Q: If we fail to capitalize on a sustainable future for Africa, it’s very simple: Africa won’t have one
Africa’s value tomorrow will be, in large part, determined by what is preserved today. The investment world is locked in a raging debate around “values vs value” in financial returns consideration. Opponents of ESG investing approaches believe that it is primarily the role of governments to fight climate change. Their responsibility, they contend, is to maximize shareholder returns, climate concerns notwithstanding. After all, government taxes them. The missing link in this argument is optimization. Portfolio optimization, the objective of which is to maximize expected returns and minimize risks, involves selecting the best portfolio out of multiple candidates that meet the risk-return objectives. Institutional investors like pension funds have a responsibility to optimize members’ returns, but do they have a role in national efforts against climate change? Put differently, does this optimization objective encompass climate considerations?
Governments generally borrow to boost the economy through development plans and infrastructure projects that will nourish the economy and drive its growth. Governments will also borrow to meet the cost of national emergencies like famine and natural disasters. Since their inception, pension funds in Africa have supported governments in these endeavours – as the largest local sources of capital and, by their nature, as the most patient institutional investors.
On average, pension funds in Africa lend 60-100% of their USD 420 billion assets under management to governments through investments in government securities. For context, they have provided governments with between USD 250 billion to 340 billion of long-term, patient capital. Questions, however, abound. With the proliferation of public debt, debt crises and the tilting of government expenditures to recurrent (non-development oriented) expenditures, the question then becomes, are pension funds still supporting governments’ growth story?
As to where national finances will be spent – this is a public policy concern largely driven by the government, out of the control of pensions funds. With the current credit squeeze in African governments, priority is placed on the payment of salaries and meeting debt obligations as they fall due. Infrastructure developments and changes in climatic conditions have fallen down the pecking order. But where pension funds do have control is in their asset allocations. Pension funds have however allocated large portfolios to government securities. This trend is propelled by three main issues. Firstly, government-driven regulations permit investments of up to 90% in government securities. Secondly, high returns are available from governments’ insatiable appetite for borrowing and thirdly, many of these local capital markets lack depth, liquidity and often shallow and undiversified asset class structures.
Investments in government securities are no longer safe as they used to be. Diversification has also become critical, as the correlation of returns and changes in risk profiles becomes more pronounced. Non-financial risks like climate change – that did not previously have direct implications on pension funds’ portfolios – have come to the fore, with dire implications on both returns and capital.
Given these challenges and emerging risks, pension funds can play a critical role in supporting governmental efforts in climate resilience for several reasons. Indeed, in the interests of value preservation, they have to. The value of pension fund assets is being eroded by the effects of climate change: a stress test carried out by the European Insurance and Occupational Pensions Authority on 187 pension funds in the EU, with more than USD 2 trillion of assets, demonstrated a USD 287 billion loss in asset value. Scaled to the size of pension funds in Africa, which would equate to a loss of about USD 60 billion, or 14% of pension assets. Given Africa’s disproportionately high vulnerability to climate change, this loss level is conservative.
It isn’t just governments that want pension funds to put climate front and centre – it’s increasingly a condition customers will demand. There is mounting pressure from asset owners for pension funds to take urgent action to prevent catastrophic environmental damage to the global economy. Investments are required to take into consideration ESG in the quest for financial returns and protect members’ financial assets by providing long-term, sustainable returns for current and future generations. In a recent article, a CEO of one of the largest retirement benefits schemes in Kenya advocated that “pension funds should prioritise ESG now more than ever.” There is a clear need to protect portfolios from the vagaries of nature – customers are not blind to this.
With that in mind, ESG investing by pension funds in Africa is not a demand problem, rather it is a supply problem. Capital markets in Africa are underdeveloped, with a limited supply of issuances, shallow investor bases, limited secondary market trading, and concentration in a few major issuers. The sustainability bonds market, despite its benefits, is nascent. A paltry USD 1.8 billion, representing 0.43% of the total size of pension assets, has been issued in a market driven by South Africa, Nigeria and Egypt – which enjoy relatively broad investor support for their instruments and boast extremely active capital markets. The rest of the continent, however, is starved.
Indeed, the few transactions available in the market have proved their commercial viability, enjoying very strong demand as hot buys. These are opportunities that sovereigns and corporates can leverage to raise capital for Africa’s sustainable future.
If we fail to capitalize on a sustainable future for Africa, it’s very simple: Africa won’t have one.