Considerations for institutional investors around divestment

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Pension funds often consider excluding certain companies, industries and even countries from their portfolios for a myriad of reasons, particularly as environmental, social and governance concerns flood into the mainstream. But should pension plans be looking to divest from these potentially problematic positions?

Fiduciary duty

When considering divestment, the traditional stumbling block for a pension plan is its fiduciary duty to members, says Andrew Sweeney, vice-president and portfolio manager at Phillips, Hager & North Investment Management Ltd. “Fiduciary duty . . . weighs so heavily on people’s minds when it comes to the question of divestment. For a pension plan, more so than other clients, the first real question is, ‘Can we divest? And is that consistent with our fiduciary duty or not?’ That’s the first fork in the road.”

Norway’s heavy exposure to fossil fuel investments is one scenario that exemplifies the argument for divestment from a fiduciary perspective. The issue came to light in 2017 when the country’s central bank sent an analysis to its minister of finance recommending Norway’s Government Pension Fund Global’s benchmark index divest from oil stocks. The analysis showed the government’s finances, including its pension investments, were twice as exposed to oil price risk than they would be in a broad, global index.

“People have made hay about Norway’s sovereign wealth fund divesting from coal assets and from some, but not all, oil assets. But Norway is a unique situation,” says Sweeney. “This is a country that has five million people that produce four million barrels of oil a day, and they have a trillion that they’ve saved. . . . So from a pure, rational thinking of the overall balance sheet, of course they’re divesting from oil.”

Read: Divesting from fossil fuels doesn’t mean sacrificing returns: report

This type of logical risk assessment demonstrates where divestment, and ESG considerations more broadly, is headed, says Sweeney. He notes socially responsible investing used to openly include a moralistic element, but the risk aspect has started to dominate the conversation because it can hold water from a fiduciary perspective.

Certain institutional investors are looking to make a statement, an impact or both, by divesting from or decreasing their exposure to carbon intensive assets, says Sweeney. But the fiduciary issues loom large for pension plans, making many hesitant to openly divest from any given sector.

Butting out

However, there are those that dare. The OPSEU Pension Trust divested from the tobacco industry in 2017. At the time, Hugh O’Reilly, the trust’s president and chief executive officer, noted corporate engagement is typically the best way to bring about positive change, but tobacco products were a special case. “They only cause harm,” he said in a press release.

Since then, several other pension plans have either gone tobacco-free or announced their intention to do so, including the Ontario Teachers’ Pension Plan and the Dutch pension fund ABP. The California Public Employees’ Retirement System has restrictions on tobacco that date back to 2000 and have become more intensive over the years.

Read: Divesting from tobacco won’t hurt investment returns: report

An analysis of tobacco divestment dating from that year demonstrates how little the conversation has changed in almost two decades. “Socially screened investments by pension funds and endowments, like other investments they make, are subject to fiduciary standards,” wrote the analysis’ authors, Washington D.C.-based attorneys Carol Calhoun and G. Daniel Miller. “All judgments about the prudence of fiduciary actions are to be made from the perspective of the time the fiduciaries made the decisions, not in hindsight.

“The relevant courts and agencies have long recognized that estimating risks and returns is imperfect. Provided that the fiduciaries exercise both the substantive and the procedural component of their fiduciary duties, a court is likely to give deference to their investment decisions, even if those decisions later prove to have been less than optimal.”

In 2018, the CalPERS’ investment consultant, Wilshire Associates Inc., penned its own report, which found the pension fund lost about US$3 billion in investment gains between 2001 and 2014 by divesting from tobacco.

But Calhoun and Miller’s analysis also highlighted decades worth of red flags, such as gradually stricter public policy in the U.S. around tobacco use, which were arguably evidence of risk for the sector. And after examining its restrictions following the report, the CalPERS decided to enhance its tobacco restrictions.

Divestment movement in CAPs

While divestment has traditionally been a topic for defined benefit plans and similarly sized funds, there’s something to be said for ESG customization in capital accumulation plans, says Jean-Daniel Côté, vice-president of retirement at BFL Canada.

Some of the growing plan sponsor interest can be traced back to the Financial Services Commission of Ontario’s 2015 guidance requiring plans to include their stance on ESG in their statements of investment policies and procedures, he says. Adoption was slow at first, he notes, but the public nature of SIPPs encouraged plans to consider whether their members would notice and object if they didn’t take a position. As a result, most plans made broad statements, saying they considered ESG in making investment decisions or when picking an investment manager, says Côté.

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The push for ESG options is actually coming from plan members, especially in the defined contribution space, he says, noting he rarely sees an employee information session without a member raising questions about responsible investments. “With no surprise, it’s usually younger plan members. Millennials are very big on this.

“There’s a lot of pressure . . . particularly if you’re in an organization that deals with environmental issues,” adds Côté. “Obviously, they’d like to have ESG-friendly funds available. But the offerings from the insurance companies is still limited. I’d love to see a [target-date fund] suite that would be ESG-friendly. We’ve talked about it a little bit, but at this point there is limited interest and also limited space on the providers’ platforms . . . .”

Many investment options offered in DC pensions and other CAPs are index-based, which means ESG assessments aren’t applicable, but insurers are working to increase the visibility of their socially responsible and ESG-friendly offerings, noted a spokesperson for the Canadian Life and Health Insurance Association in an email to Benefits Canada. Further, employers are choosing what’s available to employees within CAPs and, where demand exists for these products, insurers are there to meet it.

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So will the CAP industry consider divestment like the bigger pension players? Côté says unless a true environmental catastrophe pushes the industry towards divestment, it’s likely to be an evolution instead of a revolution.

“Folks don’t look at their investments. The only time I hear about that is when we have an employee session. That’s where we introduce the funds and the topic is on the table. They’re there, so they raise their hands and they ask the question. But I’m not really seeing anyone say, ‘I’m only going to participate in the plan if it meets the value that I have.’”

But a private sector pension plan may face divestment questions where an organization’s primary business is centred on a sector that’s problematic from an ESG perspective, says Côté. “That’s actually a question I ask any manager coming in; they know that’s one of my most frequently ask questions: ‘What are you doing from an ESG perspective?’”

Also, it may be difficult for a larger investment firm to have conversations about divesting from, or lowering exposure to, oil with one client while another client is an oil company’s pension plan, says Côté. “There are some issues there where they may want to get rid of some oil and gas [stock], but most of these [companies] are clients.”

ESG risk

Another stumbling block for ESG is that framing it as a risk mitigation strategy leaves a key detail out of the narrative, according to Paul Bevin, general manager of investments at New Zealand’s Government Superannuation Fund Authority. If the ESG risk factor associated with an asset is properly priced in, the asset’s value will be under pressure, he notes. As a result, it will be attractively priced, making it logical for a long-term investor to own it rather than avoid it, as long as the potential risk-to-reward ratio is decently favourable.

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But this presents a challenge for a pension fund with a fiduciary duty to its members to justify divesting from an asset on the basis of any ESG consideration, says Bevin, noting if investors really want to do good in the world, they need to find a way to be upfront about it.

“You should avoid investing in companies that cause environmental damage, because they cause environmental damage, not because you think it will improve your performance,” he says. “Just accept there might be a cost in doing that.”

However, there’s no guarantee a given ESG risk is actually priced into an asset, adds Bevin. “People are concerned about climate change, and I think they, maybe rightly, fear a lot of that risk is not priced into the market. We don’t know that for sure, but there must be some pricing of climate risk going on. There must be some people who are attaching a risk to coal producers, fossil fuel producers, and that’s why they’re selling it. That implies that there would be some impact on the valuation of those businesses.

“So to say, ‘We’re going to reduce the carbon footprint of our portfolio and that’ll make us money,’ — I wouldn’t be so sure about that. You might want to do it anyway, but the claim it will make you money is very spurious. We don’t know about that. People are paying high prices to invest in alternative energy production, for example. Whether that’s profitable or not is still an open question.”

Ready, set, engage

On the other hand, some investors are far more satisfied they’ve found real, qualitative risks to factor into the broad universe of ESG concerns. For instance, coal is an area where Sweeney has seen the tangible effect of engagement. About two per cent of global mining company Rio Tinto Group’s overall business was exposed to coal, both metallurgic and thermal, he says.

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“One of our portfolio managers was meeting with [Rio Tinto’s chief financial officer] in London. [He] basically said, ‘Your thermal coal assets, in some ways, make your stock unownable for us, because not only do we value them at close to zero, but we think there’s potentially a contingent liability there. And 98 per cent of what you’re doing we like and this two per cent is quite problematic.

“The surprise was that the CFO seemed genuinely surprised to hear this comment. I think he was genuinely surprised because there had been protestors picketing outside of Rio Tinto, and I’m sure they’ve talked to their corporate relations people and the media and PR people, but it never actually got to the C-suite where they’re running the business.

“When it came from someone who’s a potential shareholder, it was very different. So during the conversation, you could see the CFO realizing this two per cent, this rounding error, non-core asset was potentially affecting his cost of capital for the whole business . . . . We were surprised they were surprised to hear it from shareholders.

A year later, the company divested its thermal coal assets and was considering doing the same for its metallurgical coal assets, says Sweeney. “It was an example of, as a shareholder, we had a seat at the table, that a protester doesn’t have. We’re not trying to put them out of business, we’re thinking about cost of capital, risk management, as well as profitability.”

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Andrew Bascand, managing director and portfolio manager at New Zealand-based Harbour Asset Management, has also seen the positive results of his firm’s engagement efforts on social issues. “About five years ago, one of our largest listed companies had manufacturing plants in Asia,” he says. “They indicated to us they didn’t think their supply chain had underage labour in it, but they didn’t have a policy.”

Although Bascand isn’t certain his firm was the only investment manager to bring up the issue, following discussions, the company introduced a policy to ensure responsible labour practices across all jurisdictions.

Companies are expecting questions on sustainability from investors more than they have in the past, he says, noting his firm has been broadening its set of engagement questions, which now sits at 87. The questions are narrative in nature, so they add to the quantitative measurements that ratings agencies like Sustainalytics are already producing, notes Bascand.

As the number of questions increased, some of that initial surprise from the C-suite returned, he says. “We’re asking these questions and they often say, ’Why are you asking this question?’ And we say, ‘You realize you don’t have a policy on this when half the other companies in New Zealand are doing good stuff and you’re not?’”

While most companies are willing to engage with Harbour’s questionnaire, the outliers do exist, says Bascand. “Historically, we’ve had three companies that have elected not to respond to our corporate behaviour survey. Those companies have not been candidates for inclusion. So that is a complete red flag to us.”

Martha Porado is an associate editor at Benefits Canada.