Investor giant CalPERS wrestles with real-life challenge of ESG

Discussions ahead of a formal ESG implementation plan to be presented to the CalPERS board later this year.

So you’re managing a $200 billion investment portfolio. And now you’ve been asked to integrate environmental, social and governance (ESG) considerations across all of your asset classes. What do you do? This is not an MBA exercise, but the real-life challenge facing the California Public Employees’ Retirement System (CalPERS), the nation’s largest public pension fund. CalPERS has long been an innovator in the ESG space, but early this year it decided to scale those efforts by committing to across-the-board ESG integration. Last week in Sacramento, board members got a two-hour preview of what this mammoth undertaking will likely entail, whether for global equities, fixed income assets or alternative investments. It was clear from the outset of last week’s meeting that full ESG integration is a hugely complex undertaking for a major investor like CalPERS, whose diversified global holdings are managed by a wide range of internal and external experts. ESG is further challenging because it does not lend itself to easy financial measurement, especially on a quarterly short-term basis. But, as Mercer consultant, Jane Ambachtsheer, told the CalPERS board, the business case for ESG is compelling – and it’s growing stronger as global threats like climate change and resource scarcity become more pronounced. Ambachtsheer said a review of 36 studies (through 2009) show strong linkages between ESG integration and positive investment performance. “Eight-six percent of the studies are neutral or positive,” said Ambachtsheer, global head of Mercer’s Responsible Investment business.Rob Lake, former head of sustainability and governance at APG Asset Management in Europe, pointed to recent events – the BP oil spill, the Massey coal mine disaster, the News Corp phone-hacking scandal – as further evidence for ESG integration: “Recent events tragically tell a compelling story of how different social and environmental factors can be powerfully impactful (on investments),” said Lake, who is currently director of strategic development at the UN’s Principles for Responsible Investment. Referring to the News Corp scandal, Lake added, “Many investors, including CalPERS, tried to address governance issues there. If more had been pushing this, we might have had a more positive impact.”
The phone hacking scandal whip-sawed the company’s stock and scuttled its proposed acquisition of the British Sky Broadcasting Group. So how does CalPERS intend to fully integrate what is now 100 different ESG initiatives that have been catalogued? The responsibility falls on senior portfolio manager Anne Simpson, who is leading the fund’s ESG effort. A key first step in her mind is getting everyone to see that ESG is less about promoting social goals and all about minimizing risks and maximizing returns. “We view this entirely through the prism of fiduciary duty,” she says. She breaks the fund’s task down to three P’s: ensure that the fund identifies priority ESG issues with the biggest potential for positive risk/return impact; identify relevant ESG research performance data that can be used for financial analysis; revise procurement guidelines so that external money

managers operate from the same set of ESG assumptions and expectations as internal managers, who invest the bulk of the CalPERS’ portfolio. So what specific steps are actively being considered? Procurement is an obvious priority. It means putting alternative solicitation procedures in place to require outside consultants and other external parties to use ESG in their work. This step is especially important for CalPERS’ private equity and real assets programs, which are managed largely through outside investment managers. In the case of the public equities and fixed income programs, which are managed internally, CalPERS staff must be up to speed on ESG and the opportunities it creates. A second step is boosting the highly-regarded “focus list” program, which includes active engagement with individual ‘problem’ companies on ESG-related issues. Eric Baggesen, who runs CalPERS global equity program, expressed strong interest in expanding this program to include companies and management outside the U.S. He was cautious, however, about staff resource constraints and better systems for “monetizing” the impacts of such work. A third step is collaborating with investors and outside experts engaged in the ever-growing ESG space. CalPERS is already working closely with 10 other major pension funds on the topic, ranging from TIAACREF and the Florida State Board of Administration in the U.S., to APG Asset Management in the Netherlands and Previin Brazil. CalPERS is also exploring new alliances such as joining the Greenprint Foundation on greening real estate investment portfolios.
A fourth area – and perhaps the most important one – is resolving the misalignment between CalPERS long-term investment horizon and the investment community’s shorter-term horizon, including money managers CalPERS is using. This was a hot issue of debate with board member Tony Oliveira pointing out that the fund needs performance across different time horizons. Others at the board meeting saw obvious connections between full ESG integration, fiduciary duty and long-term portfolio value. “I feel very strongly this is the right direction to go in,” said Priya Sara Mathur, a CalPERS board member. But board member Dan Dunmoyer cautioned about sacrificing short-term returns for strong ESG performance. “If staff hits a home run on ESG and we have a (relatively low) 2.3 percent rate of return, that’s a concern,” he said. The bottom line: ESG still has a tall mountain to climb before it gains wide acceptance, let alone full implementation. But CalPERS’ work in this regard is a huge important step forward and we eagerly await the formal ESG implementation plan that will be presented to the board this fall.

Mindy Lubber is president of Ceres, the US coalition of investors, environmental groups and other public interest groups.