Yesterday both Mayor Durkan and City Councilmember Mosqueda sent letters to the Seattle City Employees Retirement System (aka SCERS) urging it to divest the pension fund from fossil-fuel investments. Three years ago when then-Councilmember Mike O’Brien, Councilmember Lisa Herbold, and former Mayor Mike McGinn tried the same thing, the request was met with sympathy but was still refused. This time it’s likely to get the same reply — but that doesn’t means that SCERS is ignoring climate change.
The SCERS investment portfolio, currently with a value of about $3.2 billion, funds retirement benefits for former city employees who are now retired, and invests to have the resources to pay retirement benefits as existing city employees retire in the coming years. Government employee pension systems are highly scrutinized, and for good reason: over the years and across many jurisdictions they have generated endless cases of inept investment practices, poor actuarial modeling for the future, and good old fashioned corruption, with the most recent high-profile case being CalPERS, the retirement system for California state employees. Several years back SCERS had its own issues, with investment returns that lagged severely behind what would be needed to fund future retirement benefits. Fortunately it has been doing better of late and is making progress in catching up to the funding level required to meet its obligations.
As you can imagine, there is a substantial amount of case law surrounding public employee pensions, and out of that has emerged some clear guidance as to what the fund managers’ priorities must be when making investment decisions. I covered this in detail in 2017 when writing about the last attempt to get SCERS to divest, but to summarize: the courts have said that fund managers must focus entirely on their duty to the employees who have paid into the system, and regulatory bodies have interpreted that to mean that fund managers must make decisions that are expected to maximize financial returns with acceptable levels of risk. In practice, that means that fund managers can’t make investment decision based upon other factors, such as climate change, if doing so would lower the expected financial return of the fund or increase the portfolio risk.
In general, that has prevented many funds from divesting from fossil fuels. But it’s even trickier for SCERS because of the investment strategy it has adopted. SCERS, like other funds, invests for long-term returns sufficient to meet its financial commitments to pay out retirement benefits. But it also explicitly has chosen to measure financial returns “net of fees” — meaning that the management fees charged by a fund that SCERS invests in are deducted from the investment return for the purposes of evaluating SCERS’ total fund performance but also for comparing one fund’s performance to another’s. This is an entirely appropriate, and not uncommon, approach to measuring financial performance, but it shines a spotlight on the difference between “actively managed” funds and “passive” funds. Actively managed funds hire a team of fund managers to research and choose investments to make, whereas passive funds don’t — they simply track a public index such as the S&P 500 or the Russell 1000 and invest in the same companies (and in the same proportions) as the index does.
Here’s the dirty secret of investing in funds: while in the short term an actively managed fund may outperform, in the long term, very few of them outperform the market as a whole — but they charge higher management fees. In contrast, index funds (particularly general ones such as the S&P 500) by definition generate the same performance as the overall market, and they have extremely low management fees because they don’t have managers. What this means is that if you are a long-term investor, investing in a broad-based index fund will often have better financial returns “net of fees” than investing in an actively managed fund.
The asset allocation for SCERS spreads across six different classes of investments:
- Public equity: 48%
- Private equity: 11%
- Core fixed income: 18%
- Credit fixed income: 7%
- Real estate: 12%
- Infrastructure: 4%
While SCERS does invest in actively-managed funds and make direct investments in equities, especially for private equity, real estate, and infrastructure, the vast majority of it public equity and fixed income investments are in passive index funds. This gives it solid, predictable long-term returns, with plenty of diversity to lower investment risk. And it can make targeted investments — say in a renewable energy company — on top of that. But some of those passive index funds contain investments in fossil fuel based companies, for the simple reason that they are part of the economy. SCERS has no ability to remove the fossil-fuel stocks from the index funds: it either buys into the funds as is, or not. And if it selects its index funds so as to avoid fossil-fuel companies, then it will reduce the diversity in the portfolio — and potentially the financial return — in violation of its fiduciary requirement to maximize return for investors. The only way for it to avoid this problem would be to switch its investment strategy wholesale to move away from passive investing — but that also runs the risk of lowering overall returns.
As of December 31, 2019, SCERS estimated that it had $33.2 million in direct investment exposure to fossil fuel companies, and another $42.0 million in indirect exposure through managed and unmanaged funds. That $75 million represents 2.4% of the entire $3.2 billion portfolio. Over time it could probably find alternative investments to the direct investments, but getting rid of the $42 million in indirect passive investments will be nearly impossible without a major overhaul of the investment strategy, since the effect would ripple out as a change in the diversity of investments and a change in the expected returns.
That’s why SCERS hasn’t divested from fossil fuels, and probably won’t anytime soon. But that doesn’t mean that it is ignoring climate change. In fact, it has a written Environmental, Social and Governance policy, which identifies climate change as “an ESG priority for SCERS because of its criticality to the long-term risk and return of the capital markets.” Yes, that sounds crass, but keep in mind that under the law SCERS is only allowed to think about climate change as a financial issue, not as an existential, social, equity, or other issue.
The SCERS managers have codified its policy against targeted divestment as part of its ESG policy:
“The Board will not divest or invest from a targeted company, sector or set of investment to further an ESG priority because doing so would be inconsistent with SCERS’ mission…, fiduciary duties… and investment beliefs.”
But it goes on to state the flip side: that it has chosen a “positive action strategy.”
“The Board has consistently stated that the positive action strategy is the most effective, permissible means for SCERS to beneficially impact its ESG priorities.”
For SCERS, this means three things: shareholder advocacy, sustainability investments, and integrating climate risk into the investment process.
Shareholder advocacy: SCERS says that it presses both the fund managers it works with and the companies it directly invests in to “encourage companies to take actions that help mitigate climate change, which include increased disclosure, conducting climate risk assessments, and ensuring robust government regulation.” That involves getting fund managers to exercise their shareholder voting rights to push companies to mitigate climate change. It also involves directly engaging (often with other institutional investors) with fossil fuel companies to drive them to take action on climate change. SCERS claims that it is a member of three ES investor organizations: Ceres, the Council of Institutional Investors, and PRI, as well as participating in Climate Action 100+ and the Climate Majority Project.
As for sustainability investments, SCERS says that it is beefing up its infrastructure asset class to include more renewable energy sector investments, as well as monitoring investments in “green bonds.”
And for integrating climate risk into the investment process, SCERS says that it will “consider climate change as a risk alongside macroeconomic, geopolitical and other risks when making investment decisions.” That involves doing climate change scenario analyses into its asset-vs-liability studies.
Click to access ESG_Report_2020Q4.pdf
Could SCERS do more? Possibly. New fossil-fuel-free passive index funds are being developed by he financial sector that purport to deliver the same return and risk potential. But even if that is true, and they align with the funds that SCERS would need to divest from, it would not be simple because of the sheer size of the investments. SCERS has over $1.6 billion in public equity investments, and since buying and selling funds involves the fund manager buying and selling the underlying stocks that the fund holds, switching could involve some massive stock trades — and potentially huge transaction costs — that would cut into the financial returns of the fund.
There’s also an argument to be made that the market will take care of the problem on its own. As Mayor Durkan’s letter today points out, in the last couple of years fossil-fuel stocks have taken a beating, tracking with their bottom-lines. Among other consequences, it led to the removal of Exxon-Mobil from the Dow Jones Industrial Average last August — and subsequently from the index funds that track the Dow. Solar power generation is now as cheap as natural gas generation, and that means the only reason to keep coal and gas generation around is for the times when the sun isn’t shining — at least until we have cheap, large-scale electricity storage. So the clock is ticking, and the stock market knows it.
In the short term, however, it’s unlikely that SCERS will fully divest from fossil-fuel investments. It would be a lot of work for a fairly small effect, and it might put the funds’ overseers in violation of their fiduciary duties. But that won’t stop Durkan, Mosqueda, and environmental activists from continuing to pressure it to make the change.
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While we’re recycling old bills maybe they should look at divesting the city banking from wells fargo again, someone should see what the Burgess public retirement account option committee found, and Sawant found motion to reduce all the council salaries to $40k until next year.
Unless the Mayor is claiming to be a better financial risk analyst than the professionals who run investment funds, there’s no reason to believe that climate change isn’t already fully priced in to the value of assets. How the asset performed in the past tells us precisely nothing about how it will perform in the future.
Apart from the important fees issue you raise, divestment from any sector is an anti-diversification strategy which increases risks without increasing expected returns.
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