The Evolution of ESG at PSP Investments

Alicia McElhaney of Institutional Investor reports on why PSP Investments is good at ESG:

Pension funds that develop environmental, social, and governance frameworks without government interference tend to have an easier time incorporating those programs into their investment process. 

This is just one of the conclusions of a recently published paper entitled “The Origins of ESG in Pensions: Strategies and Outcomes,” which included an analysis of how Canada’s Public Sector Pension Investment Board has been incorporating ESG into its portfolio since 2001. 

The C$204.5 billion ($162.6 billion) fund served as a case study for researchers Judith Stroehle, the research and program lead for the Oxford Said Initiative on Rethinking Performance at the University of Oxford’s business school, and Stéphanie Lachance, a managing director for PSP’s responsible investments team. 

“We find that the regulatory environment of pensions is not always a supporting factor for the integration of ESG, and that pensions confront strict and narrow mandates, which often make it difficult for them to incorporate factors other than those of a financial nature,” the paper said.  

PSP was created in 1999 and began operating a year later. Just one year after that, the fund adopted its first social and environmental investment policy, making it an early adopter of ESG investing.  

The policy said that the environmental and social impact of the companies PSP invested with “may be one of a number of relevant factors that our investment professionals would wish to take into account in making investment decisions.”  

According to the case study, the decision to implement this policy came not from the government, but from internal discussions with the fund’s board and its senior management. This, according to paper, enabled ESG investments.   

“As opposed to a responsible investment approach being imposed by a regulator, it allowed for the development of an approach aligned with PSP’s mandate, its investment strategy, and its total fund perspective,” the authors wrote. “This enabler helped in building a strong level of conviction about ESG risks and opportunities within the organization.” 

Since then, however, PSP’s approach to ESG has changed. In 2018, the fund adopted a policy that requires it to share how ESG is incorporated into investment practices.   

Before investing, PSP identifies any material ESG risks and opportunities of potential portfolio companies. Likewise, when the fund invests with external managers, it asks regularly about ESG. To ensure that its managers’ decisions are aligned with its responsible investment policy, PSP created an in-house assessment framework to evaluate and rank asset managers’ ESG practices. These managers are broken up by quartile and are prioritized for engagement and progress measurement based on that ranking.   

PSP also exercises its proxy voting rights, collaborates with other funds, and actively engages with boards, the paper said.

Stroehle and Lachance noted that PSP engages in ESG investing through three lenses: institutional, which covers historical and regulatory mandates that affect pension systems; organizational, which looks at investment policies, governance structures, and collaborations; and portfolio, which tackles investment strategies and asset allocation.

They noted that while pension funds are all different — and thus cannot implement ESG exactly the same as PSP Investments has — they do better when they have the same level of freedom that PSP did to create its own ESG policy. 

“The freedom of pension boards and leaders to do this, however, can be restricted through lack of clear guidance on ESG expectations from plan sponsors or regulators,” the paper said. “Additionally, regulators can inhibit the integration of ESG by placing large reporting burdens on pension funds, therefore making ESG an expensive use of resources.” 

You can read the paper entitled “The Origins of ESG in Pensions: Strategies and Outcomes” which Stéphanie Lachance, Managing Director, Responsible Investment at PSP and Judith C. Stroehle of the University of Oxford's Saïd Business School wrote here (PDF version is there but you need to create an account to view it).

Here is the abstract:

As intergenerational stewards of capital, pension funds can have many good reasons to embrace environmental, social, and governance (ESG) issues in their investment practices. Yet the particular structure of pension funds creates both advantages and disadvantages for the integration of ESG. This paper reviews the historical origins, regulatory mandates, and fund structures of pensions, to tease out exactly which of these characteristics enable and which of them impede the inclusion of ESG at pension funds. We use the case of PSP Investments to lend depth to the application of the strategies that emerge in the pensions industry.

Let me also share how the paper begins:

On November 23rd, 2020, the CEOs of the eight largest Canadian pension funds—the so- called ‘Maple 8’—made a public pledge about their commitment to ‘creating more sustainable and inclusive growth by integrating environmental, social and governance (ESG) factors into our strategies and investment decisions.’ Arguing that this was not only the correct thing to do, they also stated that [this] ‘is an integral part of our duty to contributors and beneficiaries [which] will unlock opportunities [...and] deliver long-term risk-adjusted returns’ (PSP 2020: 1). A similar open letter was issued only six months earlier, in March 2020, by the then-leaders of three of the world’s largest pension funds: the California State Teachers’ Retirement System (CalSTRS), the Japanese Government Pension Investment Fund (GPIF), and the largest UK pension fund, the Universities Superannuation Scheme (USS). Here, the three giants outlined that ‘if we were to focus purely on the short-term returns, we would be ignoring potentially catastrophic systemic risks to our portfolio’ and underlined how ‘asset managers that only focus on short-term, explicitly financial measures, and ignore longer-term sustainability-related risks and opportunities are not attractive partners for us’ (GPIF 2020: 1).

These statements tell us that pension funds can have many good reasons to embrace a sustainability lens in their investment practice, and that they are increasingly—and publicly— willing to do so. A main driver of the move to embrace ESG in pensions is the inherent need for long-term managers of corporate risks and opportunities to live up to their responsibilities as intergenerational stewards of capital. Nevertheless, the particular structure of pension funds creates both advantages and disadvantages for the adoption of sustainable finance practices and the integration of ESG. While asset owners are often hailed as the ultimate enablers of a sustainable transition on the financial market, in many instances, pension funds do not live up to this expectation. In particular, pension managers must consider how to include ESG given their primary mandate and fiduciary duty to secure long-term financial returns for their beneficiaries. Accordingly, pension managers seeking to integrate ESG must operate within a web of pension regulation, the legal interpretation of fiduciary duty, and the organizational characteristics of pensions.

To analyze these institutional and organizational enablers and inhibiters of ESG integration at pension funds, we employ the notion of ‘social origins’ (Eccles and Stroehle 2018; Eccles et al. 2019) in our review the historical and structural characteristics of the pension sector. Social origins are defined as a combination of the historical and organizational origins of actors that condition the social construction and use of often-vague concepts, such as ESG, within them. In our analysis, we mostly focus on large public and private sector pension funds. By drawing on existing literature and primary interview data, we seek to identify the characteristics and capabilities of these funds that help or impede them in contributing to a larger sustainability agenda within their mandate. To do so, we focus on three levels of analysis: the institutional level, which discusses historical and regulatory embedded within the interpretation of fiduciary duty; the organizational level, which reviews how investment mandates are translated into policies, governance structures, and collaborations; and the portfolio level, which reviews investment strategies and asset allocation, relationships with asset managers and pension funds’ stewardship activities. While drawing on the larger literature about sustainability in pension funds, we focus our review on the pension systems in Canada, the US and the UK. An in-depth case study of the Canadian Public Sector Pension Investment Board (‘PSP Investments’ or ‘PSP’) supplements this structural comparison with more detailed and practical insights.

Ultimately, our question is: what is it that makes these funds so well-positioned to drive a wider integration of ESG, and why is this potential only partly being realized to date? Accordingly, our research seeks to draw attention to both the potential that pension funds have in disseminating good practice in the wider investment community, and the inhibiting factors relevant to this system.

Take the time to read this paper, it's not too long but you need to read it carefully to appreciate all the nuances the authors discuss in detail.

I commend them for tackling all these issues which are not always straightforward. For example:

At an organizational level, pension funds still face the inherent challenge of having a long- term commitment towards their members, while facing public and sponsor expectations of generating short-term returns. This tension requires a thoughtful investment policy, strategy, and a clear interpretation of fiduciary duty at the organizational level.

Here, I want to make something clear, and this is my opinion.

ESG/ responsible investing is here to stay but in my opinion, it must be implemented and adopted in a meaningful way which enhances the long-term mission and objectives of a pension.

In other words, for me, ESG investing is another tool for pensions to reduce long-term systemic risks by investing in new technologies across the capital structure to make sure they meet their long-term liabilities while reducing their carbon footprint.

Stated more bluntly, ESG investing is complementary to other activities to meet long-term liabilities but the primacy of meeting long-term liabilities (maximizing returns without taking undue risks) must remain the overarching goal. 

It's a bit confusing but the reason I state it like this is because I have a serious problem when pensions take ESG investing to extremes without realizing their "raison d'être" to begin with.

And yes, here I am referring to the myopic, politically expedient (and detrimental) push to divest out of oil & gas without answering important questions to all members: What is the cost of divesting to the plan? Does divesting just pass on the risk to other funds who don't give a damn about ESG? Is there a better way to engage corporations to do the right thing?

Luckily, Canada's large pensions don't believe in divesting, they believe in engagement snd investing their way to a lower carbon future. They also engage with large corporations to guide them as they transition into a lower carbon future.

Also, because Canada's large pensions invest a huge portion of their assets in private markets, they need to be able to influence not only public corporations but also private equity funds that hold enormous power.

I note this from the paper using PSP as a case study:

To take into account the world of tomorrow, PSP factors ESG risks and opportunities into its investment processes—with a view to enhancing performance, steering capital towards more attractive areas, and mitigating potential issues. As part of its investment analysis and decision-making processes, PSP identifies material ESG risks and opportunities that could impact its investments long-term financial performance. PSP also leverages its ownership positions to promote good governance practices, by exercising its proxy voting rights and actively engaging with boards and management of investee companies on material ESG risks and opportunities. When PSP allocates a portion of its capital to externally- managed mandates and fund investments in public and private market portfolios, it engages regularly with its external partners on ESG topics throughout the investment lifecycle. To ensure that the ESG integration approach for each externally-managed mandate and fund investment is consistent with its Responsible Investment Policy and expectations, PSP has developed an in- house proprietary assessment framework that evaluates and ranks by quartile the overall external managers’ and general partners’ ESG practices. The quartile ranking helps the board by prioritizing engagement, sharing of best practices, and measuring progress of ESG integration in investment decision-making and asset management over time.

Responsible investment at PSP is an active process that addresses ESG factors across all asset classes. PSP’s investment teams evaluate ESG risks and opportunities in order to make more informed investment decisions, by the dedicated Responsible Investment group housed in their Chief Investment Officer group. This group works to oversee and implement responsible investment activities across the total fund, provide guidance on ESG themes and trends, build internal capacity through ESG knowledge sharing, and collaborate with industry peers to drive systemic change on key ESG issues.

I couldn't agree more with this approach and it wasn't imposed on PSP by some outside regulator, it evolved organically and continues to evolve organically as ESG/ responsible investing evolves.

Anyway, I commend Stéphanie Lachance and Judith C. Stroehle for writing this important paper which adds a lot of great insights to a topic, incorporating many practical insights using the evolution of ESG investing at PSP as a case study.

It's important to note ESG/ responsible investing is still evolving at all pensions and large asset managers, there's no one size fits all but it's also important to share experiences and learn from the successful implementation of ESG investing at some of Canada's large pensions.

Below, Stéphanie Lachance of PSP Investments and Judith Stroehle of Saïd Business School, University of Oxford present “The Origins of ESG in Pensions: Strategies and Outcomes” at the 2021 PRC Symposium, “Sustainable Investment in Retirement Plans: Challenges and Opportunities.” Slides can be seen and downloaded here. Take the time to watch this.