CalPERS, the largest U.S. state pension fund with USD 355 billion in assets under management and 1.9 million beneficiaries (as of July 11, 2018), updated its investment policy to include deforestation risk as a material risk to be considered in its investment decisions.  CalPERS updated its Total Fund Investment Policy, effective June 18, 2018. This innovative decision by CalPERS makes it the first U.S. state pension fund to include deforestation risk in its investment policy statement. It is also one of the few pension funds globally to do so.

CalPERS’ updated investment policy in its Governance & Sustainability Principles on p. 84 now requests that:

Companies should identify and manage material environmental risks and opportunities that are relevant to their short and long-term success. Environmental issues may include the following:

1. Company impact on the environment: Potential regulatory change, liability, license to operate, reputational or market access risks posed by the company’s environmental impacts, including emissions, pollution, waste, loss of biodiversity, degradation of natural ecosystems (e.g. deforestation).

Additionally, CalPERS’ updated policy on p. 74 includes direct acknowledgement of “free, prior and informed consent (FPIC) as a standard in relation to Indigenous Peoples’ rights”. This makes CalPERS the largest U.S. state pension fund to include FPIC in its Governance & Sustainability Principles guiding how it manages its investments.

The updated investment policy includes the assessment of deforestation risk across all asset classes, though there are some limitations in implementing a blanket policy at the outset. CalPERS acknowledges this on p. 55:

We recognize that much of our experience in this area comes from investments in public equities but that our evolution to a “Total Fund” approach means these Principles may need to be suitably adapted to work across other asset classes. We continue to listen and learn in this area.

This suggests that CalPERS’ internal capabilities in asset classes other than public equities may grow overtime to address deforestation risk. As such, the impact of the updated policy will likely be felt the soonest for public equities.

Potential Multi-Billion Dollar Investment Impact

Figure 1 (below) shows that with a position of USD 172.5 billion, public equities represents almost 50 percent of CalPERS’ total portfolio of USD 346.4 billion as of April 30, 2018.

Figure 1: CalPERS Asset Class Breakdown, April 30, 2018. * Market values lagged one quarter. Source: CalPERS.

To break it down further, Bloomberg estimates that CalPERS’ sector allocation to the Consumer Staples and Materials sectors are 7.4 percent and 5.8 percent, respectively, of its overall equity portfolio. This equates to roughly USD 26 billion. The Consumer Staples and Materials sectors are often where direct deforestation risks associated in the production, refining, and use of agriculture products that drive deforestation reside.

Furthermore, as shown in Figure 2 (below), CalPERS’ decision to include deforestation in its investment policy statement could impact its investments in companies in the Food, Forest Products & Paper, and Agriculture industries. These sub-sectors sit inside the Consumer Staples and Materials sectors.

It is in these three industries where many corporations who have palm oil, soy, cattle, and timber pulp and paper supply chains exist. In fact, its updated policy could impact at least 189 companies, of which CalPERS has invested an estimated USD 2.3 billion. From a portfolio perspective, these figures will invariably increase over time as CalPERS continues to execute this policy across remaining sectors of the economy and other asset classes.

Figure 2: CalPERS Annual Investment Report 2017 current portfolio estimated investment position as of July 11, 2018. Source: Bloomberg.

Divestment

CalPERS’s preferred approach is engagement. Its engagement approach on an issue includes:

• CalPERS’ Principles and Policies on the issue
• Materiality of the issue to risk and return
• The definition and likelihood of success of addressing the issue, and
• Whether CalPERS has the internal capacity to influence an outcome to the issue.

When considering a divestment after engagement, CalPERS states on p. 18:

CalPERS will sell Targeted Company investments or refrain from making them to the extent investment in the Targeted Company is imprudent and inconsistent with fiduciary duties.

Given that deforestation risk is now in CalPERS’ investment policy statement, deforestation may now be considered a fiduciary duty by its investment professionals. This suggests that CalPERS may sell investments that do not mitigate their deforestation risk profile after engagement.

Looking Ahead

The full impact of CalPERS updated policy will not be felt immediately, as CalPERS will need time to implement its policy changes. Indeed, it remains to be seen how CalPERS may apply its updated policy to its other asset classes in addition to public equities. Other asset classes such as Global Fixed Income and Private Equity may also be impacted, further increasing CalPERS overall portfolio’s exposure to the updated policy.

Given that CalPERS is the largest U.S. state pension fund, there is the possibility that CalPERS may exert its influence regarding deforestation as a material risk on other U.S. state pension funds.

Some foreign pension funds, who operate under different national legal and regulatory regimes, have incorporated a more comprehensive approach to material deforestation risk mitigation and return enhancement. In 2012, the Norwegian Government Pension Fund divested from 23 palm oil producers because of their deforestation practices. Today, the fund now integrates a wide spectrum of environmental, social, and governance (ESG) risk and return strategies into its portfolio management decisions. CalPERS is now progressing down a similar path regarding its approach to ESG risk and return strategies.