In what promises to be a transformational moment for ESG integration and investment manager accountability, CalPERS will require all of its managers to identify and articulate ESG in their investment processes.
CalPERS staff led by Anne Simpson, senior portfolio manager and director of global governance, presented the ESG manager expectations, and draft sustainable investment guidelines, to the investment committee this week.
The $307 billion fund will factor into its decisions about hiring and monitoring external investment managers the degree to which managers assess ESG factors and integrate them into their process.
“If for example a manager hasn’t addressed how to carry out an environmental impact, if that can be easily integrated, that will affect our decision,” Simpson says.
“This is going beyond asking are you a signatory to the PRI? It lifts the lid, as they have to report to us on this.”
In an exclusive interview with www.top1000funds.com, Simpson said that CalPERS considers managers that do not identify and manage these risks as having a “sub-par investment process”.
The purpose of the project, which has been two-years in the making, is to integrate ESG risk and opportunity considerations into the investment processes and decision making across the total fund at the same time CalPERS wishes to recognise the complexity and differences across asset class strategies.
It also fulfils fits in with the fund’s mandate of integrating its investment beliefs across all asset classes. One of CalPERS investment beliefs is that long-term value creation comes from management of financial capital, human capital, and physical capital.
“All of these have to be understood as part of value creation,” Simpson says. “If you’re investing in private equity and not paying attention to how the development might impact the community, then you’re ignoring the value drivers in the business, which are also the risks.”
As part of the planning process for the manager expectations, each asset class within CalPERS surveyed its existing managers to assess what was the norm with regard to ESG.
“In some cases they were already considering factors but they weren’t articulated to us in due diligence. In other cases managers were surprised that we were asking the questions.”
Simpson says that CalPERS considers ESG risks as material considerations to its total portfolio due to the characteristics of the fund.
One of CalPERS investment beliefs is that risk is multi-faceted and not fully captured through measures such as volatility or tracking error.
“Because of our size and the fact we are globally invested we believe it is part of the multi-faceted nature of the risks we face. At $307 billion we can’t hide if there is systemic risk,” Simpson says. “But we are not only huge in size, we are long term to the point of being virtually permanent.”
Simpson said the more that CalPERS can articulate its expectations the more the managers can use their skill and imagination to deploy implementation.
She said this is the start of a new phase of ESG integration and that managers had the chance to show their innovation.
“The industry needs to be asking a new set of questions. This is pioneering work, we are looking at what are the new questions we need to ask,” she says.
For external managers there will be a consistent set of questions about ESG integration when CalPERS is selecting and contracting managers, as well as monitoring and managing relationships.
Each asset class has developed the requirements for external managers, and it will be hard-wired into the contracting and managing process of funds managers.
“The manager requirement for ESG integration was not approached as a top-down, dictatorial idea, but was bottom-up and developed from staff in consultation with managers,” Simpson says. “It is very important we have done it from the bottom up, it’s in the plumbing of CalPERS.”
The draft sustainable investment guidelines framework considers CalPERS investment beliefs, the UN-backed Principles of Responsible Investment of which CalPERS was a founding signatory, and the Global Governance Principles, which states that CalPERS believes that ESG issues can affect the performance of investment portfolios.
While the fund has identified a set of relevant and material factors, each asset class has flexibility for integrating what’s appropriate. CalPERS invests in 47 different markets through many different strategies.
Integration considerations include internal versus externally management, active versus passive, security level versus the index, fundamental versus factor approach, nature of the assets and whether it is a legacy or strategic portfolio.
“There is a long list of potential factors, the question is how do you work out which factors are relevant, do you have the tools and data to assess that, and then whose job is it to implement. At what point through the lifecycle of the relationship do you raise these issues and when should they be managed?”
An example of this is the global equities portfolio which is largely internally managed and passive. This means the fund will not focus on deep security level analysis, rather the index and market-wide data is more important. To this end it has bought the MSCI intangible value platform, which it believes covers the broadest range of factors, and it has been loaded into the BarraOne risk system. This will be supplemented by integrating factor analysis at the sector and security level. In contrast, fixed income is actively managed and the fixed income team articulated the analytical process at the security level.
CalPERS will begin a one-year pilot of its ESG integration in June.
“We want to be intelligent as we proceed, and challenging our assumptions is very important. We have a very demanding fiduciary framework because people rely on us to pay pensions in retirement. By integrating ESG at scale we are at the frontier,” Simpson says.
The next phase of the project will be a communications plan to managers.