Monday, January 14, 2019

Sabia on Doing Sustainable Investing Right?

Mary Childs of Barron's reports, How to Do Sustainable Investing Right, According to a Pension Fund Manager:
Michael Sabia has one of the most enviable jobs in investing. The chief executive officer of Caisse de dépôt et placement du Québec, or CDPQ, helps oversee more than 300 billion Canadian dollars (US$226 billion) for public and parapublic pension and insurance plans.

The scale is nice, but it’s the structure that makes the difference: Canadian pension funds have more autonomy and are arguably built with a higher risk tolerance, and tolerance for failure, than their U.S. counterparts. They have stronger in-house teams, bolstered by competitive pay; empowered employees accountable for their own decisions; and less politicking interfering with investment decisions.

All that gives them room to make investments we might view as unorthodox or aggressive, like buying entire buildings, competing in private credit, or building toll roads and green transit systems. But most of all, they can focus on long-term results for their long-term liabilities, instead of managing under a board that stresses about each annual figure.

It has arguably resulted in better annual performance: CDPQ—which invests in equities, fixed income, and real assets—generated an annualized weighted average of 10.2% over the five years through 2017, beating its benchmark by 1.1 percentage points annually, the most recent data available. The find has beaten its benchmark seven out of the 10 years through 2017.

In October, CDPQ and Generation Investment Management, the sustainable-investing firm co-founded by David Blood and Al Gore, announced a partnership to invest US$3 billion in “sustainable, resilient businesses” that are a “net positive for the environment, [and] benefit society.” The investments will have a duration of eight to 15 years—up to twice the standard private-equity time horizon.

We caught up with Sabia, 65, this past Monday to discuss CDPQ’s priorities and framing, what shortsighted short-term investing misses, and why he thinks investing along environmental, social, and governance—or ESG—guidelines is destined to outperform.

Barron’s: What’s your approach?

Sabia: We come at this based on a very fundamental principle that underlies all of our investing. Being patient capital, working with management teams to build great businesses, great infrastructure, buildings, across our whole portfolio—it’s guided by a focus on the long term. To use a phrase that’s a bit hackneyed now, things that are built to last. If more long-term investors were doing that, we’d be collectively making a bigger contribution to economic growth. Growth is in our long-term interest, and right now we’re staring at a world where there’s going to be insufficient growth. One of the reasons is too much capital is focused way too much on short-term perspectives.

That same principle underlies what we’re doing around climate. There are way too many investors who address climate as a constraint—it means not doing things. We think about it as an opportunity. The amount of capital that’s going to be invested in new, more durable, more climate-friendly technologies over the next number of years—Bloomberg some time ago said 50% of the world’s power generation is going to be wind and solar by 2050, and US$11 trillion invested [globally, in new power generation capacity between 2018 and 2050].

That’s just one number—there’s lots. Climate change is not going away—this is a long-term trend that’s going to transform a lot about how the world works. As an investor, we need and want to a) promote that transformation, but b) benefit from it, as new industries and technologies develop, to make sure, as they take off, that we’re positioned to benefit substantially from the growth.

I hope this doesn’t sound like good intentions. We’re very commercial. We need to make money; we need to be good stewards of people’s savings. We manage people’s savings, and we have to get returns something on the order of 6% to 6.5% a year over the long term to meet the liabilities that, in effect, we manage. This is not noble purposes and aspiration. We believe this is a sound investment strategy, because we believe it’s going to pay substantial returns.

I think we’re North America’s largest institutional investor in wind power, and those investments are paying us essentially double-digit returns. Our investments in solar in India are paying us, very comfortably, double-digit returns; we’re building leading-edge buildings in Houston, Paris, Chicago, and Toronto, and those are paying us very comfortable double-digit returns.

It’s not like we think this is profitable—we know it’s profitable, and we’ve done enough that we’re comfortable that if we make the right decisions, there is a substantial amount of money to be made. The more we focus our investing teams on the positive side of climate change, the more money we think we’re going to make, because we’re in the game early.

What are some of other climate-related initiatives?

One pillar of this [announced in 2017] is we’re going to increase our low-carbon investments by 50% by 2020. Over 2018, 2019, and 2020, we’re going to increase by C$8 billion our investments in low-carbon assets. I’m happy to tell you we’re ahead of the game: Through 2018, in our first year of implementing, we’re already up C$3 to C$3.5 billion. The other component is we’re going to reduce the intensity of our carbon footprint by 25% by 2025. We’re very much on track there as well. The way we’re doing that is integrating climate change into every decision. Investors evaluate investments by comparing the return to the risk, optimizing across those two things. Now our investment teams have to optimize against three: return, risk, and climate.

How much harder is that?

Eh, pretty hard. I think we’re the first people to do this. In the same way each investment team has to work within a risk budget, now they have a carbon budget. That carbon budget year over year goes down so we can accomplish the 25% reduction. That requires every investor to weigh the climate and carbon consequences of every investment decision. If somebody wants to invest in something that isn’t very green, we don’t refuse, but we say, “Well, you still have to live within the carbon budget, so you’ve got to give up things in other areas.”

What was the response?

Initially, I don’t think it was greeted with overwhelming applause. It does make people’s lives more complicated. That said, in many ways the worst thing you can do to someone running a portfolio is tell them “You can’t do this or that.” They need autonomy. We’re trying to structure their environment where they have to take this into account, where climate’s an element of the culture.

Saying “We’re not going to invest in coal” or “we’re not going to invest in hydrocarbons”—there’s nothing wrong with that, but by and large that’s a political statement. It doesn’t change the way the organization works. We’re changing the way our place works.

Will profits come as people realize the urgency?

Yeah. Too many people think that climate change is essentially about what governments do. Governments have a role to play, but this is becoming a consumer issue, influencing how consumers make choices. Therefore, it’s causing companies to worry about how their brands are positioned relative to climate change. That then causes them to be concerned about what kind of buildings they’re in. As millennials become more and more an important part of the labor force, they care as employees about where they work and [how their companies] address an existential issue. With all those changes, the demand for, and therefore pricing of, highly energy-efficient buildings gets affected.

Similarly, there’s a lot of first-mover advantage in wind and solar. In Montreal, we’re building what will be the third or fourth largest automated transit system in the world. That project is carbon-neutral beginning to end, from the construction process through the operation. That’s [projected to] pay us somewhere between 8% and 9% a year, for 30 years. Now we hope we’re going to be able to do the same thing for the city of Auckland, New Zealand, along with a local counterpart.

We do have a sense of urgency about this, and we are trying, along with others, to mobilize. The industry has a responsibility to get with it.

This notion in the investment business—“Well, we want to do these good things, but oh gosh, it’s going to cost us in terms of return”—it’s just wrong. You took the math test and you got the wrong answer. Done smartly, there are big opportunities to get highly attractive returns. People are more and more becoming aware of and assigning some importance to these issues, which is good, but what fundamentally has to change is this view: “It’s good to do good things, but those good things cost you. We’d like to, but it’s contrary to our fiduciary obligation.” We don’t believe you have to give up returns to do this. If anything, it’s probably positive from a return point of view. This is a false debate.

Some say ESG investments will not outperform their “sinful” counterparts, because as investors divest, it will raise the cost of capital for those sinful companies—which translates to higher yields for those who do buy them, which means a higher return for investors.

Companies making decisions for the long term are better investments. There’s growing and significant evidence that more companies focusing on issues of climate durability, of sustainability, over the long haul perform better. So as a long-term investor, we don’t think that argument holds water at all. But the time frame can make a difference. The investment industry needs to get more focused on building things that actually last, rather than the short-term craziness of the past 20 years.

How did we get so shortsighted? Fear of missing out on dot-com riches, post-9/11 carpe diem, regulatory changes?

It’s a million things. It’s the rise of mutual funds, in particular of mutual funds run by publicly traded investors that have to live with the tyranny of quarter-to-quarter results, which cause people to manage their portfolios in a particular way, because the organizations have to worry about earning targets, et cetera. There’s the rise of algorithmic trading, more sophisticated technology. It’s not all the doing of the investment industry. There are consumers of financial products who themselves have a very short-term perspective: “If my mutual fund isn’t performing over a couple quarters, I take my money somewhere else.” That creates a whole environment where, in order to continue to accumulate assets, the key to their profitability, [funds] have to keep performing on a quarter-to-quarter basis.

In 1960, the average hold on the New York Stock Exchange was eight years; now it’s eight months. If you’re thinking quarter to quarter, you’re basically a tourist, just visiting companies. You’re not taking a longer-term perspective on how that company is going to grow and develop, so you don’t really care whether they’re investing enough in their future, doing enough R&D. But from a social point of view, those things really, really matter.

I’m not saying there’s a “fault” on the side of the investment industry; people are responding to what their clients want. But that’s given a very tyrannical short-term focus to investing.

The upside is more and more you see big investors starting to go, “Wait a minute, we can’t do this anymore.” Larry Fink’s letter to shareholders, influential firms like McKinsey, CEOs, investment organizations, ours and others, saying you’ve got to have a longer-term perspective. There’s a long way to go, but there’s a lot of positive change under way to get out of this prison of short-term thinking that we’ve been in for the last 20 to 25 years.

This fits with the current reexamination of financial-market capitalism, with everyone from Paul Tudor Jones and Ray Dalio to the Democratic Socialists of America saying our system isn’t working.

I agree with that, but let me go a little further. Yes, it involves climate, appropriate treatment of employees, human rights. But from an economic and investment point of view, if because of short-term, delivery-of-results pressures, companies are systematically compromising what they’re doing—on R&D, capital investment—that has real economic consequences. If that’s happening on a systematic basis, we are collectively underinvesting, underinnovating, and that’s undermining growth.

The financial crisis of ’09 was the poster child of this: The financial system has become disconnected from the real economy. The financial system is the circulatory system of the real economy, but it’s forgotten that role—it’s become an end in itself, a source of profit-making in and of itself, as opposed to playing its social role. Thinking long term is going back, or forward, to a world where the financial system will once again do what it’s supposed to: support the growth and expansion of the real economy.

That contributes to what we’re seeing politically, whether it’s left or right populism in Western Europe, Eastern Europe, other countries, to some degree in the U.S. These things are all connected. We’re a pension fund, we have the luxury of time, so I understand when I say it, it doesn’t apply equally to other people in other circumstances. But there are more and more people arguing this, who believe something’s got to change, and I do think we’re beginning to see that.

Thanks, Michael.
In December, Michael Sabia sat down with McGill University professor Karl Moore as part of his CEO series to discuss sustainable investing and more. Sean McNally of Bull & Bear, McGill’s student-run magazine, covered it in his article, Michael Sabia on Sustainable Investing and Our Ability to Change the World:
In last week’s CEO Series, Michael Sabia did not sugar-coat his response when Professor Karl Moore asked him to share his perspective on the current global landscape. “The world’s in a hell of a mess,” he said convincingly. The audience was lured. For those who know Mr. Sabia, an introduction like this should not be surprising. In his investment and managing styles alike, convention is of little concern to him. As the incumbent CEO of Caisse de dépôt et placement du Québec (CDPQ), Canada’s second largest pension fund, Mr. Sabia is somewhat of a pioneer, emphasizing ‘building’ over ‘trading,’ and venturing “way outside the mainstream of pension investing.Rather than traditional pension methods of funding projects through debt or specialized securities, CDPQ under his watch offers a ground-up approach by offering financial, construction, and operating services.

He elaborated on his ominous opening remarks by outlining the root of this ‘mess’ as “a departure from core values,” which has given rise to populism and demagoguery. From Brazil to India, political divisiveness introduces a high level of political and economic unpredictability, dissuading funds like CDPQ from investing in burgeoning economies that need it most. Further, this global instability has contributed to the quarter-to-quarter myopia that commands Wall Street’s largest funds. Mr. Sabia refers to his most hated entities, hedge funds, as “the blight of the landscape”, offering a prime example of the short-term invest return obsession at the expense of social decency. The way Mr. Sabia sees it, these companies have become nothing more than “commodities traded on an exchange.”

Perhaps aware of the pessimistic lens he is using to view the world, Mr. Sabia shifted his tone and put the onus on the audience, an eager class of MBA students. “The responsibility will be on you guys,” he continued with a more sanguine mood, “to step in and attack these issues head-on.” Ultimately, it is about bringing your “core values to work every day,” and ensuring those align with your employer’s. While the issues of the world are pressing, they are not insurmountable. True leaders, he went on, emerge in times of distress, not prosperity. Getting excited about tackling these issues rather than discouraged will give rise to this generation’s great problem solvers. The formula for strong leadership was surprisingly simple: combine your core values with an eagerness to solve key issues.

When asked about these values, Mr. Sabia answered in the same manner he responds to every question, with a quick grin and slight seat readjustment. “You need to go to work every day and tell yourself ‘I do what I do because I am contributing to something a lot bigger’.” That ‘something’ could be anything; your family, society, or the corporation itself. This sort of selflessness is exactly the culture with which CPDQ operates. The fund has made exceptional returns on good-for-society investments, with a portfolio centred on renewable energy, urban transit, and the mitigation of climate change. “Doing good for society doesn’t mean sacrificing your returns,” he told the class compellingly.

Like all great leaders, Michael Sabia has an incredible knack for articulating key issues. By outlining them as he did last week, he is able to provide angles for attacking the world’s most daunting problems. Perhaps unknowingly, Mr. Sabia taught the class an important lesson in problem solving: by clearly defining the problems, from macroeconomics to personal budgeting, the path to resolution becomes less ambiguous. Despite beginning the discussion with a sharp dose of reality, Mr. Sabia departed on a more optimistic, cheerful note “you are all capable of solving the world’s greatest challenges,” he assured the MBA students.
Those of you who don't know him, I can tell you Michael Sabia is a tireless leader who has a set of core values and beliefs that go way beyond his role as the Caisse's chief. He sees his role as not only producing the requisite long-term returns the Caisse's beneficiaries need but also as a leader who isn't afraid to shake things up and transform the business as usual culture.

For example, in December, I discussed his vision for a new paradigm on growth where he sees an instrumental role for large pensions and other long-term asset managers in helping debt-ridden governments meet their growing infrastructure and other needs.

No doubt, Michael is extremely intelligent but definitely not the easiest person to work for (think he'll be the first to admit this) because he has extremely high expectations of himself and often passes those on to those working under him without realizing there's a limit to what you can ask for without placing undue stress on them.

His management style is more hierarchical, top-down, and to understand this you need to understand his upbringing and the important influences in his life. The same goes for his tireless work ethic which he inherited from his father and mother.

I mention this because each CEO has their style, their vision, their way of managing, and Michael has tremendous strengths and some weaknesses too, just like everyone else. I wouldn't say he rules by fear but it's not always pleasant having to deal with all his demands, some which are legitimate, others which are onerous.

I also believe there is an aspiring politician in Michael Sabia. I've said this before and I'll say it again, I believe he eventually wants to return to public life for his last chapter and will likely follow in the footsteps of Roland Lescure, the Caisse's former CIO who is now at the forefront on Macron's reforms, once his mandate at the Caisse is completed.

There, I don't blame the man. I'm a lot more cynical than Michael when it comes to the state of the world. He calls it "a hell of mess", I believe the "world is a sewer," an expression that stuck with me from one of my mentors at McGill University, professor Tom Naylor, the combative economist, historian, criminologist and now ecological expert (when I used to ask Tom about his beliefs, he'd stare right at me and say: "just call me an eclectic cynic").

But Michael is right about something, good leaders aren't cynical people by nature, they don't focus on problems but on working on long-term solutions to problems and setting achievable goals that are measurable.

Climate change is a perfect example. My own personal belief is we are screwed, way past the point of no return and the biggest problem of all is there are way too many people on this planet. Admittedly, even if true, this isn't going to solve the ongoing climatic challenges humanity is facing and will face over the next 100 years.

We need to stop dithering and start taking steps toward reducing our carbon footprint, and the Caisse and other large asset managers can play a role by taking concrete steps to reduce their carbon footprint and put pressure on public and private companies they invest with to do the same.

OPTrust's climate change symposium was all about this, how institutions can start by taking small steps which collectively will produce the desired result of addressing climate change and investing in technologies of the future which will bring about much-needed change.

Notice how in the Barron's article, Michael talks about how the Caisse's investment teams have to now optimize for three things: return, risk and climate.

He's not saying the Caisse needs to divest from fossil fuels, something I don't believe is realistic, but if there is a better way to invest in public and private markets to achieve the same risk-adjusted returns and reduce the carbon footprint over the long run, then it is incumbent upon the investment staff to do so. Other Canadian pensions are also doing this as they cross the ESG threshold, but admittedly, the Caisse has taken the lead here and the REM project is just one example of this.

I'll give you another example, today I was looking at the relative performance of First Solar (FSLR) relative to Exxon Mobil (XOM) over the last five years (click on image):


It's a 5-year weekly chart showing relative performance of the two and there are times when First Solar outperforms Exxon and others when it underperforms like from March 2016 ro April 2017 when you had global synchronized growth.

I'm not going to get into the mechanics of this but my point is there are times when investing in alternative energy makes sense and others when it makes less so. Still, over the long run, the trend will be to invest in solar and wind across public and private markets as the world shifts away from fossil fuel sources of energy. That's a very long-term trend but that's definitely where we're heading.

In private markets, Michael Sabia said the Caisse is already a leader in wind and solar projects all over the world, many of which have produced double-digit returns. There, I must admit, I was dead wrong about the Caisse blowing hundreds of millions in the wind (someone told me without government subsidies, these projects are money losers).

Lastly, as far as short-termism in capital markets and his disdain for hedge funds, I can't say I'm surprised. Since his arrival at the Caisse, the focus has shifted away from hedge funds into long term private markets like infrastructure. The Caisse has drastically reduced its hedge fund portfolio since 2009 and only invests with top hedge funds I covered last week as part of legacy investments.

By the way, Ontario Teachers' Pension Plan has also significantly trimmed its hedge fund portfolio over the last four years, all you need to do is look at their annual reports.

But here I'm not completely in agreement with Michael and would caution him to discuss hedge funds at length with Ron Mock, his counterpart at Teachers' because it's not as simple as Michael portrays it to be.

Don't get me wrong, I think many hedge fund managers are insanely overpaid for the mediocre results they deliver over the long run, contributing to gross income inequality, but in my opinion, it's wrong to call them the "blight of the landscape". This isn't exactly true or wise and could lead some to question whether you're taking your fiduciary duties seriously by properly diversifying across liquid and illiquid alternative investments.

In these markets, you need as many degrees of freedom and sources of alpha as possible. Period. You also need to balance your portfolio to manage your liquidity risk.

Anyway, I've covered a lot here. Just like CPPIB is ramping up its green team, the Caisse is taking sustainable investing very seriously, Michael Sabia is making sure of this.

Below, a conversation with Michael Sabia, CEO of the Caisse de dépôt et placement du Québec, during the World Bank Investor Forum in Argentina which took place late last year. Good discussion, he explains his vision on sustainable investing very well.

Update: Geoffrey Briant, President & CEO of G2 Alternatives, shared a follow-up guest comment on rethinking sustainable investing. You can read it here. Watch the clip below.

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