OPTrust's Climate-Savvy Project?

A couple of days ago, OPTrust put out a press release, OPTrust Climate-Savvy Project Delivers New Insights for Pension Fund:
OPTrust today released the results of its climate-savvy asset liability management/strategic asset allocation (ALM/SAA) project in partnership with Ortec Finance. The project marks another important step for OPTrust’s Climate Change Action Plan to ensure the portfolio remains resilient and agile in meeting the challenges of climate change.

The ALM/SAA project is one of the first efforts of its kind to integrate quantified physical and transition risks and opportunities associated with climate change into traditional multi-horizon, real-world scenario sets that drive strategic investment decision-making.

James C. Davis, Chief Investment Officer of OPTrust said, “Taking action on climate change and considering the financial implications is in the best interests of our members at OPTrust. In integrating climate risk into our portfolio construction framework, we continue to explore and develop various climate change scenarios and analyze the impact on the entire portfolio. We are pleased with the results of the pilot project as it helps provide a current state assessment of climate risks to our fund.”

Key Findings from the Report
  1. Top-down, macro-economic and systemic climate risk perspective delivers new insights. The pilot has established that it is crucial for investors to consider the macro-economic and systemic implications of different global warming pathways (top-down approach).
  2. For a globally diversified investor, a transition to stay under 1.5°C warming, even a severely disorderly one, is preferable over a 4+°C scenario. However, there are material differences across regions; largely determined by the relative energy efficiency of the economy and dependence on carbon intensive production and exports.
  3. At a global level, a steep economic transition to limit warming to 1.5°C may entail significant opportunities for economic growth, perhaps even above current market expectations – the infrastructure investments required, research & development and employment generated are strong drivers of growth and competitiveness. The more orderly the transition, the more pronounced these economic and investment opportunities become.
  4. The time to act is now – even if physical climate-related risks may only become financially material on a longer time horizon. The expectation that physical climate-related financial risks are likely to only materially manifest as of mid-century is no reason to be complacent as an investor today.
  5. If action fails today and the transition to a low-carbon, climate-resilient economy is not completed by mid-century, our economies will be locked into a higher global warming pathway where the global economy is likely to increasingly and structurally slow down. The negative impacts of a 4+°C pathway take over the impacts of a disorderly transition to 1.5°C around 2030-2080, depending on the country.
  6. The climate-savvy ALM analysis permits investors to fulfill increasingly stringent disclosure requirements and upcoming regulatory compliance.
  7. The project supports strong climate action through informed strategic choices: Gaining insights to enable portfolio optimization for a chosen global warming pathway (that matches investment beliefs/goals/targets), while at the same time ensuring the portfolio is robust for other global warming pathways.
  8. There is no silver bullet when managing climate-related financial risks. Each step in the investment process requires a different forward-looking scenario-based approach.
For more details, download the full report.
Take the time to read the full report, I assure you, there's nothing else like it in Canada and perhaps the world.

I briefly mentioned this report when I discussed Canada's expert panel on sustainable finance but I wanted more context to discuss it properly.

This afternoon, I had a chance to talk with OPTrust's CIO, James Davis, for an hour and we covered a lot. James was joined by Katharine Preston, Director of Responsible Investing at OPTrust, and Matthew Zhao, a portfolio manager there who handles all the ALM/SAA analysis and investments and who worked closely with Ortec on this project.

Let me begin by thanking all three for taking the time to talk to me and thanking Jason White, Public Affairs Analyst at OPTrust, for setting this up on short notice.

Talking with James is a pleasure and a bit nerve-racking because as I told Jason afterward, he's "scary smart", speaks fast, really knows his stuff, and it's hard jotting down notes and keeping up with his train of thought but I did my best and he's a super nice guy. Truth is, I need to move to a video or podcast format for some of these interviews.

Anyway, James began by stating the overall ability to pay a pension is their primary focus and since strategic asset allocation (SAA) is the key driver of long run results, they wanted to dig deeper and look at all the risks, including climate change risk which isn't captured in traditional risk analysis.

Interestingly, James told me he has a "meteorological background" (he didn't elaborate) so for him, it's only natural to delve into this risk analysis with a keen focus on climate change risk.

He said the challenge of doing this type of analysis is finding a language that most investors understand because traditionally, climate change was all about compliance and just checking off some boxes.

For OPTrust, this isn't an acceptable way to understand climate change risk because it's not just about compliance, as you will shortly see, there are serious investment implications.

Most of the metrics on climate change risk are bottom up but as Katharine told me, there is no standardized way of measuring these risks across public and private markets but Canada's large investors are meeting and sharing information, working on finding best practices (she told me there's a working group set up).

In this report, Matthew explained Ortec Finance which is their ALM/SAA software provider, wanted to take a top-down approach to understand the effects of climate change risk on the total portfolio.

They used three different climate change scenarios, ran over 1000 simulations and looked at the effects of climate change on three macro variables to draw inferences on strategic asset allocation:
  1. GDP
  2. Interest Rates
  3. Inflation
You can view the three outcomes of OPTrust's pilot run below (click on image):

But what you cannot see in this report and will only read here on Pension Pulse are some of the interesting investment insights that James shared with me.

He said for Canada, under the first scenario where there's a 1.5 C rise in temperature, the 10-year Government of Canada bond yield would be considerably lower because inflation expectations would drop significantly.

And as we all know, a drop in rates raises the funding risk of a pension plan because the duration of liabilities is significantly bigger than the duration of assets, so when rates decline precipitously, they have a disproportionate effect on a pension's funded status (in a negative way).

James told me the conclusion from this analysis is for Canada, climate change risk is very real and argues for more, not fewer government bonds in your strategic asset allocation. It also argues for fewer growth assets like equities.

Now, think about that, here's the CIO of a major Canadian pension plan who is telling you in no uncertain terms climate change risk is real and it has very real implications for strategic asset allocation in terms of your stock/ bond mix.

Remember, OPTrust has adopted Member Driven Investing (MDI) strategy which has as a primary goal to achieve pension certainty by striking the appropriate balance between two objectives:
  • Sustainability – Generating sufficient returns to keep the Plan full funded
  • Stability – Keeping contributions and benefits as stable as possible over time
James emphasized they're not looking to "shoot the lights out" year in, year out like most asset managers, they want to just make sure they have enough assets to cover their long-term liabilities and are looking for steady, uncorrelated returns.

He said it's silly to look at hedge funds versus the stock market because the objective of a hedge fund is to produce uncorrelated alpha (but agrees with me that most hedge funds are delivering leveraged beta and no alpha).

Interestingly, he agrees with IMCO's Bert Clark that the Canadian pension model needs to evolve and here is where we had a great discussion on long-term retunrs and the battle between public and private markets.

I told him if you look at OMERS's 2018 results, it all came from Private Markets because Public Markets got clobbered in Q4 of last year but people are wrongly extrapolating these results into the future.

I specifically said if we had a bad year in Public Markets, not just a bad quarter, then there's no way Private Markets would have delivered such stellar returns. Worse still, in a prolonged deflationary scenario, Public and Private Markets will get clobbered.

I also said there's too much money flowing into Privates and that illiquidity premium has come down significantly.

James agreed, said that stale pricing in Privates smooths returns and that if you get into Privates at the wrong time when the illiquidity premium is negative, you will experience terrible returns.

It's a bit of a warning, one which CPPIB's CEO Mark Machin made in Davos and why he's warning investors to prepare for lower returns.

Interestingly, James told me at a breakfast hosted by Institutional Investor in Toronto last year to discuss climate change risk, there were a lot of representatives from Canadian and US pensions but the Canadians were a lot keener on the topic. I told him most US public pensions are so underfunded that they're not taking an ALM approach or taking climate change risk seriously, they're looking to shoot the lights out which is why most of them are cooked when the next crisis hits.

James also told me he has more confidence in making longer-term forecasts than shorter-term ones but they remain humble and use different assumptions to model their portfolio over the long run, recognizing there is a margin of error.

Again, they stay conservative, they're not looking to shoot the lights out and he recognizes that geographic diversification isn't what it used to be and neither is the illiquidity premium.

They are focused on the return required to meet their long-term obligations and how to generate that return taking the least amount of risk possible.

He said they do take tactical asset allocation decisions over a three year period but nothing that swamps or jeopardizes the returns of their added value strategies.

Anyway, I once again thank James, Katharine and Matthew for taking the time to speak with me, this was a great and very enlightening conversation (more for me than for them). I didn't get a chance to discuss how OPTrust is treating data as an asset class but I covered that topic well.

Hope you all enjoyed it too and please remember to kindly donate/ subscribe to this blog on the right-hand side in the PayPal options to show your financial support. I thank all of you who take the time to contribute, it's greatly appreciated.

Below, Barbara Zvan, chief risk and strategy officer at the Ontario Teachers' Pension Plan, joins BNN Bloomberg to talk about where the financial sector and businesses stand when it comes to sustainability and clean tech.

Update:  Following this comment, I asked Jason White, Public Affairs Specialist at OPTrust, what are the next steps.with this Ortec pilot project and what are the concrete takeaways. Jason shared this with me:
For OPTrust, climate change presents a real risk to our members that cannot be ignored in our investment approach. The climate-savvy ALM/SAA pilot project which we completed in partnership with Ortec Finance has provided us valuable insight into that risk and the potential climate paths we may find ourselves on.

A key focus of our Climate Change Action Plan is about building an understanding of where our portfolio sits today from both a top-down and bottom-up perspective. This baseline will serve as the reference point when we are making future SAA or investment decisions. The Ortec findings will serve as a top-down baseline under the three climate change scenarios we studied. When we review our long-term strategic portfolio we will consider perspectives from this new Climate-savvy ALM lens.

We are pleased with the findings of this pilot project, but we still have a lot of work to do to better understand climate risk. In SAA decisions, we have to consider all different perspectives, not only climate risk, but also other risk exposures, liquidity, etc. However, the takeaways from this pilot project have shed light on a number of scenarios that will inform our decision making going forward.
I thank Jason for sharing this with my readers.