Asset owners struggle with divestment as ESG tool

Asset owners such as CalSTRS say they are loath to resort to divestment as they increasingly act on incorporating sustainability and ESG factors into their investing.

The threat of divestment, of course, can be a potent instrument for asset owners to wield when seeking to persuade companies on matters of environmental, social and governance concerns, advocates say. However, once asset owners divest, companies no longer need to pay attention to their concerns. What's more, divestment could negatively impact returns.

So far, CalSTRS' divestments have been small, noted Christopher J. Ailman, CIO of the California State Teachers' Retirement System, West Sacramento, during a Sept. 5 investment committee meeting. CalSTRS itself has opted to divest from tobacco, manufacturers of firearms and high-capacity magazines, and private prisons. Other divestments were required by state laws.

Still, those divestments can and do add up, he said.

"Those are straws and we're at the point of breaking the camel's back," Mr. Ailman said.

The competing demands stemming from the $241.3 billion pension plan's sustainable investment and stewardship goals, its overall investment goals and pressure from beneficiaries and the public were in full view during the investment committee meeting.

Kirsty Jenkinson, director of sustainable investment and stewardship strategies, who joined CalSTRS in January, said the pension fund aims to be a catalyst, because of its size, for financial markets to appropriately value and integrate sustainability and ESG considerations, including its focus on the transition to a low-carbon economy. In an increasingly crowded and resource-constrained world, ESG and sustainability factors are going to influence the pension fund's long-term return, she said.

At the meeting, the committee approved mostly cosmetic revisions to its corporate governance program and policy. The revisions did not impact the scope of CalSTRS' enhanced engagement activities consisting of formal or informal expressions of concern to company management, shareholder proposals and participation in litigation.

Before the committee's vote on the policy revision, members of the public and CalSTRS beneficiaries asked the investment committee to add divestment to its toolkit as a way to persuade companies to reduce CO2 emissions.

Harry M. Keiley, investment committee chairman, replied that the transition to a low-carbon future is a top priority in CalSTRS' fiscal year 2020 work plan.

"The members of this committee and myself as the chair of the committee … all care deeply about this issue. Individually and collectively, it's a matter of serious concern and focus for us," he said. He added that CalSTRS officials disagreed that divesting immediately from fossil fuels was the right approach.

"Because we haven't taken that action today does not mean we don't take this issue seriously. We do," Mr. Keiley said. "As a group, we are making inroads on this issue and we do have a sphere of influence that we're exerting strategically and at certain periods of time."

In a written statement, CalSTRS said it supported policies such as cap and trade, engagement with companies and investments in sustainable businesses over divestment in light of its fiduciary duty to act solely in the interest of providing participants.

During a discussion on CalSTRS' ongoing asset-liability study, a trustee asked whether staff and consultants considered possible future divestments. CIO Ailman responded that it depends on the size of the divestment.

So far, the divestments have been small, but they have had an effect, he said.

The last time the board voted to divest was in November when it decided to sell its investments in two private prison operators, CoreCivic and The GEO Group Inc. As of Nov. 6, 2018, CalSTRS had a combined $12.1 million invested in the companies from its global equities and fixed-income portfolios.

There's a point that small divestments can add up to increased costs and lower returns, albeit slightly, Mr. Ailman said. When CalSTRS divests from a major industry, it has a much larger impact on returns, he said. Allan Emkin, managing principal at Meketa Investment Group Inc., CalSTRS' general investment consultant, added that since the pension plan's total divestment has been fairly small, it would not impact the implementation risk of its investment programs significantly.

Even so, the impact of past divestments is far from trivial. Since January 2000, CalSTRS' portfolio has underperformed by about $5.8 billion as a result of its divestments, with the majority of that underperformance coming from tobacco divestment, Mr. Emkin said. In terms of asset allocation modeling for its asset-liability study, divestment could increase the volatility and decrease the diversity of the public equity asset class, which would change the risk-return characteristics, he said.

In addition to CalSTRS, other large pension funds say they, too, are loath to divest.

When officials at Japan's ¥159.2 trillion ($1.5 trillion) Government Pension Investment Fund helped to develop an ESG index for its domestic equities, it did not cut tobacco or alcohol maker stocks, said Hiromichi Mizuno, executive managing director and CIO, at an Aug. 20 workshop of the CalPERS investment committee. He said to do so would eliminate the Tokyo-based pension plan from the discussion, he said.

Divestment is also not a preferred strategy at the California Public Employees Retirement System, Sacramento.

"As an investment office, we believe in engagement and we have shown engagement works," said Simiso Nzima, investment director, global equity and head of corporate governance at $378.4 billion CalPERS, in an interview.

For example, he noted that between July 2017 and July 2019, 53% of the Rusell 3000 companies that CalPERS officials contacted due to their lack of corporate board diversity have added at least one female director to their boards. When engagement did not work, CalPERS voted against 255 directors at 97 companies in 2019, down from 468 directors at 145 companies in 2018. The decrease shows that its discussions with corporate executives are working, he said.

Should CalPERS divest from companies, such as fossil-fuel producers, then it could no longer affect the use of fossil fuels, Mr. Nzima said.

"How can you make any change if you don't have a seat at the table?" he said. Company investors can generate debate and push company executives to think about ESG issues over the long term, he added.

It's also about investment diversification and returns to make sure these companies are managed in a proper way, Mr. Nzima said.

Some people see ESG as social issues, he said. "We see them as investment issues."

CalPERS said in a divestment report that as of June 30, 2016, CalPERS-related divestment initiatives, including forgone performance and transaction fees, are estimated to have cost the fund nearly $8 billion.