In February of 2022, Senate Bill 1173 was introduced in the California legislature that would require its public pension plans to divest from companies in The Carbon Underground 200TM (CU200) on or before July 1, 2027. In March, the Board of the California State Teachers’ Retirement System (CalSTRS) voted to oppose the bill while acknowledging the role that fossil fuels play in global warming and the urgency with which climate change needs to be addressed.
We appreciate the CA Senate bill and its intent, particularly its focus on our CU200. However, we equally understand the CalSTRs response, as it reflects the unique position pension funds face among asset owners as they look to decarbonize and set Net Zero goals.
The primary responsibility of a pension fund trustee is to serve as a fiduciary. In this role, they must manage plans solely in the interest of participants and beneficiaries. When adopting a divestment mandate, pension trustees must conclude that the exclusion of fossil fuel companies is likely to improve the long-term risk adjusted returns of the plan assets, thereby enhancing the security of the promised retirement benefits.
Standards of conduct are imposed on trustees to protect beneficiaries. Divestment based solely on moral grounds, or on the harm fossil fuel companies inflict on the environment is not, in and of itself, sufficient to satisfy most pension fiduciary standards.
In addition, trustees are typically charged with making investment policy decisions, not security selection. This further complicates divestment efforts, as investment decisions are delegated to either internal or external portfolio managers, who are given mandates by the trustees to implement the policy.
Many investors and market participants believe that the long-term prospects for fossil fuel companies are dim (a position we share at FFI Solutions). However, in light of fiduciary responsibilities, there is more to implementing a divestment strategy for a pension fund than removing securities of The Carbon Underground 200TM from its portfolio.
CalSTRS has adopted a Net Zero pledge in which it has committed to achieve a Net Zero portfolio by 2050. The pledge is the first step of a four-part implementation framework to chart a path to Net Zero that is consistent with the United Nations’ Race to Zero campaign. The second part of the implementation framework is to develop a Net Zero Action Plan that will establish a baseline and milestones for managing emissions-related risks, expand investments in low-carbon solutions, and drive ongoing engagement with portfolio companies in order to promote a responsible Net Zero transition. CalSTRS has committed to use its voice as a shareholder in fossil fuel companies to effectuate activities that lead to decarbonization.
Ultimately, there is no “one-size-fits-all” approach to achieving Net Zero, and for pension fiduciaries, a decision on how to deal with fossil fuel companies is part of the policy determination process. Divestment has typically been thought of as a binary decision: should we divest from fossil fuels, or not? Pension trustees who are facing this issue should understand that the market has evolved in a way so that this decision is no longer confined to a simple yes or no answer.
Rather, to develop a fossil fuel investment strategy that squares fiduciary concerns with the view that fossil fuel investments are not compatible with Net Zero, pension trustees can consider the following nuanced approaches:
Develop a mandate specific policy
One challenge with a blanket fossil fuel divestment policy is that it might prohibit an asset owner from investing in certain alpha generating strategies. For example, many managers may utilize computer algorithms designed to generate returns based on short-term stock price dislocations, where positions are only held for short periods of time. A blanket divestment policy may preclude investment in such a strategy because it would require changes to the algorithm that a manager may not want, or have the capacity to make. One way to navigate this challenge is to exclude, from a broad divestment mandate, strategies that are not simple long-investments in reserve owners. These “exempt from divestment” strategies (or funds) could include quantitative strategies based on computer algorithms, or merger arbitrage strategies that may be market neutral.
Evaluate the transition readiness of fossil fuel companies
Some investors believe that fossil fuel companies can effectively reposition to take part in the energy transition. Certain fossil fuel companies have made commitments to align their businesses with Net Zero and many have taken actions to reduce emissions or invest in clean energy. Others have not. As the differences in transition strategies among fossil fuel companies become more evident, investors will increasingly obtain data and develop principles that identify those fossil fuel companies that might meet their specific thresholds for investment or divestment.
Consider synthetic divestment
Synthetic divestment refers to the use of short positions on certain fossil fuel companies to hedge exposure to fossil fuel investments. With a short instrument (outright or via a swap contract), investors avoid profiting (and losing money) from the fossil fuel industry, maintain ownership and a shareholder voice in certain companies, as well as keep their current asset allocation and manager structure. Such transactions can be effectively used to hedge the sector risk inherent in private fossil fuel companies that cannot be readily liquidated.
An increasing number of pension plans will be evaluating Net Zero and making commitments. Pressure from stakeholders, including lawmakers like those in CA, to divest from fossil fuels will be a part of that process.
Yet that decision need not be a simple yes or no. The issues involved with divesting a public pension fund are complex and the hurdles are high. Investment decisions regarding fossil fuel companies can be nuanced, and should be made within the context of other approaches, such as shareholder engagement, to both enhance returns and decarbonize portfolios.
Despite the conundrum public pension funds face, this is yet another opportunity to do good, and do well.