Convincing colleagues at the Illinois State Treasury of the importance of integrating ESG into investment strategy was a three-year journey, Deputy State Treasurer and CIO Rodrigo Garcia told delegates at the PRI in Person conference in San Francisco.

“I knew a number of factors were hitting our bottom line but there was scepticism out there in terms of integrating these factors. Many folks asked: ‘Why are we integrating this liberal social agenda?’ ” Garcia said in a panel session addressing the enduring scepticism about responsible investment.

Change came when colleagues understood the financial risk to the portfolio that climate factors posed. They connected to factors that could affect the bottom line, like the vulnerability of insurance companies in the portfolio to rising sea levels and the vulnerability of investee oil companies to stranded assets, Garcia said.

The growing awareness of the importance of intangible assets has also turned sceptics into ESG believers, said Ben Yeoh, senior portfolio manager at RBC Global Asset Management.

“Intangible assets are things missing off the balance sheet but if you treat them badly, they hit your balance sheet,” Yeoh explained.

He added that using easily understandable language, rather than ESG’s endless acronyms, was key to getting the message across.

Lisa Woll, chief executive of US SIF: The Forum for Sustainable and Responsible Investment, also noted the need to use simple language, arguing that many investors still don’t know what is meant by ‘sustainable investment’. Woll observed that there are too many terms around that describe ESG and added that the industry was bad at selling its success stories around climate or diversity.

“Why aren’t we telling our stories and talking about them? This is how we convince people – tell them why they should invest in ESG,” she said.

The panel listed the professions in the investment industry most prone to scepticism about ESG – consultants, asset managers and trustees. Many pension funds and asset managers remain preoccupied with short-term returns, rather than focusing on long-term integration of ESG. One problem is the overwhelming emphasis on alpha, said Dave Zellner, CIO of Wespath Benefits and Investments.

“We spend too much time on alpha and not enough on beta,” Zellner said. “This is where can improve ESG integration and help bring a more prosperous world.”

Consultants were also picked out as ESG laggards. “Consultants have a lot of work to do,” said Garcia, who urged asset owners to wrestle control over ESG strategy from their consultants.

“If you are the fiduciary, you are deciding on ESG strategy, but many pension funds defer to their consultants, slowing progress.”

The panel noted that pressure on pension funds to integrate ESG would grow as the Millennial generation demanded more ESG investment. “Millennials think differently about how their money should be put to work and will drive change,” said Rick Davis, partner, Pegasus Capital Advisors.

Already, the panel noted, dissatisfied Millennials were picking robo advisers, rather than investing and saving through traditional managers. It could be a powerful incentive for change, Woll noted.

“Scepticism goes when your client is about to walk out the door,” she said.

When private equity firms came under fire recently for the demise of Toys R Us and the harsh treatment of the company’s shop workers who lost their jobs without severance pay, it did little to suggest private equity investors were ESG-minded. Yet in an interview with Tanya Carmichael, managing director and head of global funds at Ontario Teachers’ Pension Plan, private equity firm TPG revealed it had been integrating ESG for years.

“ESG is a core value focused across the whole range of our business,” said TPG co-chief executive Jon Winkelried at the PRI in Person conference in San Francisco. “It affects how we think about the companies that we invest in, our due diligence process, the composition of our portfolio and how we want investors to think about us.”

TPG, a PRI signatory since 2013, has more than $84 billion in assets under management in buyout and growth strategies, along with a social impact fund named RISE. Winkelried believes ESG is now engrained at a cultural level, defining the firm as a GP.

The strategy is apparent in TPG’s daily work with its portfolio companies, Elizabeth Lowery, TPG’s managing director, sustainability and ESG told Carmichael. Lowery cited efforts to introduce initial cost reductions in portfolio companies around energy use or water waste as typical examples of ESG integration reducing risk and return value. It also focused just as much on the opportunities, building additional value like employee engagement or using renewable energy to save money, something TPG did with investee company Cirque du Soleil, Canada’s iconic entertainment group.

“We worked with Cirque on their touring shows on how to connect to the grid via renewables,” Lowery said. Another example was TPG’s work with portfolio clothing chain JCrew on sustainability in its cotton sourcing when it relaunched its brand.

TPG finds that its portfolio companies are open to integrating ESG.

“There is a perception that management teams are resistant about ESG,” Lowery said. “What we found is that ESG is already on their mind and not something to be avoided. We say it is part of how we build a sustainable business and that it is really important to integrate within the firm.”

Winkelried added that he found little resistance from chief executives of TPG’s portfolio companies.

“Companies partner with us in driving positive ESG outcomes. It comes back to the core of our identity,” he said.

In some cases, TPG can play a role in ESG education for limited partners that invest in its funds. It is also a journey that evolves, as more ESG issues such as diversity and inclusion emerge, Lowery said.

One of TPG’s flagship ESG innovations is its Rise Fund. With a $2 billion pool of capital, the fund invests and scales with companies, with real impact. Winkelried attributes part of the success of the fund to the fact TPG doesn’t run a segregated investment team for the Rise portfolio, rather it is managed through the main team.

Carmicheal noted encouraging signs of more convergence between mainstream private equity and ESG best practice.

“Some people are interested and others not,” she said. Continued dialogue and access to a good networking community to allow shared experiences and best practice are important. Carmichael also noted initiatives by the PRI and the Institutional Limited Partners Association to set up resources for investors to allow GPs to improve knowledge on ESG. Greater alignment around reporting would also help, Lowery noted, as would guidance in integrating new frameworks such as SDGs in private equity.

Integrating ESG into investment strategies is easier with active allocations than passive ones. Yet a panel of experts speaking at the PRI in Person conference in San Francisco argued that ESG integration in passive investment is getting easier and is set to grow.

“We see strong demand for integrated passive solutions,” said Laura Nishikawa, head of fixed income ESG research at MSCI. “There is demand for indices from asset owners on the institutional side that have strong ESG in their active mandates and find their passive exposure contradicts broader goals.”

Nishikawa also notes a growing sophistication in the market, with demand from investors to combine ESG approaches with factor-based strategies like value and momentum.

“There is more tailoring to marry ESG with returns,” she said.

US pension fund California State Teachers’ Retirement System uses an index strategy and engagement to integrate ESG into its large passive equity allocation. CalSTRS has a 55 per cent public equity allocation, of which 60 per cent is passively invested, explained Brian Rice, portfolio manager at the $225 billion fund. The fund has “taken a step into the ESG-themed space”, introducing a low-carbon index that will have an emerging market component by the end of the year. CalSTRS combines the strategy with robust engagement on ESG issues with companies in the index. Rice noted that key challenges included deciding which ESG strategies to follow and the inconsistency of data.

Swedish buffer fund AP1 began integrating ESG into its passive allocation by clarifying the most important seam of its ESG strategy, Majdi Chammas, head of external management at AP1 told delegates. The fund has a passive emerging market equity strategy that encompasses half of its emerging market exposure. The strategy was developed to meet the cost pressures it faces as a public pension fund and for its liquidity.

“If you take low carbon as the most important thing, low carbon is the one you should choose,” Chammas said. “For us, we wanted good ESG integration across the board not just carbon.”

He also advised investors to get comfortable deviating from the benchmark and adopting a long-term approach.

“If you move into more sustainable investment, you will do well in the long run,” Chammas said. “Deviate from market-cap indices, be more of a long-term investor rather than chasing quarterly results.”

MSCI’s Nishikawa picked up on this point; she noted that more passive ESG investors are prepared to deviate from the benchmark, particularly in Europe.

State Street ESG investment strategist Nathalie Wallace advises clients to think carefully on where their ESG priorities lie. Whether they want a 70 per cent reduction in carbon emissions with tracking error or to dial up exposure incrementally over time is a question to consider. She noted that smart beta and factor approaches were often a precursor to adding a climate factor or tilt.

“Sustainable index-based strategies are growing faster than traditional index strategies,” said Jessica Huang, director of sustainable investment at BlackRock, which offers investors 340 index funds. Huang noted that ESG index strategies were still new compared with traditional ESG investment.

The importance of good data

One of the biggest challenges for passive investors is accessing accurate data on the companies in the index.

“If it’s in the index you hold it. So, you rely on good data,” said Huang, who noted that reporting is improving. She also added that ESG index investors faced an absence of the compelling “company stories” that tend to drive ESG investment.

“It is a question of figuring out how to get through to the end investors what ESG means.”

Chammas also reflected on the challenge of holding all the index.

“Whenever there is any controversy in one of the companies in the index, we are asked why we invest in it,” he said. He advised delegates to draw on unique sets of information, rather than relying on existing data, which can lag

. “You need more real-time unique data; if you do what everyone else doe,s you will never outperform,” he said.

Are ESG indices performing? Experts said success depended on whether available data could inform better index construction and strategies. They noted that for straightforward strategies, performance delivered is usually what’s promised.

Low-carbon strategies with low tracking errors that don’t seek outperformance, perform as expected. Other approaches can be more challenging, like indices that look to track leading ESG companies in each sector. Although this has proven a strong strategy in emerging markets, where ESG leaders do well, ESG leaders in developed markets tend to track the same performance as other companies but at a reduced risk.

The panel also talked about the engagement element that can come with index investment – how to choose what issues to focus on and how to pressure companies to integrate ESG. BlackRock has a stewardship team of 40 that it is committed to doubling to 75 globally.

“Our engagement approach is first to be patient, but we are not infinitely patient,” Huang said.

Investors need to understand the risks and opportunities related to water in their portfolios, including recognising the different water users in the sectors or regions where they are investing.

Experts used California’s water shortage and seven-year drought as context for a panel discussion on the issue at the PRI in Person annual conference in San Francisco. The message for delegates: take water seriously.

Although California faces some unique water challenges, many of its issues are prominent in other parts of the world as well. Demand is growing and in a free market, water runs “uphill to money”, Pacific Institute president Jason Morrison said. But California’s agricultural community has disproportionate access to water, given its smaller role in the state’s GDP compared with urban areas, which are massive generators of economic activity. Yet taking water from the agriculture sector is difficult because it would have real-life implications for rural communities, Morrison explained.

California’s challenges also include capturing the rain water that is replacing snow fall because of climate change, Morrison said. Historically, most of California’s water has fallen in the north, where it lies in the mountain range in the form of snow until spring, when it melts. It is then transported south, where most of the state’s people live.

“We are seeing a lot more winter rain rather than snow, Morrison said. “Instead of a snowpack and slow release, rain is coming when we don’t need it as much and we don’t have the infrastructure to hold that water in wet months and have it last all the way through to late summer and fall.”

Much of California’s difficulties stem from local water providers not being able to deal with changing weather patterns, he said.

Other challenges include generating pressure to divert water in rivers for agricultural and urban purposes and, until recently, the unregulated use of ground water in times of drought. Landmark legislation in the state now requires agencies to plan long-term sustainable management of ground water.

The risks

Disregarding water risk can have a profound impact on a company’s wider supply chain and cause reputational damage. Yet many companies struggle to measure and report water risk accurately, making it difficult for investors to judge the extent to which their portfolios are exposed.

“It is a macroeconomic risk that affects entire regions. Global investors need to understand it,” said Piet Klop, senior adviser, responsible investment, at the Netherlands’ PGGM, which charts water risk in its portfolio and calculates what percentage of its assets are in areas where these risks are high. Klop notes the challenges around data gathering. Coverage is patchy and companies that do supply water data question the extent to which the disclosure and data they provide is being used.

“We can’t expect companies to keep disclosing [under these circumstances]; we need to act on this data, otherwise we will never get anywhere,” Klop said.

Regulation

Regulation can help investors manage investee companies’ water risk and leads to creative solutions from companies, too, Klop notes. Recent regulation in California that caps overall groundwater use has led to creative solutions by companies and exciting opportunities.

“Investment opportunities arise once companies and investors understand the risk and governments set incentives,” he explained. “Once you have this, creativity breaks through.”

For example, a dairy farm, a non-government organisation and an Israel tech company have partnered to develop a drip irrigation system to water crops for cows that uses manure. In a win-win, the system reduces the amount of fresh water needed to irrigate crops and the amount of fertiliser crops need, while increasing the yields.

“A lot of technologies can come into play,” Klop said. “These combine efficiency with other benefits and make an investment case.”

That is important because low water prices in many regions make it hard to build a water investment case. Even the most successful investments may not be scalable. In the drip-irrigation example, the technology may not be transferable to other farms with fewer crops; and irrigating food crops in the same way would pose regulatory problems because of questions about whether the manure could be transferred to other crops in the area, like almonds, Morrison said. It also puts all the responsibility on first-movers.

“It is a problem we need to solve together,” he said.

Company risk

The panel noted how companies are navigating water risk. Agribusiness Olam, the world’s second-biggest grower of almonds, with extensive farms in California, faces falling yields and rising costs in line with water availability. The company now stores more water and is involved in better management of ground supplies, investing in projects to flood orchards in wet months; however, the absence of a policy overlay or framework has made it challenging because neighbouring farms have benefited from replenished aquifers but have not contributed to the cost.

“At the end of the day companies won’t mitigate the risk until there is policy intervention,” Morrison said.

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Most investors gathered at the PRI in Person’s annual conference in San Francisco believe there will be a disruptive transition to a non-carbon economy as the world scrambles to cope with climate change.

Rather than an orderly transition with policy action combining with technological developments and innovation to usher in a fairly smooth change, 63 per cent of respondents expect a late, forceful policy response. The world will meet its climate objectives but at a higher cost to society because of delayed action, conference attendees said, in a gloomy prognosis attributed to the absence of government leadership on the issue.

“We are missing a policy response,” said Eva Halvarsson, chief executive of Sweden’s SEK345 billion ($38.4 billion) buffer fund AP2, who noted the challenges of portfolio construction when there is so much uncertainty. AP2 has steadily focused its efforts on constructing a portfolio in line with a 2-degree warming scenario.

“We are looking at the portfolio from a new perspective,” she said.

The approach has involved intense work with academics and external partners and has led the fund to invest in a different way.

MN, one of the Netherlands’ largest asset managers, handles the assets of the €70 billion ($81 billion) Pensioenfonds Metaal en Techniek. It has adopted a similar approach. It began measuring its carbon footprint after the Paris Agreement and is now in the process of building a portfolio in line with that agreement.

“We are integrating a strategy framework and looking at opportunities,” said Gerald Cartigny, chief investment officer and member of the managing board at MN.

Investors also espoused the virtues of co-operation.

“Now is an incredible time in terms of what we can do,” said California State Controller Betty Yee, who is responsible for accountability and disbursement of the state’s financial resources.

Yee cited the Investor Agenda, which guides asset owners on investment in low-carbon sectors, the phasing out of coal, engagement with the largest emitters and advocacy.

“This is a step-change in terms of investor action and alignment of activities,” said Yee, who also serves on the boards of the California Public Employees’ Retirement System and the California State Teachers’ Retirement System.

She also said the growing consequences of climate change – from fires to rising sea levels and drought – would start to affect local policy in California.

“Policymakers will wake up [when] it is hitting home,” she said. “Investors need to work out how they can be part of the solution.”

National policy is starting to emerge in China, said Yimei Li, chief executive of ChinaAMC, one of the country’s largest asset managers. She noted the Chinese Government has begun to make action on climate change a national priority.

“China is new to this concept but at the same time we have seen a lot of top-down work from the government,” Li said. This raised awareness is helping asset managers engage with Chinese companies in a new and open way, she explained.

“When we approach to engage, we can do it in an honest and sincere way, so the company is not defensive or intimidated,” she said.

She has also noticed an increasing trend amongst Chinese investors to engage with policymakers and target different government organisations with different goals.

“We are very excited about this concept,” Li said. “This is key in China because it is very top-down; if you can get the government on board, it helps.”

Investors also noted that engagement with companies was a powerful and effective strategy that could help compensate for the lack of political leadership.

“Engagement does work, engagement does make sure companies move,” MN’s Cartigny said.

Successful engagement is easier if you have a long-term relationship with the company, rather than just “flying in”, he noted.

Cartigny cited MN’s engagement with 12 heavy polluters in its portfolio and said engagement involved a long and drawn-out process of pushing for change that could stretch for 10 years or more. MN engages with three sets of stakeholders: companies, external asset managers and policymakers.

“We are active at all levels,” Cartigny said.

Yee cited the positive influence and importance of Climate Action 100 in engagement. The five-year investor-led initiative to engage greenhouse-gas emitters and other companies on driving the clean-energy transition has had a positive effect.

“It is not just a shaming initiative,” she said.

AP2’s Halvarsson counted engagement as a key responsibility.

“It is so easy to see things in black and white, and just sell it off, but we have a responsibility in driving change,” she said.

She also talked about the importance of investors’ own disclosure to beneficiaries when encouraging investee companies to disclose.

“We have a leadership model within our own organisation whereby we have to do it ourselves, too,” Halvarsson said. “We know what to expect when talking to companies.”

The panel also observed the risk to investors from the transition to a non-carbon economy. Some companies will transform and adjust to the new world and others will fail. It will require investors to take money out of companies that can’t transition and to scenario-test at a company level to gauge the robustness of companies and their ability to transform. If a company has never discussed the transition to a low-carbon economy at the board level, it is unlikely to make the leap.

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Leading investors are moving forward on integrating climate change into their portfolios and solving complex problems without support or leadership from governments, a panel of experts at the PRI in Person annual conference in San Francisco said.

The $356 billion California Public Employees’ Retirement System (CalPERS) is developing a new approach to real-estate investment and has navigated complex tax issues that had made investments in renewables tricky.

“We have invested $500 million in the last couple of years in wind and solar and we are looking for more,” CalPERS managing investment director, sustainable investments, Beth Richtman said. “Renewables are an ideal investment with long contracts and long cashflow, but investment has been a challenge because of tax policy and required a creative problem-solving.”

CalPERS has also applied climate-conscious thinking to unearth opportunity in assets it already holds in its portfolio. The pension fund now looks at energy use in its $30 billion real-estate allocation, specifically introducing energy-saving measures in properties that require renovation.

“In the first two years of asking our manager these questions, they have identified 80 million kilowatt hours of electricity we can save annually,” Richtman said.

Now the pension fund is looking systematically at energy use across the whole real-estate portfolio, exploring initiatives such as installing community cooling systems into buildings, or better analysis of data to save energy.

“If you are not looking for energy-saving opportunities, you are leaving money on table,” Richtman said.

Australia’s HESTA, the $A46 billion ($33 billion) superannuation fund for health and community service workers, started investing in renewables in 2006; in 2012, it developed a climate-change policy.

“When we launched a climate-change policy, it was about protecting long term returns and about financial outcomes,” HESTA chair Angela Emslie said. “In 2015, we broadened this to a responsibility to improve the environment and society for our retirees who will face the outcomes of climate change,”

The fund is refreshing strategy and developing a transition plan to place $2.5 billion in a variety of low-carbon investment strategies, amounting to 6 per cent of the total portfolio.

Responsible investment strategy at PFZW, the €180 billion ($210 billion) Dutch pension fund for the healthcare industry, has grown out of the fund’s commitment to meet the needs of its participants.

“We asked our participants what they thought was important,” PFZW chief executive Peter Borgdorff said.

Pension returns and a “liveable world” were the two priorities beneficiaries came back with, and PFZW has now integrated these into a three-pillar policy that includes a commitment to sustainability. This includes a pledge to reduce the carbon footprint of the fund’s portfolio by 50 per cent by 2020, combined with continuing to be an active owner and pushing for change.

“The world will only change when companies change – we can help convince them to change,” Borgdorff said.

The fund is also committed to investing in solutions, pledging $20 billion by 2020.

“Reducing carbon is much easier than finding investments with impact,” Borgdorff noted.

Most progress on climate change in China has come from the country’s fast-growing green bond market since the green bond issue in 2015. Integration outside fixed income has been slow, but policymakers, including the Central Bank, regulators and government agencies like the Ministry of Finance, are pushing for the development of a green finance system, said Sau Ha Kwan, president of E Fund Management Co, the largest of China’s 128 fund managers. She called the push towards mandatory disclosure amongst China’s listed companies by 2020 “baby steps”, but said it showed policy moving in the right direction and reflected a determination to act.

Kwan also called for greater collaboration among pension funds to raise awareness of responsible investment amongst local investors in China.

“In China, progress is stymied by an absence of demand for responsible investment,” Kwan said. “As a service provider, we are equipping ourselves, but demand is missing.”

She noted that upcoming pension reform in China offers the chance to encourage long-term responsible investment.

“Asset managers should talk to pension fund trustees in China and make them see that responsible investment doesn’t sacrifice returns,” she urged delegates.

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