Gerdie Knijp and Dieuwertje Bosma: Pension fund, broaden your horizons!
This article was originally written in Dutch. This is an English translation.
Pension funds are looking closer and closer to home with their impact investments, often for good reasons. But sustainable impact is not something you make exclusively in your backyard.
By Gerdie Knijp, Project Manager, Sustainable Finance Lab & Sustainable Pension Investments Lab, and Dieuwertje Bosma, Project Manager, Sustainable Finance Lab & Sustainable Pension Investments Lab
Climate change and other sustainability challenges do not stop at the border. Pension funds can push their boundaries and deploy capital where it is desperately needed.
Worldwide, there is a lot of attention for mobilising private capital to emerging markets. It is precisely in these markets that the need for climate mitigation and adaptation, the preservation and restoration of biodiversity and broader economic development is greatest. The annual investment needed to achieve the SDGs in these markets is estimated at $3-4 trillion (G20, 2023; UNCTAD, 2023). How can pension funds contribute to closing this investment gap? Pension funds are investing less in emerging markets. The pension funds that do invest in these markets mainly do so through liquid investments such as shares and bonds, and then primarily in the larger markets. Impact investments via private debt and private equity are lagging behind. Although Dutch pension funds are at the forefront of impact investing, the focus is increasingly on ‘close to home’. However, impact investments in emerging markets can be well aligned with the sustainability goals and impact ambitions of pension funds. Yes, they come with challenges, but there are certainly opportunities as well.
The challenges
Those who invest in emerging markets know there are challenges: higher credit and country risk and limited availability of data to make a good risk assessment. The GEMS database offers a first step towards better mapping these risks1. For example, it appears that projects initiated by multi- and bilateral development banks (such as the IFC or the Dutch FMO) have a much lower credit risk than is generally thought.
The discussion in the boardroom is not always easy about the necessity or the possibilities of investing in emerging markets. Often the right knowledge and experience to explore the opportunities is also lacking. Pension funds are usually organised around the usual asset categories, based on which the mandates per investment category are drawn up via strategic asset allocation. However, for this type of investment there is not always an existing category and therefore an appropriate mandate is often lacking. This is often the case for private debt investments in emerging markets. In such cases, there is only a mandate for emerging markets in liquid shares or a private debt mandate focused on Europe.
Funds can start exploring the possibilities today and building knowledge and capacity to lower thresholds.
The opportunities
The market for private impact investments in emerging markets (including frontier markets) is worth $95 billion worldwide and is expected to grow further. Such investments offer diversification opportunities within the existing investment mix and are in line with growth potential: 85% of young people (15-24 years) live in developing countries, while Europe is ageing (United Nations, 2024a; WRR, 2024). The estimated economic growth in emerging markets is greater than that in developed markets (IMF, 2024). This difference in demographic and economic growth means that the expected risk premiums in emerging markets may become more attractive, despite the somewhat disappointing results in liquid equity portfolios in the recent period.
Work with partners
It is advisable to work with specialised parties for these types of investments. Pension funds can, for example, engage local and/or public parties such as governments or development banks to cover part of the risks. These parties are more familiar with the local context and can absorb the initial losses. There are also other forms of collaboration, such as private funds that work with local parties to better understand and manage the market and risks. Pension funds can also enter into dialogue with impact investors to see which customised options fit their wishes, mandates, scale and models.
Prevent perceptions from gaining the upper hand
Investments in emerging markets are not only about actual risks; risk perception also plays a role. These types of investments are associated with higher risks, but that is not always based on fact. Board members can discuss this: what perceptions and possible biases exist on this subject? Sometimes small adjustments are useful to ‘de-bias’. For example, investment decisions can be ‘finalised’ geographically: the investment is first assessed on its own merits before it is labelled ‘emerging markets’. It is important to outline a clear vision. How does the board feel about investing in its own country, developed markets and emerging markets?
Investments in emerging markets are associated with higher risks, but this is not always based on fact.
Which impact themes are chosen and on what basis? In the investment beliefs, the board can, for example, include the conviction that impact investments in emerging markets are necessary to accelerate the global transition to a sustainable economy.
Look at what is possible
To enable impact investments in emerging markets, it will sometimes be necessary to think outside existing structures. This can be done with mandate exceptions or with specific mandates that allow room for, for example, smaller deals or a shorter track record. Asset categories can be defined more broadly. They can also be categorised less strictly. Then the focus is less on whether or not it fits into the ‘box’, and more on the added value for the total portfolio objective (the ‘Canadian Model’ (Van Gelderen, 2024), or the ‘Total Portfolio Approach’).
It is possible and desperately needed
In short, too little is happening, but it is possible and desperately needed. There are already examples of pension funds that are taking the first steps in this direction. Funds can start today by exploring the possibilities and building knowledge and capacity to lower thresholds.
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SUMMARY Pension funds focus their impact investments primarily on their own region, but climate and sustainability challenges occur worldwide. Emerging markets have a great need for investments for SDGs, estimated at $3 to $4 trillion per year. Challenges include higher risks, limited data and lack of mandates. Opportunities lie in diversification, more attractive risk premiums than expected, and economic growth in emerging countries. Collaboration with local partners and revision of investment structures can lower barriers. |
1 GEMs - Global Emerging Markets Risk Database Consortium of MDBs and DFIs
References
G20. (2023). Strengthening multilateral development banks – The Triple Agenda: Vol 1. Report of the Independent Experts Group. https://www.cgdev.org/sites/ default/files/The_Triple_Agenda_G20-IEG_Report_Volume1_2023.pdf IMF. (2024). World Economic Outlook. https://www.imf.org/en/Publications/ WEO/Issues/2024/04/16/world-economic-outlook-april-2024 UNCTAD. (2023). SDG Investment Trend Monitor. https://unctad.org/system/ files/official-document/diaemisc2023d6_en.pdf United Nations. (2024). Department of Economic and Social Affairs Youth. Frequently asked questions. https://www.un.org/development/desa/youth/ what-we-do/faq.html Van Gelderen, E. (2024). On the Sustainability of the Canadian Model. SSRN Electronic Journal. https://doi.org/10.2139/ssrn.4722747