Climate change has added urgency to investors’ efforts regarding environmental, social and governance (ESG) factors. The $230 billion California State Teachers’ Retirement System (CalSTRS) has been at the forefront of addressing such issues, adopting an investment policy to mitigate ESG risks in 2008. Recently, Christopher Ailman, CIO of CalSTRS, spoke with Loretta Clodfelter, editor of Institutional Real Estate Americas, about the system’s sustainability endeavors. The following is an edited transcript of their conversation.
Could you tell me a little bit about CalSTRS’ program of low-carbon emission investing and also the system’s broader efforts regarding sustainability?
Do you have three hours? We have been at E, S and G since before we used that acronym. To give you a little history, you can go back to the mid-1970s; this fund had a social investment policy way back then. Social issues tend to be more sporadic, and kind of one particular issue at a time. Probably the biggest stand the Teachers’ Retirement Board took, from a social standpoint, was in 2000, when they divested of tobacco stocks. We’ve been at the governance efforts since 1983, and that’s been a continuing effort. The environmental area is the one of the three that’s actually newer. We really started with that as an effort in 2003, around clean energy. I remember in real estate, at the time, the idea of a green building was really far out. And I think it’s fascinating that LEED standard is now just a business term for real estate. And it’s now become widely accepted. It’s not even considered different.
We’ve been at this in a lot of different ways. In some areas, like real estate and infrastructure now, it’s just ingrained as part of the investment opportunity. Our board has said, basically, “We recognize that of the E, S and G, the E area is more profound and is right in front of us.” The governance issues seem to just always be there. We make improvements and then things flow back. Obviously, social issues are going to be around for a long time. But environmental change is a material area, and it’s right in front of us.
Our board picks a couple of projects a year to really dive deeply into. Next year, once they finish the Asset Allocation Study, they really want to look into the low-carbon future. More specifically, what they’re saying is, “Let’s study the potential for a low-carbon future.” You can listen to climatologists that will say what happens to different industries in the economy if we limit our carbon so the Earth only warms one and a half degrees, if we limit it to 2 degrees or, worst case, we don’t do anything and keep burning carbon the way we do and it goes to 5 degrees or 7 degrees.
We’re not climatologists, so we want to conduct a thorough analysis. We want to understand what the ramifications are, and the likelihood of government action on many of those things as they develop. It would be a lot of education at the beginning, and it will last well into 2020. Within these scenarios of the future, do we have a high degree of confidence that any of them are the most likely, and how much of our portfolio do we want to tilt? Do we want to make an active decision that the world’s going to limit itself to one and half degrees warming, and therefore it’s going to limit its carbon? That means certain industries would do well, and certain industries would do poorly. Certain parts of the world will do well, and certain parts of the world will do poorly. And do we want to actively tilt our portfolio, or do we think the market will efficiently self-correct?
There’s a really wide spectrum of thought on that, and a lot of emotion around it. But we’ll be looking at academic research. You’re forecasting into the future, so there’s a huge potential for error, but it’s the recognition of how profound these changes could be. The one area I’ve used the most in real estate has been sea rise. Let’s say we all can agree the sea is going to rise. You still need to know two factors — when and by how much. Let’s say you’re trying to decide if you should invest in real estate in Miami and you agree the sea is going to rise. Knowing when and by how much is really important information because it’s going to tell you whether you want to be on the coast or not.
We’re an education-based fund. It’s going to be a lot of education for the board, and a lot of decisions about tilting the portfolio one way or another, or believing the market’s going to be efficient and make these corrections. I’ve often told the board that, in investments, being right but a decade too early is indistinguishable from being wrong. You’ve got to get the decision right, and you have to have the right timing. So that’s why we’ll do a lot of education. Bottom line is we have a 30-year investment horizon, and the minute we move one year closer, it’s not like we now have a 29-year horizon. We still have a 30-year investment horizon, so we’re always thinking long term. The teachers that will start working in the classroom this fall are going to be retiring in 2050, 2055.
What’s the world going to be like in 2055, when they retire? They’re going to live for another 30 years pulling down their pension. We care about our investment return for that long of a time period. We have to think about these big-picture global issues. And to me, the true definition of sustainability is we want investments that will still be around producing returns as late as 2055 or 2085. That’s why in the equity markets I’m constantly drumming the drumbeat: We don’t care about the next 91 days. That is a blip. What we care about is the next 91 years. Make them think longer term. In infrastructure, you’re looking at opportunity over a 10-year period, and even that’s short for us. If we have a 30-year horizon, I don’t want to buy a building, hold it for 10 years, and then sell it, because that means they’re going to flip it three times to make my steady return.
What are you looking for with regard to sustainability from your external investment managers? And does that vary?
No. For the investment managers, No. 1 is we want them to be factoring these things into their decision model. And, obviously, in many cases, it’s fairly new to a lot of people. The CFA is just adding it into their investment curriculum. Universities are just starting to teach this. Here’s an anecdotal snapshot but it’s interesting to me: Harvard Business School now has a class on impact investing. The first time they taught it, about four years ago, it had less than 40 students signed up. Now it’s five times oversubscribed. Obviously the dynamic is changing.
We realized money managers need to get up to speed. They’re not going to do it overnight, but they need to factor this in. I don’t want somebody just to have two people in a side office across the street that are their ESG staff. I want them integrated and involved. They can still have a dedicated team, but they better be involved and active in everything. And the actual deal people had better be thinking about sustainability. Traditionally, everybody is just looking at financial metrics. Let’s recognize a lot of those financial metrics are prior-year statistics. They’re rearview mirror information. I want managers to be thinking about the forward information on the landscape ahead. Thankfully, for infrastructure and real estate, because they’re physical, people do tend to think a little bit about those kinds of future risks. If you’re building a skyscraper, you pay attention to wind speeds and the strength of storms. Where are there tornadoes? Where are there hurricanes? And nowadays, it’s absolutely common sense to think about how that is likely to change in the next five years with stronger storms.
It’s hard trying to predict how things will go in the future. I’ve had fun debates with our real estate staff about parking lots. Are they a bad investment, or are they actually a good investment? And I think part of it is the rate of change is often very difficult to predict. Probably infrastructure and real estate do think about it more than the traditional equity or private-equity managers.
The big thing is that we’re really looking at our holding companies. They are real estate companies that we own, or infrastructure companies that we invest in. We’re looking for disclosure. We want them to be thinking about these long-term, 30-year risks and giving us some information, as investors, about how they’re addressing it and how are they preparing for it.
With that, are you feeling fairly satisfied at the level of transparency and disclosure that you’re getting? Or is this becoming a real pain point for you?
It is a pain point. It is an ongoing, constant topic. I’m devoting a lot of my time and attention because we’re getting really inconsistent reporting. People are measuring in different metrics. They’re not following a common template. And companies will tell you they’re getting survey fatigue. They get so many ESG surveys. And so what we’re really trying to do is promulgate more consistent standards, certainly the TCFD — Task Force on Climate-Related Financial Disclosures — standards for corporate disclosure. We’re big proponents of SASB — Sustainability Accounting Standards Board — in terms of sustainability disclosures, and those aren’t just U.S.-based frameworks. Those are really global. And then the ultimate step you’d like see everybody get to is the GRI, the Global Reporting Initiative. But we’re not there yet.
We do have ESG principles on our website that we’ve posted to say to companies: “This is what we’d like to see in terms of disclosures and consistent reporting.” Part of the challenge right now is a lot of companies will put out a sustainability report, which is great, but we don’t know if those numbers are audited. In many cases it’s not consistent reporting; they’re not always reporting on the same metrics. To make an investment decision, you need useful, consistent information. We are seeing better disclosure. The rating agencies are demanding this stuff, the index providers are starting to want it, and news services are starting to realize it’s a comparative advantage if they can get this data and push it out for investors.
Part of what are we asking our investors to do is get more educated, so they understand how to use this data and to factor it into their decisions. If they’re looking at two toll roads, they need to be thinking about the environmental impact of the carbon. Is this likely to be replaced by a railroad? Is this likely to be automated in some place? How is the weather likely to change? I mean, look at the record rain you’re seeing in the Midwest this year. Aberrant weather is going to absolutely continue for the rest of our lifetime.
You are considering investments over the next 30 to 50 years. When you look at your peers or the wider investment community, do you see the same level of commitment?
It is not consistent. Our global peers are absolutely focused. These are active discussions, and we’re very involved in a lot of issues working cooperatively. Globally, it’s definitely the prime discussion and topic. The United States, as evidenced by our own government’s policies, has been more asleep at the wheel. Here’s an interesting anecdote: you would think I’m going to say Texas would be the last place willing to talk about climate change. But I was really astonished by talking to trustees and people who live in Houston. That storm a couple of years ago clearly changed their perspectives, and that’s when people really become believers that something is different. We may want to argue about the causes of it, and how we change it, but I think that’s the reason you’re seeing reactions and changes in people’s personal views on these issues pretty rapidly. If you’re buying a building in Battery Park in Manhattan, you now really care about sea tides and floods because you never expected your whole bottom floor to flood. Now you do.
If you’re speaking to institutional investors as well as their investment managers focused on real assets, what’s your bottom line to that audience?
They had better be thinking about these issues now. They had better be planning for a potential worst-case scenario. Hopefully, we don’t get there, but they have to think about it because human nature, sadly, is to not react to risk unless it’s right in front of our face. If a bus is coming down the street at 100 miles an hour, you jump out of the way. But we’ll all engage in behaviors that are not good for us over the next 30 years — eating high-fat food, things like that. So it’s just human nature, to me, that we don’t react to risk until really confronted. Which means mankind may just push this right to the limit before we finally realize, “Holy bananas! We’ve got to do something serious.” Managers actually really need to be thinking about this and planning for it today. Not fighting it, not avoiding it, but thinking about it — especially regarding long-term assets that have a physical presence, like real estate and infrastructure. People are always predicting the future when they’re trying to make an investment decision. But they need to have a wider spectrum than they’ve had in the past.