Even in Washington, the numbers are impressive. The Council of Institutional Investors, who met in Washington DC this week, represents 23 trillion (with a t) dollars, mostly made up of retirement and other savings of working families. Compare that to the entire budget of the US government, less than two trillion a year. Like most industry group meetings in Washington, this one had presentations on what to expect from Congress and the regulatory agencies and how millennials will change the way the members do business, plus snack breaks and wireless sponsored by firms trying to sell products and services to the attendees. But the a two and a half day session featured repeated agenda topics on climate change and what are called ESG issues, suggesting that pension funds may step in where governments have failed.
ESG stands for what used to be termed “non-financial” metrics: environment, social concerns like diversity and treatment of employees, and corporate governance issues like CEO pay and board independence. Institutional investors, skeptical of traditional financial measures following the Enron/WorldCom era scandals, the dot.com bubble, and the financial meltdown, are increasingly relying on non-traditional measures to help them evaluate risk and return in their portfolio investments. Wall Street securities analysts may fixate on quarterly returns, but large institutional investors investing pension money are concerned about the long term, and they understand how misleading the traditional metrics, based on accounting principles developed in the 19th century, can be.
One of the opening sessions featured an interview with Hiromichi Mizuno, head of Japan’s $1.3 trillion government pension fund, who supervised the transition of the fund from all-Japanese investments to deployment of half of its capital in stocks around the world. “Through that process, I came to realize that the best way to improve our performance was to focus on stewardship in investing,” he said. He was inspired by a meeting with former UN Secretary General Kofi Annan, who asked him “why Japan was so indifferent on environment and social issues. I thought Japan was the most environmentally friendly and inclusive country, but we had never stepped up internationally.”
Mizuno told the group that they have a 100-year sustainable investment scheme with a 25-year investment horizon. They are “the textbook definition of a universal owner” with near-permanent holdings in just about every publicly traded company. Investment restrictions and transaction costs make selling out of any individual stock impossible, so the only alternative is engagement with corporate managers to make sure their strategy is sustainable over the long term.
Mizuno “expects best in class stewardship from our asset managers,” which means they will reduce their business with those who fall short on ESG measures and are willing to pay more for managers who can show they effective exercise of ownership rights like proxy voting and communication with executives and directors. Regardless of any short-term adjustments a particular government may make to the rules around climate change, Mizuno’s fund will ask whether the business model is sustainable, not over the course of one administration but over the next 25 years.
The panel on “Next Generation Investing” echoed this focus on sustainability. State Street Global Advisors’ Mizuno told the group that “there are risks and opportunities that can be overlooked by confining yourself to traditional analysis.” And one of those opportunities is appealing to the millennials who will control as much as $7 trillion in investable capital in the next five years. The “client careabouts” they have identified for that group include a strong interest in sustainability. As Morgan Stanley’s Thomas Kamei put it, “I’m already voting my dollars as a consumer. Why wouldn’t I want to invest that way as well?” The information he wants to see on sustainability will connect it to tax consequences and free cash flow.
Another panel examined the push for better financial disclosures on climate impact and sustainability, including guidelines and proposals from GRI, IFRS, SASB, and TCFD, which are filling in the gaps left by GAAP. “Climate has become a systemic risk,” said Paul Lee of Aberdeen Asset Management. The panel agreed that they want to see climate risk reflected in financial statements, whether the business is direct, as with fossil fuels and beachfront property, or indirect, as with the banks and insurance companies that do business with the enterprises with a more central connection to climate issues. Fortunately, the sustainability reports are less often being written by the marketing department, and becoming the province of the same people who are responsible for other financial reports. ESG is taken seriously.
Anne Simpson, the highly influential representative of CalPERS, said, “The financial case around risk is powerful….And this is what the economy needs. Sustainable businesses create jobs and growth.” She noted that Exxon responded to her fund’s shareholder initiative by adding an atmospheric scientist to its board for the first time. Simpson appreciates the Paris accords as a roadmap for investors and companies, no matter what happens in the US. “We’re not changing course because one country is doing certain things,” said Neil Hawkins, Dow Chemical’s Chief Sustainability Officer. Like the CFA Institute’s Rebecca Fender, who called this movement “a slow-moving but unstoppable train,” the CII members consider climate change a material investment risk and opportunity that they must understand and respond to.
Large institutional investors are permanent owners of stock, many of them through index funds that track the market as a whole. That means their only opportunity for protecting and enhancing returns is by pushing the management and boards of those companies to do better over the long term, often through ESG issues. “We own the best stock and the worst stock,” said McKnett. “Why wouldn’t we want to make the worst stock a little less worst?”
Publisher’s note: That’s a very understated sentence about Nell Minow. Check out the 100,000 entries about her on Google. I added the graphics, the ad and a few more references to ESG for search optimization.