The Investor Problem

INSTITUTIONAL INVESTORS ARE POORLY SUITED TO ADDRESS THE GROWING RISKS THEY MUST CONFRONT

Returns unable to meet cash flow requirements
Inability to address growing systemic risks
Structural inability to effect change as needed

Institutional investors, such as large pension and sovereign wealth funds, face three daunting problems:

Every year, institutional investors struggle harder to produce the annual returns needed to meet obligations to their beneficiaries and capital commitments to those managing their funds.  Increasingly, they are having to demand higher contribution levels or reduce cash funding requirements.

At the same time, a  growing set of  critical global issues will force these same investors to re-evaluate beliefs about portfolio value, diversification, entity structures and compensation practices.  An ever growing set of asset categories, including energy, utilities, insurance, transportation, agriculture are ever more exposed to climate change and other growing systemic risks. 

The governance and compensation schemes at most institutional investors make it challenging to deal with these issues:  Because they function as quasi-governmental institutions, public institution investors are far more constrained in their ability to compensate professional teams, they are required to be more risk constrained and they typically do not reward behavior that challenges the status quo.  As a result, they tend to perform nearer the median and be more exposed to large systemic changes, like recessions and depressions that affect all.

These risks and constraints are further explained below:

 
STRANDED ASSET ENERGY RISK

•   Energy companies are 7% of S&P 500

•   One third of FTSE 100 is oil, gas and mining

•   Fracking-led shift from coal to gas

•   Volatility, growing recovery cost and competition threaten business models

•   35% of known oil, 52% of gas and 88% of coal reserves labeled “unburnable”

•   Oil demand falls to 75m barrels/day by 2040

•   State Attorneys General and SEC actions re potential overstatement of assets

 
UTILITIES RISK

•   FLAT DEMAND AND WHOLESALE PRICE DECLINE:

     •   Variable renewables decrease utilization of inflexible coal and nuclear plants

     •   Escalating T&D costs spread over fewer kWh of energy sales, forcing higher rates

     •   Transition from manufacturing toward services reduce energy intensity of economy

     •   Increased self-generation and energy efficiency reduce energy purchases from the utility

•   GROWING TREND TO DECENTRALIZED, GRID-EDGE ASSETS

     •   Solar providers like Solar City are driving adoption of renewables

     •   Growing trends toward time-of-use rates and efforts to animate the grid edge

•   FORCED TRANSITION TO SERVICES MODEL:

     •   The proliferation of smart devices led by companies like Nest and Ecobee

     •   Service companies like Amazon, Comcast and Best Buy looking at energy market

•   CHANGING CONSUMER SENTIMENTS:

     •   The rise of the iPhone/ iPad generation

     •   The demand for personalized, simplified and mobile interactions with service providers

     •   The growing interest in energy services that are reliable and affordable, but are now also cleaner and more  controllable

 
TRANSPORT RISK

•   GROWTH IN AUTONOMOUS AND ELECTRIC VEHICLES:

     •   Even near-autonomous vehicles have major accident/insurance ramifications

     •   Growth in EVs will have impact on oil demand

     •   Deeper penetration of renewables will require EVs for load balancing

•   ECONOMIC IMPACTS OF DRIVERLESS TRANSPORT

     •   Transport jobs are the number one employer in more than half our States

     •   Impacts on cost of transport will drive shift

•   IMPACTS OF GROWING RIDESHARING MODELS:

     •   Lower ownership levels and much higher utilization will change auto industry

     •   Urban congestion will force change even as automakers resist

•   REVISED URBAN MOBILITY MODELS:

     •   Multimodal transit models and far greater reliance on smart transport

     •   Change will impact need for parking, use of transit, desirability of real estate

•   IMPACTS ON AIR AND SHIP TRANSPORT:

     •   Air travel has yet to contend with carbon pricing impacts

     •   Higher transport costs will change attractiveness of onshore vs. offshore manufacturing

 
INSURANCE RISK

•   CHANGE IN VOLATILITY AND INTENSITY OF WEATHER:

     •   Weather is already significantly more volatile and affecting claim size and frequency

     •   Changing patterns mean that historic risk data is unreliable

•   IMPACTS OF FLOODS, DROUGHTS, FIRES

     •   Flood plain designations will require major change and impact insurability

     •   Drought will change crop and agricultural coverages

     •   Fire danger will need major reassessment

•   IMPACTS OF CHANGING TRANSPORT MODELS:

     •   Autonomous vehicles will dramatically lower accident risk

     •   Lower ownership levels and much higher utilization will change auto industry

•   IMPACTS ON WORKER PRODUCTIVITY:

     •   Extreme heat and weather impacts will affect jobs

•   IMPACTS ON REAL ESTATE HOLDINGS:

     •   Sunny-day flooding may make entire cities uninsurable

     •   A complete resilience reassessment will likely be required for real property holdings

 
FOOD AND AGRICULTURAL RISK

•   GLOBAL DEMAND FOR ENERGY, FOOD AND PROTEIN:

     •   Driving deforestation and shift to beef production

     •   Massive growth in energy crops

     •   Driving focus on agricultural productivity

•   CHANGE IN VOLATILITY AND INTENSITY OF WEATHER:

     •   More flooding and more droughts affects agricultural productivity

     •   Ideal crop locations shifting with climate change

•   IMPACTS OF FLOODS, DROUGHTS, FIRES:

     •   Flood plain designations will require major change and impact insurability

     •   Drought will change crop and agricultural coverages

     •   Fire danger will need major reassessment

•   INCREASED NEED FOR FERTLIZER:

     •   Phosphorous limitations

     •   Impact of algae blooms

•   OCEAN ACIDIFICATION:

     •   Impact on fish productivity

 

WHY AREN’T FINANCIAL INSTITUTIONS RESPONDING?

•   Intelligent portfolio management requires constant re-evaluation of possible futures and the preparation of actions to take should any one of those futures become the imminent reality.

•   Benchmark compensation systems, existing diversification/asset allocation strategies and the reliance on the current fund model are major contributors to the same kind of inaction as characterized the sub-prime crisis.

   –   Benchmark driven compensation insulates managers from long tail risks – but Boards and owners held responsible for absolute performance

   –   Addressing systemic risk, by definition, requires action that is contra the benchmark

•   The world faces a set of very real risks to portfolio-as-usual behavior, yet most portfolio managers seem to be assigning extraordinarily low probabilities to change outcomes, and are taking few steps to hedge accordingly, even when such outcomes may have devastating consequences.

   –   The risks we are focused on are known and real, the question is not if, but when

   –   Current asset classes non-diverse to these risks

   –   Current funds model not suited for long-term asset management

•   Achieving better outcomes dictates a new approach.