Changing expectations

Natraj S and Chirag Mehta of Quantum Advisors, which sponsors Business India’s Climate Change Weekly Newsletter, interview Marcie Frost, Chief Executive Officer of California Public Employees Retirement Scheme. As CalPERS CEO, Frost oversees a $1.6 billion budget and three lines of business – pensions, health benefits, and investments. With an investment portfolio of about $485 billion CalPERS is the country’s largest pension plan administering a defined benefit retirement system for two million California, public employees and their families. CalPERS is also the nation’s second largest purchaser of healthcare, covering more than 1.5 million lives

What we saw in the 1980s is that pension funds, including CalPERS divested from companies that were doing business in South Africa as a reaction to Apartheid policies there; how has CalPERS investment policies evolved over a period of time? 

CalPERS has evolved over time. Divestment and removing capital allocation to get to a certain outcome was really the only option. The evolution and the importance of engagement and the importance of an active voice at the table, trying to help companies resolve certain issues related to climate, related to human capital, related to governance issues – that I think is what we have found in particular for CalPERS and our voice really does matter.

How do you engage with fossil fuel companies or coal companies which are perceived to be bad for climate in general? If you were to come to developing markets, these companies are very crucial to nation building. So how do you manage that engagement?

There are a couple of ways to manage engagement. One is climate action 100 plus – there’s $55 trillion in assets under management behind that push. There is also an engagement strategy with companies that are the largest emitters of greenhouse gas emissions. That’s why we think you can’t focus on all 10,000 companies in our case, but we should focus on the 100 companies that have the biggest carbon impact on our portfolio. So that’s one way that we do it. We also have a sustainability team. We have our team that engages and does our proxy voting.

The other thing we did in the eighties and nineties, is what I would call public shaming of companies. If they weren’t managing their risks or managing certain expectations that we had in our investment beliefs, we would make that a little more public than I think was really necessary. We believe in private engagement, in getting a set of data, a set of metrics that is normalised and standardised, in order to see evolution or improvement over time. That’s the way to really transition. One of the questions that I’ve gotten more recently is about greenwashing – how do you know you’re just not being greenwashed?

So engagement is a part of our sustainability strategy, but also policy development and working with the regulatory bodies, like the SEC here in the US or IFRS and setting that transparency of what companies have to report, whether that is greenhouse gas emissions, or the use of alternative energy sources or human capital, or governance and the diversity of board members. And not just the diversity of board members, but very important that it’s diversity at all levels of the decision-making process, including C-suite investment decisions, etc. 

 On climate change itself, you’ve seen wildfires in California, right in your backyard to famines in Madagascar to floods in Europe. Climate change is manifesting in many ways. What is your view on how climate change is affecting the world and as a result, our investment framework at CalPERS?

You’re right. We are based in Sacramento, California. We’ve had the worst wildfire season on record just an hour-and-a-half north of lake Tahoe – significant fires burning there over the last few months. And we’ve gotten to the point where people have started to understand that this climate change is real, that the science supports it and you see fewer climate deniers. 

We invest for decades and looking at our real estate portfolio there might be land close to the water tables which will rise over time. So, this is not something that any single country or any single entity like CalPERS can resolve. This is going to take a monumental effort to get people to work together towards these common goals and common outcomes. We’re investing $500 billion on behalf of two million members. We have to make sure that the investment decisions we’re making are steeped in data and research. We will continue to push on the transparency of those metrics so that we understand whether that company we invest in understands the risks that they’re taking on, but also how are they mitigating those risks over time.

Climate change is largely a result of consumption habits in the developed economics. But if you were to look at the next 20-30 years when emerging economies could go through their own consumption cycles and contribute significantly, what happens if we don’t fund that growth so that they achieve prosperity as well as sustainability? 

The problem cannot be solved by any single country. And also, no country can be left behind. And the developed economies certainly have led this problem in its creation. And we can’t leave countries behind that are starting to build out their prosperity. But we must find the right regulatory environment that continues to allow for both innovation and clean energy as well as prosperity. 

So I think the prosperity issue can be front of mind. But it’s really up to each of the countries to figure out how to solve this problem. How do we bring everyone along in this transition? 

There is the move from the pension funds of the world towards a more passive approach to investing. So, in that process, do you think that some strategies would work when it comes to ESG based investment decisions, considering most of the benchmarking indices are not so clean? They have companies with questionable governance or fossil fuel-based businesses. 

Well, I think the approach is not only in engaging with companies, but also having changing expectations for the index providers. You’re right, much of our equity portfolio is passive. And we are very careful about any active risks we take on in the portfolio. But it doesn’t mean we won’t use our active risk budget to think about how we allocate capital to industries or companies where we think that they are handling this transition at a good pace. I think there’s a significant role for the index providers and I’d like to see them come to the table with us.

Companies report carbon emissions, but nobody knows whether that’s the right number or wrong number. What has been the general observations that you’ve seen?

Here in the US domestically, I think there is a willingness, an openness to this. I think there’s some fear about the level of transparency and, you know, what might happen to the quarterly earnings report if there’s transparency around, for example, greenhouse gas emissions. After talking to a number of CEOs, in these companies, I don’t sense resistance to this. What I sense is we need to come along together.

 Traditional pension allocations are based on public equities, debt, private equity, infrastructure and real estate, in separate buckets. So, with this sustainability as a theme, has the time come for a separate allocation towards sustainability as a single bucket on its own? 

You know, I think where we’re at in the cycle is that we believe sustainable investing needs to be factored into all of our asset classes, whether that’s public equity, private equity, real estate, real assets or fixed income. We have to take sustainability measures and due diligence. And we have to place those into all of the integration decisions that we’re making for the portfolio. That’s today. But five years or 10 years from now, we may need to evolve that.

If we don’t see the appropriate progress leaning towards this 2050 date, which is very important to CalPERS, then we may have to look at asset allocation a bit differently. But I think what we would more likely do is make capital allocations differently within the current asset class structure. And that fits our investment belief where we manage risks on three forms of capital. And one of our most important responsibilities is the fiduciary responsibility we have to the two million members of the system. And right now, that fiduciary responsibility means we have to invest to get close to a 6.8 per cent growth over time.

And, you know, I think as we look at the investment, the true investment opportunities are related to ESG right now. We are finding opportunities and alternatives in private assets; about 20 per cent of those portfolios are now invested in what we would call green investments. 

You know, there’s a lot of products and service providers riding this theme of sustainability, ESG, impact investing and everyone wants, you know, a share of the pipe. Much as there is ESG there is also what we have called internally, and we are telling investors this, is Eyewash, Hogwash and Greenwash – E, H and G. As an asset allocator what are the key investment factors that you look for through this lens of EHG, as well as ESG?

That’s a great question. I hadn’t heard the eyewash and hogwash, so I thank you for that. I think, like other investors, when we are doing due diligence on a deal, we ask three pretty deep probing questions and, you know, we see some of the ESG-related discussions start to fall apart. Our focus has been and will continue to be getting the data so that we can make informed investment decisions. So, one of the things I mentioned earlier is that we paired up with Carlyle, one of our GPs. The private equity space is starting to really understand that this data is something they need. But you know, some of this is not transparent enough to the investors. And you asked me a question about divestment. We still get a lot of pressure about divesting from fossil fuel companies. As an example, we’re completely divested from coal. 

And the way that we respond is that engagement really does work. And we have several good examples of where we think our engagement strategy or engagement posture has worked in a very successful way. As we get closer to 2050, we’ll have to determine whether that engagement is still going to work or whether our capital allocation processes need to change. 

 Given that we are approaching COP26, if you had to give three recommendations to COP26, what would they be?

I think creating a regulatory environment and a market environment that rewards the transition; we have way too many subsidies that are incentivising the wrong behaviour. So, let’s subsidise the transition versus subsidising the fossil fuel companies. I think the second is putting a price on carbon. It needs to be priced appropriately and fairly within the markets, a fair level playing field for all. And then to the extent that we can coalesce on a set of metrics and, you know, we’re a little agnostic to the framework that is being used, but let’s coalesce on a set of metrics so that we, again, understand what our baseline is. We do not have a good understanding of what that baseline is and whether we’re making progress for those 2050 goals. So those would be my three recommendations or three requests, you know, of our leaders.

 Could you comment on gender and inclusion, especially in the US? 

Well, CalPERS has long been a believer that diverse companies, including gender diversity companies, are going to perform better in the long run as that brings different perspectives and different backgrounds to inform decisions that that company makes. There are still too many meetings where I’m the only female in the room and that has to change.