CalSTRS CIO: ‘Material risk’ strategy missing in ESG

Managers can integrate ESG more successfully into their investments if they prioritize business risks to their assets, says Christopher Ailman.

The definition of ESG by managers and investors needs reviewing in order to encourage more action on environment, social and governance issues, according to Christopher Ailman, chief investment officer at California State Teachers’ Retirement System.

To better integrate ESG, managers need to prioritize risks that would have the most impact on a particular asset, he said.

“What’s missing in ESG is materiality. There are lots of problems worldwide that impact our domestic industries, but are they material to our investment? You can’t expect to solve all the issues. You need to know the level of the risk, and when it might occur,” said Ailman, who was speaking at a CFA Institute webinar this week.

“I describe ESG risk as long-term, material, operational business risk. Get away from ‘responsible,’ and think of it as long-term risk. When you describe it in those terms, you can then label issues as environmental, social or governance risks. Sometimes, the words can get in the way,” Ailman added.

Simon Witney, special counsel at Debevoise, a global law firm, agreed. Regardless of where appetite for ESG stems from, such initiatives de-risk an asset and push up its pricing on exit, he said.

“To some extent, it’s down to whether the impetus for ESG is coming from LPs, or whether GPs see it as ‘good business’ – and it is clearly both,” Witney told pfm. “Many private equity firms would be doing this whether LPs demand it or not. Buyers tend to pay more for a well-run business with good governance.”

In addition, being a smaller firm is not a disadvantage when establishing an ESG policy, said Witney, following research last week that showed smaller firms were the least likely to includes ESG policies in their fund’s terms.

“I think mid-market firms are focusing on ESG. Often, they are dealing with founder-led businesses, where ESG standards haven’t yet to be implemented. A mid-market firm can work with that business to professionalize the governance and risk protocols, which makes it a better business and, ultimately, more sellable,” he said.

“On the other hand, a private equity firm working with a large business, or perhaps taking a public company private, is more likely to find that the business has already put ESG standards in place.”

Anecdotally, larger managers are not moving any quicker than the mid-market overall on ESG implementation, said Ailman.

“Almost every money manager has signed up to the Principles for Responsible Investment, and most haven’t done a darned thing about it. Around five or 10 have started to implement ESG principles,” he said.