to understand what it means to decarbonize the financial economy, and the debate prompted by energy security in response to the war in Europe has translated a much more sophisticated debate and a realisation that we need to empower the financial system to pursue an investment agenda to provide the capital that the real economy needs to finance emissions reductions.

It is very constructive today that the debate has moved away from divestment to investment. It's also very constructive that we have moved away from a singular focus on greening the energy system to the delivery of a secure, affordable and green energy system that supports the sustainable decarbonisation of the economy and preserves public and political support for confronting the challenge ahead of us.

We've long been of the view that to talk about the transition is too simplistic, and that the debate has to be about how we deliver the optimal transition - one that removes the most emissions from the economy with the least damage to the economy and one that is inclusive and sustainable of all stakeholders in the economy.

In terms of market convention - it is fantastic that all the market’s largest players are committed to decarbonizing the financial system and to supporting companies in the real economy and decarbonizing. However, we remain some way away from an end point where all underwriting and all financial contracts are integrating climate considerations, both risks and opportunities, by design. Advancing market convention quickly to this end-state is imperative if capital market participants seek to deliver on their long-term climate ambitions.

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