California Regents Break with Yale on Ethical Investing
The CIO for the university system’s Board of Regents divests from coal and tar sands and offers a new road map for responsible investing.
In early September Jagdeep Singh Bachher, chief investment officer for the University of California Board of Regents, announced near the end of an investment committee meeting that the office had divested all its direct coal and tar sands holdings, selling stock totaling a little less than $200 million.
The news caught climate activists, including author and environmentalist Bill McKibben, by surprise.
“Um, developing story: It looks like the Univ of California is divesting its enormous portfolio from coal and tar sands oil. If true—wow,” he tweeted September 9, the day of the UC investment committee meeting. The next day he added:
A friend on the UCLA faculty sent an e-mail simply titled “green.”
Carbon divestment has been the rallying cry of a growing body of student and environmental activists for more than three years. The movement was galvanized by McKibben’s 2012 article in Rolling Stone, “Global Warming’s Terrifying New Math,” which was a call to arms particularly for Millennials. In fact, the decision by Bachher, who oversees some $98 billion of pension and other assets, will not have a direct effect on other UC endowments such as those of UCLA and Berkeley, which are managed separately. But it is a big deal, and not just because of the divestment. Even more significant is what it says about how the University of California system now views sustainability.
Almost a year and a half ago, Stanford University in Palo Alto, California, announced that it would seek to divest its direct coal holdings and make no more fossil fuel investments. UC’s commitment is more far-reaching but occurred with less fanfare. UC’s step also contrasts with many other endowments across the country, notably from standard-bearers such as Yale and Harvard, which have not divested their carbon assets, despite coming under pressure from students and other stakeholders.
The UC announcement is symbolic. As I explained in my April 2014 Institutional Investor feature on carbon divestment, “Climate Change and the Fossil Fuel Divestiture Movement,” the university, notably the University of California, Berkeley, played a pivotal role in the 1980s campaign to divest from companies doing business with apartheid South Africa. That earlier campaign was an inspiration for the current climate divestment push. A sustained effort from students, supported by faculty, prompted the Board of Regents to take up the question of climate change in 2014, shortly before Bachher was hired as CIO.
UC’s legacy might now come in the form of a new way of thinking about environmental, social and corporate governance (ESG) policies in investing and make the university system the thought leader for the next generation of fiduciaries.
At the September 9 investment committee meeting, Bachher presented a policy paper, “Sustainability Impacts Investment,” that makes clear that the CIO’s office views sustainability factors as part of a prudent investment approach. “We have learned that strengthening the environmental sustainability, social responsibility, and prudent governance component of our risk evaluation improves the clarity of our analysis,” argues the paper. Markets change, and investors should adapt to new inputs, such as the risk of so-called stranded carbon assets — carbon assets on the books of fossil fuel companies that can currently not be burned because of atmospheric carbon level limits — to portfolios.
Since the mid-1980s, when Yale University’s Investments Office hired Wall Street derivatives trader David Swensen as CIO, the so-called endowment portfolio model, which he and his team pioneered, has been held out as the gold standard for institutional investing. A number of major institutions have adopted that approach: diverse investment portfolios with high allocation to alternatives, including hedge funds and private equity, and a heavy reliance on outside investment managers.
The endowment investment model encourages investors to hire the best money managers and allow them to do their jobs. The idea is that managers are experts, and over the long term they and the markets will take into account any material externalities. If, say, carbon risk is a problem, the markets will figure it out in due course. Anything that is not material, such as using children to pick cocoa beans, is not relevant and has no place in investment decisions.
Most universities have a mechanism for dealing with environmental and social concerns that students and other stakeholders bring to the table. As with investing, Yale pioneered this mechanism by forming an Advisory Committee on Investor Responsibility in 1972 to deal with “the ethical responsibilities of institutional investors.” The committee was established following the advice set out in The Ethical Investor: Universities and Corporate Responsibility, by John Simon, Charles Powers and Jon Gunnemann and published by Yale University Press in 1972. The book was a response by the university to the then-emerging South Africa divestment campaign.
As quoted on the committee’s web site, the ethical investor principle allows the consideration of factors “other than maximum financial return” in the case of “social injury.” Consider child labor. We can agree that the use of child labor causes grave social injury, and that we should divest from a chocolate manufacturer that employs children. However, divestment would only be warranted if the company is the direct cause of the injustice. If the cocoa manufacturer is just buying the material from a third party, which uses child labor, then divestment should not occur.
Most injustices happen at arm’s length. As an institution, it is impossible to divest from everything. In practice, the policy means endowments very rarely take a stand (the most common exceptions are divestment from companies doing business in the Republic of the Sudan, tobacco stocks and some proxy voting). The existence of the advisory committee as a sort of ethical safety valve allows uncomfortable issues to be swept aside. The discussion resembles armchair philosophizing: Should I divest from my cocoa manufacturer if it means that many of the children picking plants wind up in prostitution? Which is a greater injustice?
The issue should be, What needs to happen to supply chains to ensure that child labor is not used, and how do we support developing-market farmers in such a way that communities can earn reasonable wages and not have to put their children into the workforce? Those are the types of issues that good (in both ethical and financial terms) companies spend considerable time and effort wrestling with. Framed like this, ESG becomes a business risk and thus an opportunity.
Like UC, Yale has come under pressure to divest its carbon holdings. Last August it announced its policies for dealing with the issue. Relying on the principles set out in The Ethical Investor, the advisory committee found that divesting from fossil fuel companies was not warranted because they were only indirect actors and beneficiaries of the larger issue. “How one determines the net socially injurious impact of fossil-fuel combustion by particular companies, and how one goes about identifying the companies responsible for the incremental emissions that cause injury (and thus who should be held accountable) are questions fraught with difficulty,” Yale said in the statement, stressing to the endowment’s managers the need to be aware of climate risk “as a matter of sound business practices.”
Yale puts the question of divesting in an ethical box, assuming that managers and markets will take care of any economic problems. The model presumes a rational market with no informational blind spots over, say, how to price carbon risk. Yale went on to lay out all the ways in which the university community could and should help tackle global warming, but it did not suggest that the institution’s knowledge or expertise on the topic might be brought into the Investments Office.
Unlike Yale, UC is flexible. It moves away from the tortured notion of social injury; allows that values, like ethics, can have a place in the investment office; and sees that so-called nonfinancial factors may actually be valuable when thinking about investment decisions and risk mitigation. It also, crucially, takes away some of the agency from the money management community and puts it back with the institution itself.
One of the commitments Bachher has made since becoming CIO is to leverage the resources of the UC system for the benefit of the office. This includes finding partners and advisers, such as Amy Myers Jaffe, the executive director of energy and sustainability at the University of California at Davis graduate school of management and an expert on global energy policy, geopolitical risk and energy and sustainability.
UC’s radical thinking suggests that people like Jaffe, who helped develop Bachher’s policy paper and is now working with UC climate experts to explore the effect a carbon price might have on the portfolio, have valuable insights on climate risk. It dares to say that Jaffe and others are likely to be more knowledgeable about these issues than the average money manager or investment consultant, and that the investment office might benefit.
Clearly the pendulum can swing too far the other way. It would likely annoy Stephen Mandel if every institution that invested in his hedge fund firm, Lone Pine Capital, started calling him up to share their expertise. But given the all-hands-on-deck cry emanating from institutions like Yale to deal with the climate crisis, you would think it’s time to consider some new voices, especially when those experts are close at hand. Money managers pay professors to serve as advisers when they need them; now it may be time that the universities look inward to tap the expertise on climate change.