Moving Asset Owner Organizations To Sustainable Investing: Advice From A Truly Expert Panel
“In general, we find that asset owners are resource-challenged, especially on sustainability issues. This needs to change…..it is one thing to build a solid plan surrounding issues of sustainability, and another to execute that plan well.”
“The recommendations speak for themselves, so please read them, think about them, and most of all, adapt and adopt them.”
Cary KrosinskyExpert NYSCD Panel Member
A Truly Expert Panel
The quotes above come from a Top1000Funds article by Cary Krosinsky on a just-released set of recommendations by an awkwardly-named body, the New York State Common Decarbonization Panel. The title of its Report is equally awkward: “Decarbonization Panel Beliefs and Recommendations”. Don’t let the awkwardness fool you. This is a great piece of work by a truly expert panel.
This Letter takes Cary Krosinsky at his word by reading and thinking about the Panel’s recommendations, and adapting them to a broader context. That broader context is the global asset owner community at large. As we show below, the Report embodies unique insights relevant for the many asset owner organizations now en route to adopting their own version of the sustainable investing paradigm.i The Letter ends with a few of our own thoughts on the “resource-challenged” issue raised by the Panel.
The uniqueness of the Report starts with its six authors. They came together a year ago with diverse sets of expertise and work backgrounds. Alphabetically:
- Cary Krosinsky: educator, author, and senior advisor in the global sustainable finance field
- Bevis Longstreth: legal expert, author, former SEC Commissioner, corporate director
- Alicia Seiger: educator, author, integrator across fields of law, finance, energy, and climate
- George Serafeim: educator and researcher in finance/investments, ranked in the top 20 in SSRN article citations out of 12,000 authors
- Tim Smith: shareholder engagement expert, champion for business ethics
- Joy Williams: professional engineer, climate change expert, global advisor to governments and asset owners, she acted as Chair of the Expert Panel
In their Report, the authors mention that they came into the project with differing expertise, experiences, and viewpoints. Also, despite the narrow mandate suggested by the Panel's title, a broad consensus was reached that the Panel's Report should go well beyond the narrow issue of 'divestment vs. engagement' in a climate change context. As the project progressed, this broader mandate was implemented, and what initially appeared to be six differing perspectives eventually integrated into a broad consensus on not only the issues the Report should address, but also on the recommendations of how to address them.
Recommendations cannot come out of thin air. They must be based on a set of foundational beliefs. Here is an edited version of how the Panel articulated theirs:
- Climate change is an existential threat to global economies, markets, and earth systems. The threat has both physical and transition dimensions.
- Global warming of +2C would cause significant value-destruction….which would become major at +3C…..a reality still under-appreciated by the public at large and undervalued in financial markets.
- The window to +2C is closing as policies are not matching ambitions. Both adaption and mitigation measures should be vigorously pursued. Physical risks are already appearing in certain regions. Transition risks are already appearing in certain industry sectors with high carbon emissions.
- There is an opportunity side to these dynamics, for example in such areas as energy, agriculture, real estate, and infrastructure.
- Organizations with effective modeling and decision-making capabilities will have comparative advantages in navigating these risks and opportunities.
- ‘Back-testing’ as a risk mitigation measure may be unhelpful as climate-related future events are likely to differ from past events.
- ‘Soft barriers’ are also likely to be unhelpful; traditional rules about geographical and industry weightings, about benchmarks, and about how investment managers and consultants are used, may stifle the innovative mindsets needed to address future climate-related risks and opportunities.
- More active oversight and execution capabilities will be required for asset owners to deal with the realities of climate change and its investment consequences. In short, start where you can, but expand Fund capabilities with a genuine sense of urgency.
Taken together, these foundational beliefs lead to the Panel’s opening ‘Transition Ambition and First Big Step’ recommendation.
The ‘Transition Ambition and First Big Step’ Recommendation
To kick-start the journey to sustainability, the Panel recommends setting out an explicit time-bound Fund Transition ambition. Specifically, that all Fund investments are ‘sustainable’ by 2030, where ‘sustainable’ means investments that are “consistent with a +2C degree future or lower”. Such investments may directly or indirectly work to help create that future or have a neutral effect on its development. To help visualize this, the Panel offers a counterfactual: “Unsustainable assets assume expected values that are inconsistent with the physical impacts and transition pathways of whichever warming scenario is assumed. Sustainable assets have integrity against science-based assumptions. Unsustainable assets do not”.
In addition to being the basis for a ‘Minimum Standards Test’ for divestment, this ‘sustainable’ definition also leads to the Panel’s ‘First Big Step’ recommendation. It is to create an explicit ‘climate solutions’ component of the Fund. All investments in this component meet the ‘sustainability’ test. It would act as a leading edge in the drive towards achieving the Fund’s 2030 100% sustainability ambition. It would also foster the development of the requisite modeling capabilities to test for sustainability. Such capabilities should be able to model corporate value-creation chains from product demand, cost structures, competitive positioning, to sustainable profitability. Organizationally, achieving this Transition Ambition would be led by a Head of Climate Solutions. A key accountability for this position would be to expand the ‘sustainability’ criterion for investments to 100% of the total Fund by 2030.
Specific Investment-Related Recommendations
There are seven specific recommendations:
- Establish and employ a ‘Minimum Standards Test’ which would serve as the basis on which the Fund decides to buy, hold, or sell assets exposed to transition and physical risks. The Report devotes a detailed exhibit on the development and uses of the Test.ii
- Reconsider benchmarks. Traditional market indexes reflect historical trends without regard for future climate-related impacts. They should be replaced by newly-developed sustainability-oriented indexes and best-in-class investment products.
- Develop expertise in climate-risk modeling. Most currently-available models and databases need upgrading. The Fund should build its own capabilities, working with highly-qualified partners.
- Re-audition asset managers and consultants. Given the Panel’s Transition and related recommendations, do the Fund’s current managers and consultants have the necessary culture, skills, and experience to be effective partners? If not, it will be essential to replace them.iii
- Integrate sustainability metrics into compensation structures. This holds for internal professionals as well as for external asset managers and consultants.
- Break the soft barriers. To achieve the Transition Ambition to sustainability, old conventions (e.g., target weightings, performance targets, fee structures) will have to be broken, and replaced by new metrics and criteria.
- Review staffing requirements. To successfully manage the Transition, the Fund will have to materially enhance its management, research, and development capabilities.
From here, the Report moves on to make recommendations in the engagement, advocacy, and education areas.
Specific Engagement, Advocacy, and Education Recommendations
There are four specific recommendations:
- Support forward-thinking companies. Publicly celebrate corporate leadership in sustainability!
- Advocate for smart climate finance policies. This should be done locally, nationally, globally, and include the creation of green investment opportunities.
- Engage with consequences and collaborate with peers. Develop and employ the ‘Minimum Standards Test’ as soon as possible in engaging with both investee corporations and with asset managers. Look for and lever collaboration opportunities with like-minded peers, in both advocacy and on co-investment opportunities.
- Educate beneficiaries and staff. Resources should be devoted to keeping both Fund beneficiaries and employees up-to-date on climate-related developments in general, and on the Fund’s Transition plan and progress towards its achievement in particular.
Taken together the Panel’s broad Transition recommendation and its 11 specific implementation recommendations add up to a monumental challenge for the New York State Common Retirement Fund (NYSCRF). While the Panel recognized this in their Report, it was not part of their mandate to assess the likelihood that their recommendations would be successfully implemented. This Letter is not so constrained, and addresses this question below.
Can NYSCRF Implement the Panel’s Recommendations?
It is a truism to say that it will take a highly effective asset owner organization to successfully implement the Panel’s challenging recommendations. A measurable attribute of such an organization is how it tells its value-creating story to its stakeholders and society at large. For example, last month’s Letter showed how Cbus Super does this through its Annual Report using the Integrated Reporting Framework.
The 2018 Cbus Super story started with a clear description of why the organization exists and how it creates value for its members, their employers, and the community at large. From there, it made clear the roles governance and its business model play in that value-creation story. Next, the Annual Report describes the actual value the organization has been creating in both recent and longer-term time frames. From there, it was on to an assessment of future risks and opportunities, its value-creating goals and strategies in the years ahead, and the roles of the key managers and professionals accountable for making it happen. All this was done in 78 pages with colour, lots of photos, user-friendly graphics, and links to additional sources of information.
Searching the NYSCRF website, I was unable to find any document resembling the Cbus Super Annual Report. The closest was a 202-page document titled “New York State and Local Retirement System Comprehensive Annual Financial Report - 2018”. Going through it, Marshall McLuhan’s dictum that “the medium is the message” came to mind. The only photo in the entire Report was that of the System’s sole Trustee: NY State Comptroller Thomas P. DiNapoli, followed by a 6-page first-person Letter of Transmittal. Its key messages were that the System’s funding and investment programs were sound and that member and employer services were being improved. Most of the rest of the Report contained mind-numbing dumps of financial, investment, and actuarial data with little context to help interpret what it all means.
On governance, Mr. DiNapoli explains that as sole Trustee, the buck stops with him. However, he claims to seek input widely both inside and outside the organization. Yet, there is no explanation how using a 7% discount rate to calculate the System's liabilities can possibly be prudent. Who underwrites the material risk that the assets will not generate a 7% return over the next 10, 20, 30 years? The Report is silent on this question. It is also silent on the people side of the NYSCRF organization. Is any decision authority delegated to people the Report calls ‘staff’? What is the culture inside the NYSCRF organization? And what about its compensation structure? Again, the Report is silent on these questions.
Given the Expert Panel’s challenging recommendations related to building high-quality internal management and technical expertise in the NYSCRF organization, these silences are surely disturbing.
Resource-Challenged Asset Owners
In the opening quote in this Letter the Expert Panel notes that many asset owner organizations are resource-challenged, especially on sustainability issues, and that this needs to change. A good start would be to read the Panel’s Full Report. But that will not be enough. While Mr. DiNapoli is to be applauded for commissioning the Panel's Report, he, along with many other asset owners, now needs to recognize the material governance and technical resource implications of implementing its recommendations.
- See, for example, a new HBR article by Eccles and Klimenko titled “The Investor Revolution: Shareholders are Getting Serious about Climate Change”.
- The Minimum Standards Test should cover more than climate-related risks. For example we argued in the October 2017 and November 2018 Letters that tobacco companies do not pass any reasonable Minimum Standards Test as investments for ethical, social, regulatory, and litigation risk reasons.
- As an example of an asset management organization transitioning to sustainable investing, the Panel cites a report by BNP Paribas Asset Management titled “Global Sustainability Strategy”.
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