How operating with an impact objective can add financial value for investors.
This first report by the California Public Employees’ Retirement System (CalPERS) responds to the recommendations of the Taskforce on Climate-Related Financial Disclosure (TCFD). CalPERS has been an active supporter of the TCFD’s work from the outset.
At the time this report is being published, the world is facing a global humanitarian tragedy and severe economic uncertainty as governments, business, finance and civil society respond to COVID 19. The pandemic has demonstrated with brutal clarity that tackling a systemic risk requires international cooperation between the public and private sector, driven by innovation at pace and scale. The lessons are evident: we need vision, partnership, and a relentless pursuit of scientific evidence to drive decision-making.
CalPERS’ motivation to address climate change is to ensure that we can provide benefits in retirement, disability and illness for our nearly 2 million members, people who come from all walks of life. CalPERS makes annual benefit payments of approximately $25 billion. For every dollar paid out, 58 cents come from investment returns. With a pre-crisis funding ratio of just over 70% and a target rate of return of 7%, we must seize the opportunities and control for the risks climate change presents to our portfolio.
Scientific evidence demonstrates that reducing greenhouse gas (GHG) emissions is critical to slowing global warming and driving sustainable economic growth. Physical impacts pose short and long-term risks to our members’ assets. These risks include rising sea levels, floods, severe storms, drought, and wildfires. Dramatic changes to the global energy economy, particularly as the world recovers from COVID-19, also pose transition risk as companies are challenged to adopt new strategies, without leaving their investors holding stranded assets, or in extreme cases, bankruptcy. In addition, companies are increasingly vulnerable to litigation. Climate change is a global challenge and one we cannot afford to ignore as long term investors, with inviolable fiduciary duty to our members. The consequences of inaction will be measured not just in the impact on workers and communities, but also on the companies we rely upon to generate the investments that pay benefits. The United States government’s own fourth National Climate Assessment notes the impending financial impact:
“The impacts of climate change beyond our borders are expected to increasingly affect our trade and economy, including import and export prices and US businesses with overseas operations and supply chains.”
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A circular economy is an industrial system that is restorative or regenerative by intention and design. It replaces the end-of-life concept with restoration, shifts towards the use of renewable energy, eliminates the use of toxic chemicals, which impair reuse and return to the biosphere, and aims for the elimination of waste through the superior design of materials, products, systems and business models.
To access From linear to circular – accelerating a proven concept click here
Nobel prize winner Esther Duflo suggests institutional investors can help alleviate poverty by fostering new supply chains and looking beyond a country’s credit rating.
For institutional investors that are unsure how to play a direct role in helping alleviate poverty exacerbated by COVID-19, Esther Duflo, Professor of Poverty Alleviation and Development Economics at the Massachusetts Institute of Technology (MIT) and current winner of the Nobel Prize in Economics, has a few ideas.
Speaking at FIS 2020 Digital, Duflo urged investors to think “carefully” about country credit risk, “reading” and “processing” credit ratings to ensure that countries trying to help their populations during the pandemic are not “punished” by high external borrowing costs. India’s pledge to spend 10 per cent of its GDP on a pandemic recovery plan has been mired by credit agencies cutting its country rating to a notch above junk in early June, increasing borrowing costs and making lenders wary.
Duflo said that although poverty reduction has progressed in recent decades, the pandemic means fewer people will now escape poverty. The poor are particularly vulnerable because poor countries can’t protect their citizens to the same degree; have no social protection systems and will suffer from the slow-down in production.
“They have much less scope to weather uncertainty,” she said.
COVID-19 hasn’t just increased poverty in poor countries. Inequality has been growing in the US for decades with the top 1 per cent of the population owning a larger and larger share of the national income while wages of the bottom 50 per cent remain stable.
“The pandemic has put the spotlight on the consequences of this,” she said, adding that some racial groups are much more likely to get sick – and die if they are sick – because of deep inequalities in treatment. There is an “unacceptable” level of poverty amongst Africa Americans and Latinos who are keeping the US economy going but dying for it, she said.
Globalisation
Institutional investors can also play a role in helping poor countries by encouraging a shift in supply chains. The idea that poor countries benefit from globalisation because they have an abundance of labour is pervasive, yet a closer look at the data questions the assumption that globalisation has been good for the poor. Although poverty has fallen in China and India as a result of integration with the global economy, inequality in these countries has also risen.
Moreover, many countries struggle to benefit from globalisation. For example, countries producing labour intensive goods are squeezed out by the dominance of China. It will take countries like Ethiopia or Kenya a long time to build new production hubs, not because they don’t have the ability, but because they don’t have the reputation, she said.
But the pandemic could trigger a positive shift. Companies are realising that it is risky to source all their production from one country, more so a particular town.
“What we realise is that we need to spread the global supply chain across more countries, and this could be an opportunity for developing countries,” she said.
However, it won’t happen without a collective effort by governments and trade associations.
“It is not in the interest of firms to do it – they want to work with their trusted provider. But it is in the interests of the entire sector.”
The costs, and a steep learning curve, make companies reluctant to move their supply chains. Every new country and relationship with a producer is a risk because “there is a chance it won’t work out,” more so if there is no track record of production in that country.
Duflo told investor delegates that they had an incentive to encourage diversification. They could either look for potential investee companies in new producing countries, or support efforts by large firms in importing countries to look for new partners. Currently, much of this type of matchmaking is done by not-for-profits supported by governments. Building new relationships and financing new production hubs needs to be long-term and patient. Here she suggested collective groups, acting on behalf of an industry, could raise bonds to finance new supply chains for the whole membership.
Duflo said that the reduction of poverty is a success story and that amidst today’s challenges progress on poverty is a “bright spot.” She also said that much of the alleviation has been achieved by developing countries own economic management.
Finally, she advised institutional investors to consider social impact in their investments, urging them to “exercise scrutiny” and “follow the evidence” to assess the social value of an investment.
To listen to the Fiduciary Investors Series podcast interview with Esther Duflo, click here.
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Global asset manager Robeco has found proactive stewardship triggers important changes in corporate behaviour. Chief executive Gilbert van Hassel urges FIS 2020 Digital delegates to do the same.
The appointment of climate expert Samuel Leupold onto the board of energy multinational Enel Group after a campaign led by Robeco and Climate Action 100+ (the investor initiative targeting the world’s dirtiest companies) shows the power of investor collaboration, said Gilbert van Hassel, chief executive, Robeco, speaking at FIS 2020 Digital. Discussing how to ensure a sustainable recovery in the wake of the pandemic, he called for action among governments and major asset owners to push for sustainability, saying “now is the time.”
“We hope Enel will make major steps towards the non-fossil fuel delivery of products to clients,” he said, reflecting on the long-term impact of investor collaboration on the energy company. Something that he said has also triggered change at oil giant Shell where investors like the United Kingdom’s Church of England Pension Board have influenced corporate sustainability policies.
“Making sure we actively vote and actively engage with corporates can change behaviour. We just need to persist and make sure we do it together,” he said.
A sustainable recovery and sustainable economy require leadership and capital, said van Hassel. Investors need to look at long-term trends and focus on a “healthy planet” that ends species extinction and warming trends.
“If we continue on this path, we will have more storms, disease and vulnerability,” he said. van Hassel also said it was essential that wealth was shared.
“People are protesting about inequality,” he said referencing a lack of opportunity to study and access healthcare particularly.
He argued that the recently common argument that “this time things will be different” has no basis: human behaviour doesn’t always change. Indeed, he observed how the recent re-opening of Brussels airport showed undiminished demand for air travel. However, van Hassel is also encouraged by the sacrifices people have made and the “willingness to do things differently” in lockdown. During the crisis social distancing was respected and biodiversity in Amsterdam’s’ canals increased.
“I hope this could be the spark the world needs to start working together to get into a sustainable economy,” he said.
Robeco, which manages around $200 billion, has had 95 per cent of its 1000 staff working from home since mid-March, but is now starting to bring employees back into its offices. He said there are many more rules on bringing people back to corporate premises.
“Working from home is going to be constant for a while,” he said, but added that working from home brings challenges like maintaining a company culture, cohesion and the loss of the social side of office life.
He said Robeco’s assets were conservatively positioned and the manager was able to generate cash relatively easily during the crisis. Getting the operational side of lockdown right was more of a challenge, however.
van Hassel said when sustainability is integrated into investment decision making and processes, it is no longer possible to greenwash. He said sustainability has become “mainstream” and many organisations are trying to “catch up.” Those that understand that sustainability ensures better risk-adjusted returns, and fully integrate ESG into their analysis alongside adopting regulations and taxonomies, are “no longer greenwashing.”
He said governments which have focused on short-term health issues and the need to support companies now need to focus on rebuilding in a sustainable way. Here he urged governments to galvanize around the SDGs.
“The Paris agreement and the SDGs are a road towards a more stable, inclusive society,” he said, noting how the SDGs ensure long term growth, less volatility and a better quality of life. van Hassel concluded that if governments had the “audacity” and “willingness” to introduce a global carbon price it would “be a huge help” and one of the quickest ways to solve pollution.
“Polluters are not seeing the consequences, but we, society, pay the price,” he concluded.
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FIS 2020 delegates heard how US pension fund CalPERS wants to use leverage to push deeper into private assets, while Ronald Wuijster, chief executive officer, APG Asset Management said the policy response has made taking advantage of buying opportunities difficult.
Leverage will enable CalPERS to invest more in return-producing private equity and debt allocations, and deployed prudently and opportunistically “could be very helpful,” Ben Meng, CIO of the $400 billion US pension plan told delegates at FIS Digital 2020. In a conversation with fellow investor Ronald Wuijster, chief executive officer, APG Asset Management, Meng acknowledged introducing leverage equivalent to up to 20 per cent of the assets of the fund (around $80 billion) exposed CalPERS to risk, yet he said the pension fund couldn’t hide from risk.
The use of leverage whether through borrowing or the use of derivatives is integral to his plan to increase the fund’s allocation to better-performing private equity and private debt. Meng said private equity is the only asset class that consistently delivers above CalPERS 7 per cent return target, and as more companies stay private for longer, it will continue to represent an attractive opportunity. “We are trying all possible ways to increase exposure to private equity,” said Meng who doesn’t have unanimous board approval for the policy. Margaret Brown voted against the policy changes at the June board meeting – the only dissenting voice.
Boosting the allocation to private equity holds other challenges beyond tapping liquidity or “having more assets” via leverage. CalPERS won’t manage the allocation in-house (around 80 per cent of the total fund is managed in-house) yet the “performance dispersion” amongst General Partners is large.
Access to the top GPs is critical, yet CalPERS mustn’t increase private equity by compromising the underwriting standards or liquidity provision of fund, said Meng, explaining that a key question is assessing how much the pension fund can “give to top managers.” In its new approach to private equity investment, CalPERS is “ramping up” its ability to co-invest and invest in separately managed accounts, as well as talking with potential captive GPs, willing to work with one Limited Partner. Although CalPERS scale and brand will help access top GPs the fund is also limited by its size and the fact GPs only raise money “every three years or so. “This is not something we can rush,” said Meng.
Managing liquidity risk is also a key component to the success of deploying leverage said Meng, who explained how the fund’s new liquidity framework will help ensure sucess. CalPERS has identified all “potential uses of liquidity” spanning paying benefits to margin calls, rebalancing needs and ensuring dry powder on hand. Similarly, it has identified all potential sources from contributions to dividends, turning assets to liquidity and, as of late, “borrowing liquidity.” Meng told delegates that not all sources of liquidity are the same and noted the potential risk, but reassured that the fund has run scenario analysis and standard risk management procedures.
Real market pricing?
When the conversation turned to how the investors are responding to the crisis, Wuijster noted that the policy response makes taking advantage of buying opportunities challenging. “We worry if we are looking at real market pricing,” he warned. In the first few weeks of the crisis the main concern was liquidity, particularly around access to credit markets and the asset manager’s ability to hedge its liabilities via interest rate swaps. “Central banks started intervening after one to two weeks and this made a difference and kept markets up,” he said. “It was a tight situation in the first weeks.”
APG has rebalanced for most of its client funds and is now starting to look at positioning the portfolio for opportunities. “We are talking with clients about financial positions and different economic scenarios, working with them to see what they think, and their risk appetite.”
As for corporate restructuring, Wuijster noted “companies in the middle” that will need to rethink strategy and emphasise sustainability.
Meng reminded delegates that because the current crisis stems from a health issue, only a vaccine will bring resolution. Until then, volatility will dominate, countered by fiscal policy providing short-term relief “to see if the market can work it out.” He added: “One way or another volatility will stay.”
Regarding inflation rising due to the stimulus, Wuijster said high inflation “would be a surprise” and is “not the most likely scenario.” He cautioned, however, that higher prices for petrol and medicines could drive inflation, as could the economic impact of Covid-19 “being less-than-expected.”
Both men agreed that more opportunities exist in less efficient and transparent private markets where dislocations are more pronounced. Although technology companies are driving the recovery in public markets they noted “laggards in the index too,” and flagged that the real impact of Covid-19 is still “evolving.”
CalPERS navigated the immediate volatility and “extreme dislocation” by “keeping calm and carrying on,” said Meng. The pension fund was able to rely on its “ten pathways” to liquidity and rebalance the portfolio. He said the fund’s “serendipitous” liquidity planning and preparation for this part of the cycle has allowed it to navigate the crisis so far. “We have a plan,” he concluded.
Amanda White will interview CalPER’s CIO Ben Meng this week as part of the Fiduciary Investors podcast series.