The California Public Employees’ Retirement System (CalPERS), the largest public-employee pension system in the US, with about $350bn (€317bn) in assets, in June launched a pilot programme that will lead to formal requirements that all managers receiving capital allocations articulate and implement ESG principles into their investment processes.
To date, ESG policies at most large pension plans have focused on company-specific issues where major asset owners could engage directly with management to push for changes at the company level.
Other managers have met pension fund requirements that they incorporate ESG criteria by signing on to the Principles for Responsible Investment administered by the United Nations Environmental Programme Finance Initiative.
CalPERS’s initiative aims to identify and document on a consistent basis the ESG practices, and supporting data and modelling, that managers in all asset classes use in actual investment decisions.
In an exclusive interview with IPE, Anne Simpson, senior portfolio manager for global equity and head of the Corporate Governance Program at CalPERS, discussed the genesis of the pension fund’s new approach, the scope of the pilot programme and the strategic goals for the initiative.
“We’re reframing the ESG debate as an investment issue,” Simpson said. “For us, it’s the natural next step from adopting investment beliefs a couple of years ago. We’re shifting from thinking about this as ‘ESG issues,’ and thinking about what is required for our funds to be sustainable over the 70-year liability horizon we’ve got.”
Two of the investment beliefs “set the stage for what CalPERS is doing.
“One is that long-term value creation comes from the management of three forms of capital – financial capital, human capital and also physical capital,” Simpson said.
“We’ve never been terribly fond of the ESG acronym. By reframing this as sustainable investment around these three forms of capital, we’ve given an economic framing of the issue to use in explaining what it is we want our managers to be paying attention to when they’re deploying capital.”
The second CalPERS investment belief is the statement that “risk is multifaceted for an investor like CalPERS, because of our size, the longevity of our liabilities and so forth”.
“Risk for us isn’t captured just through tracking error and volatility – natural resource scarcity and demographic and climate changes are also risks.”
From that global basis, Simpson said, “the next question is what sort of agenda does that set for the policies and the monitoring we want our managers to report to us on”.
CalPERS felt strongly it was important to develop this bottom-up and formed an internal cross-asset-class team of 20 people that undertook a two-year project with two objectives.
“The definitions of what is meant by sustainable investment are hazy at best, so the first thing we need to do is define this for ourselves, and that’s where the investment beliefs come in,” she said.
“Second, we needed to review the data and tools that might be available because, although we might be saying human capital needs to be properly managed for purposes of producing long-term value, there’s precious little by way of data and useful information about that that can be integrated into your financial assessments.”
CalPERS’s system staff will develop expectations about the factors relevant to investing sustainably in each asset class and how those factors should be woven into the manager selection process.
The development of sustainable investing criteria will focus most on external managers.
At CalPERS, 70% of assets are invested internally via quantitatively managed public equity portfolios and an active fixed income portfolio.
External managers are used primarily for private-market assets.
“What we’re just starting now is a pilot phase, for about a year,” Simpson said. “We want the managers to come back to us and articulate the ESG factors – the sustainable investment factors in the new language – which they have reflected in their investment policies, and second, to report to us on how those are not just identified but how those are tracked and integrated into the decision-making process.”
Despite the large number of managers that have become signatories to the PRI, Simpson said the identification of relevant sustainability issues was still at an early stage.
“People might say, ‘oh yes, environmental issues are terribly important,’ but which issues, at what stage and where – something that might be just relevant at a sector level can become material depending on your location,” she said.
“You can think about something as simple as water – either too much or too little. If you’re in a coastal property that might suffer inundation from the sea level rising or extreme weather events, that’s one kind of risk, while if you’re in California you can be acutely aware of what water scarcity can do to your business strategy.”
Both are serious risks, she said, “but we do not have an agreed accounting standard or even a set of reliable data to track water as an input”.
CalPERS aims to jump-start a process that will lead to rigorous quantification of the factors that affect the long-term sustainability of a business.
All managers will be asked to explain how they define these issues, what their policies are and their data and modelling of sustainability factors.
At the same time, CalPERS is reducing the number of external managers.
“Another aspect of the investment beliefs is the simple and obvious statement that costs matter,” Simpson said. “We’ve got more managers than makes sense.”
In what Simpson described as a “shrink-to-fit” process, CalPERS will trim its roster of more than 200 managers.
“The goal is to have around 100 managers so we can have bigger strategic relationships where we’ll be able to have more impact on the fee structure and better alignment,” she said. “Next year, we’ll take a look at what managers come back with.”
Responses to the sustainability initiative will be one more data point in the review.
“In what will become the legacy portfolio, managers will be wound down over a period of time. In the strategic portfolio that comes out of this review and selection process, managers will report to CalPERS for the long term, and our thinking will evolve as we work our way through this pilot programme.”
While some managers will lose CalPERS mandates in the course of the review, Simpson said she remained focused on the big picture.
“One of the most important things we’re doing in this process is setting up an investment demand for better sustainability data and better modelling, and fundamentally, the integration of these factors into financial reporting,” she said.
“At the moment, there are 101 terrific initiatives around, which gather data from some companies on some issues, but it’s not integrated into the reports that get filed or audited.”
Ultimately, CalPERS is seeking to spark investment management innovation.
“The prize here would be that, through this process, you get investment managers behind the notion that sustainability issues need to be properly defined, properly tracked and ultimately connected into the risk/return framework that investment is all about,” Simpson said.
“That’s a big project but one that a fund of our size takes on.”