Stewards of capital must become the stewards of a new form of capitalism.
The simulations and scenarios of central bankers and government regulators, the World Bank and the IMF and stock exchanges and trading networks surely included pandemics. But for all of the handwringing about Too Big to Fail, they apparently forgot to put the economic system through a global health stress test.
A system failure of this magnitude reflects, um, a system failure.
But don’t blame it on bureaucrats. There’s a cast of private actors that had also assumed responsibility for safeguarding the sustainability of the world’s financial system. Now that they too have failed, such ‘universal owners’ must step up to make sure the pandemic doesn’t make pre-existing problems even worse.
These captains of the world’s supertankers of capital steer the sovereign wealth of nations and the retirement security of hundreds of millions. The largest of the universal owners, Japan’s $1.5 trillion Government Pension Investment Fund, or GPIF, owns about 10% of Japan’s stock market. The second-largest, Norway’s Government Pension Fund Global, owns about 1.5% of all listed equities worldwide. In the first quarter, it lost almost 15% of its value, or $112 billion.
Such huge institutional asset owners place hundreds of billions of dollars with asset managers like BlackRock and State Street, fueling the entire financial industry. Those managers in turn have to spread so much money around that universal owners essentially ‘own the market.’
Because such large holdings can’t escape a systemic downturn, these owners of the world’s largest pools of capital have to worry about the sustainability of the global economic system itself. Owners of everything don’t want everything to tank.
“If we were to focus purely on short-term returns, we would be ignoring potentially catastrophic system risks to our portfolios,” three such universal owners wrote in a remarkable letter last month that announce a ‘partnership for sustainable capital markets.’
In the letter, under preparation for months, the GPIF’s Hiromichi Mizuno; Christopher Ailman of the $227 billion (as of March 31) California State Teachers’ Retirement System, or CalSTRS; and Simon Pilcher of USS Investment Management, a $94 billion private pension plan in the U.K, make no mention of COVID. Instead, they cite Moody’s to warn of the potential for climate change to destroy $69 trillion in global wealth through the end of the century.
“As investors with the longest of long-term horizons, more inclusive, sustainable, dynamic, strong and trusted economies are critical for us to fulfill the responsibility we have to multiple generations of beneficiaries.”
Companies that maximize revenues at the expense of the environment, workers, communities and other stakeholders “are not attractive investment targets for us,” they wrote. Asset managers who ignore long-term sustainability risks and opportunities “are not attractive partners for us.”
Mizuno, the spearhead of the initiative, had backed up such warnings with the shift last year of a $50 billion passive-equities mandate to the U.K.’s Legal & General. BlackRock, the GPIF’s largest manager, saw its mandate cut.
“We still have a long way to go,” the authors admit, despite promising four-letter initiatives such as TCFD (Task Force on Climate-Related Finance Disclosures) and SASB (Sustainable Accounting Standards Board). Mizuno already was on his way out the door and has since left the GPIF. “Entrenched interests are strong and resistance to change is fierce,” the authors warned.
If the Pandemic of 2020 confirmed the worst fears of universal owners, it should also spur them to redouble their efforts, which even they admit have been inadequate to date. When the GPIF ran its own portfolio through the climate-risk rubric of the TCFD, it found it was in line with a temperature rise of greater than 3℃, well into the catastrophic scenario.
The record was even worse on the other great system risk: rising inequality. Even before the pandemic, the air was thick with such calls to reimagine, reinvent or reset capitalism, to usher in the New Capitalism, Capitalism 2.0 or stakeholder capitalism. Last year, billionaire Ray Dalio, who manages $125 billion as founder of Bridgewater Associates, cited the self-reinforcing spirals up for the haves and down for the have-nots as an “existential risk” for the U.S.
“As a result of this crisis, that conversation ramps up with a much greater degree of urgency,” Amit Bouri, CEO of the Global Impact Investing Network, told me in a recent podcast interview. “We see the downsides of having an unequal society and we’ll also the impacts it has on our ability to make headway on addressing climate change.”
Here are four ways universal owners can ramp up that conversation in the aftermath of the COVID crash:
Forge a new social contract
Investors can insist labor be treated as an asset, not a liability, on corporate balance sheets, and optimize for the value of that asset. A Morgan Stanley research report this week that warned of “cost headwinds” for companies that rely on low-wage workers. Though the report is couched as a warning to the retail, restaurant and hospitality industries, it makes the case for increased benefits even better than Bernie Sanders: One-third of U.S. workers don’t get sick pay. Part-time and gig workers can’t get unemployment benefits. Federally mandated benefits in the U.S. amount to about 8% of compensation, one-third the average of the G7 industrialized countries.
The report suggests regulations and corporate policies deployed in the COVID crisis could outlive the pandemic and says investors show “a renewed focus on corporates’ treatment of employers and other stakeholders.”
The late, great business theorist Clay Christensen convened a fascinating discussion in the Harvard Business Review in 2014 that’s well worth a re-read: “Financial markets—and companies themselves—use assessment metrics that make innovations that eliminate jobs more attractive than those that create jobs,” argues Christensen and co-author Derek von Bever. Those metrics are based on the outmoded notion that capital is a scarce resource, “and, if companies want to maximize returns on it, they must stop behaving as if it were. We would contend that the ability to attract talent, and the processes and resolve to deploy it against growth opportunities, are far harder to come by than cash.”
Like pandemics, the mispriced risks of climate change are likely to be reset with sudden “repricing events.” Markets have not fully priced either the physical risks of climate, from floods, hurricanes, rising seas, crop failures and more, the consultancy Mercer warned last year. That has led to mispricing as well of transition risks, such as “inevitable policy responses” that strand or devalue assets like coal and pipelines. “In reality, sudden changes in return impacts are more likely than neat, annual averages,” Mercer reported.
Realistically pricing such risk is the new fiduciary duty. If ESG investing lowers risks, the inverse must also be true: portfolios not screened for ESG contain undisclosed and uncompensated risks. “We believe ESG is a risk mitigator and an alpha generator,” State Street Global Advisors Rakhi Kumar told ImpactAlpha last year. But of State Street’s $2.5 trillion in total assets under management at the time, however, only about $179 billion, or 7%, were managed with ESG considerations. Leading asset managers, almost all of which have embraced ESG investing, face an uncomfortable question: Are they exposing the majority of their clients to uncompensated risks that are hiding in plain sight?
Bet on the future
Despite years of rock-bottom interest rates, corporations have been sitting on massive amounts of cash, buying back their own stock while failing to invest in productive capacity and innovation to drive growth. Even President Trump now says he doesn’t like stock buybacks. “When we did a big tax cut, and when they took the money and did buybacks, that’s not building a hangar, that’s not buying aircraft, that is not doing the kind of things that I want them to do,” he said, referring to Boeing and some U.S. airlines. In a guest post on ImpactAlpha, William Burckart and Steve Lydenberg argue investors should stop investing in companies that don’t pay their fair share of taxes and in financial services firms that promote tax avoidance services.
Even before the COVID crash, many institutional investors had started to recognize climate risks. The safe path was to buy try to future-proof the portfolio with low-cost “insurance.” That’s what New York State’s $211 billion Common Retirement Fund did with a low-carbon index fund developed by Goldman Sachs Asset Management. The pension fund committed first $2 billion, then $4 billion, to the index, which claims to reduce carbon emissions by 70% while tracking mainstream market benchmarks. Arguably, that still leaves more than $200 billion in New York Common’s assets exposed to uncompensated carbon risks.
Investors could also make an active bet on the future direction of progress on climate action or income equality or sustainable development more broadly. That would be a vote of confidence that the world will indeed manage toward a 2℃ carbon budget, for example, or make material progress on the Sustainable Development Goals. If universal investors signal they are making investments in line with such expectations, optimism about the future can become self-fulfilling.
Hold corporations accountable
One of the clearest signals of the growing pressure on corporations was last year’s declaration by more than 180 CEOs redefining the purpose of a corporation and committing to generate value for employees, customers, communities and suppliers as well as shareholders. The pledge has mostly been honored in the breach: A study by Aneesh Raghunadan and Shiva Rajgopal (h/t Matt Levine) found that signatory companies actually had higher than average rates of environmental and labor-related violations, were more likely to have settled lawsuits over workplace discrimination – and paid their CEOs more.
Asset managers, on behalf of universal asset owners, can help corporations fulfill their pledges in the annual shareholder meeting season now upon us. ESG and climate-related resolutions again top the agenda, despite aggressive moves by corporate management to prevent many resolutions from reaching a vote at all. Under pressure earlier this year, BlackRock signed on to Climate Action 100+, an investor effort to force the largest corporate greenhouse gas emitters to take action on climate change. Universal owners have made clear they’re watching.
“Asset owners that integrate ESG factors throughout the investment process, vote according to the mandate to which they have pledged, and are transparent with us about their level of corporate engagement, demonstrate to us a commitment to long-term value-creation in line with our interests,” wrote Mizuno, Ailman and Pilcher. “We prefer to build and maintain relationships with asset managers who fit this description over those who do not and pledge to work with these partners to hold them accountable and ensure they deliver on the commitments they have made.”