California pension funds chart ESG path in U.S.

While most of their U.S. pension fund peers continue to ignore the issue, CalPERS and Cal-STRS are expanding their ESG agendas.

Sacramento-based California Public Employees' Retirement System, the nation's largest pension plan with $226.6 billion in assets, is in the process of developing by this June 30 a portfoliowide plan to integrate environmental, social and governance factors into all asset classes.

In doing so, it is following the lead of the West Sacramento-based California State Teachers' Retirement System, which took that step in 2008.

CalPERS' expansion of ESG to the entire portfolio is based on the assumption that ESG factors contribute to risk management and improved returns, said Anne Simpson, CalPERS' senior portfolio manager for corporate governance, in an interview. She said ESG principles should hold whenever and however CalPERS allocates capital.

“The trick is to ensure that our strategies in certain asset classes (public vs. private) or capital (debt vs. equity) have been well considered and are complementary across the portfolio,” she said.

CalPERS has about $7 billion in ESG-specific strategies.

CalSTRS, with $140.1 billion in total assets, has four global equity managers running a total of about $600 million in ESG-specific global equity portfolios; commitments totaling more than $600 million with several private equity funds that target renewable energy and clean technologies; and more than $2.5 billion in corporate governance mandates.

Chief Investment Officer Christopher Ailman said he expects the number of ESG managers to expand, but gave no further details.

The two retirement systems have acted independently of each other in their ESG efforts but now are establishing jointly the “Diverse Director Database,” which will provide a listing of qualified candidates for corporate boards, expected to be operational in the next several months, according to Ms. Simpson.

Not only do CalPERS and CalSTRS plan to use the database to choose independent candidates for corporate board openings, but they intend to sell the information to other institutional investors that embrace their ideas of good corporate governance.

“We're moving away from a check-in-the-box governance approach,” Ms. Simpson said. She said the initiative is an effort to support bringing new talent into boardrooms and enhance a company's governance.

Ms. Simpson said it's not just about bringing independent directors to boards, because being independent doesn't mean a board member has the necessary expertise to question management decisions. “Independence criteria tell you nothing about what a director brings to the table in terms of relevant skills and experience,” she said. “It is a list of what they are not.”

At CalSTRS, Mr. Ailman makes no secret of his support of ESG factors, and was instrumental in the 2008 policy move that applied them across the system's portfolio.

He also is critical of those institutional investors that haven't adopted ESG principles. “Sustainable investment returns is the key to our future,” he said.

Mr. Ailman said that while many institutional investors overseas realize the importance of ESG, most U.S. plans and Wall Street are behind the curve, adding: “Ultimately, I believe we will all pay the price for being short-term oriented and shortsighted.”

He said, for example, that while a large number of plans in Norway, the Netherlands and Australia all have endorsed the United Nation's Principles for Responsible Investing, which advocate integrating ESG factors into the investment process, only a few U.S. plans have done so. In addition to CalPERS and CalSTRS, there are 11 other pension plans — none is corporate — in the U.S. that have endorsed the UNPRI. (In total, there are 20 “asset owners” from the U.S. listed on the UNPRI website; the others are foundations and other institutional investors).

Performance of the systems' ESG portfolios are outperforming their benchmarks.

Since inception in 2007 through Sept. 30, CalSTRS' global equity ESG managers — Acuity Investment Management, Generation Investment Management LLP, New Amsterdam Partners LLC and Light Green Advisors — all topped their benchmarks, with the return alpha ranging from 0.26 percentage point to 10.57 percentage points, according to information provided by the fund.

At CalPERS, the domestic and international equity environmental strategies returned an annualized 0.4% since inception.

Ms. Simpson said the problem with the strategy was its approach: It relied on the external manager to screen out companies whose policies had the most negative impact on the environment.

“What we've found is that "avoidance' strategies are less attractive than those which are designed to capture opportunities,” she said.

To that end, CalPERS announced last November a new $500 million internally managed portfolio to invest in global public companies that are actively working to improve the environment and mitigate the adverse impact of climate change.

At CalSTRS, Mr. Ailman said so far the specific ESG managers and the system's corporate governance efforts are outperforming their public markets benchmark net of costs, but it's too early to judge the overall results of applying ESG criteria to the overall portfolio. Still, he has no doubt the benefits are positive: “It should help us avoid some risks — that alone will enhance returns.”

Mr. Ailman said he is asking his investment managers to think long term and to look at risk more broadly.

“The world is more complicated and interconnected,” he said. “ESG matters.” n