Resources

• The Recommendations of the Task Force on Climate-related Financial Disclosures (TCFD) report describes the risk lexicon used throughout this and other episodes and outlines guidance for disclosure.
• The World Economic Forum Global Risks Report, 2020 puts climate risk in context and demonstrates that environmental risks are one of the top global risk categories in 2020.
• The Harvard Business Review Cold Call Podcast: Should a Pension Fund Try to Change the World? Features a discussion with HBS Professors Rebecca Henderson and George Serafeim on their HBS GPIF case study, which provides further analysis of Hiro Mizuno’s efforts to address climate risk and other environmental, social, and governance (ESG) factors in his approach to investing.

Guests

Host: Mike Toffel, Senator John Heinz Professor of Environmental Management and faculty chair of the Business and Environment Initiative.

Moderator: Vikram Gandhi (MBA 1989), Senior Lecturer of Business Administration

Guest: Hiro Mizuno, then Executive Managing Director and CIO of GPIF

Transcript

Hiro Mizuno:
If you believe in climate change, but don't take that into your portfolio management, I don't think you are satisfying your fiduciary duty. We'll only be able to make our portfolio sustainable for a long term by making the whole world more sustainable.

Mike Toffel:
This is Climate Rising, a podcast from Harvard Business School. And I'm your host Mike Toffel, a professor here at HBS. In early 2020, Harvard Business School convened financial industry experts, HBS alumni, and our faculty members for a conference entitled risk, opportunities and investment in the era of climate change. The conference focused on the financial sector because equity, debt and insurance will be heavily influenced by climate change, and we wanted to see how some leading companies were thinking about this. We also wanted to discuss how the financial sector is working with the companies in which they invest to learn and influence how they are addressing climate change. In this episode, we get both sides of the story from a leader of one of the largest pension funds in the world that changed its strategy to better account for climate change risks and opportunities. We'll hear from Hiro Mizuno, then executive managing director and CIO of the Japanese Government Pension Investment Fund or GPIF.

In conversation with HBS faculty member Vikram Gandhi, Mr. Mizuno describes how his firm changed its investment approach by embracing the universal ownership model. That's the idea that funds as large as GPIF are managing so much money that they need to invest so broadly in index funds, private equity and other securities, that they essentially become universal owners of all companies. As a result, they have to pay attention to the whole market, not just to their portfolio. In that context, Mr. Mizuno discusses his decision to have his team and the asset managers they hire take a long term view when making GPIF investment decisions. This includes incorporating climate risk and a number of other important environment, social and governance, or ESG, factors. He discusses many challenges he faced in leading these changes, including his push for passive asset managers to change their business model in order to better align their incentives.

Hiro Mizuno:
I think taking the climate as one of the major ESG issues, we are trying to find a way to make our portfolio more sustainable because our fiduciary duty is to make a sustainable performance out of our portfolio. But four years ago, I really tried to think how we can do it. I majored in finance and I grew up in this industry. I did all the other studies for a CFA type of the qualification. There's no tool, we were taught, how to hedge this type of systemic risk. When I asked all my peer CIOs four years ago, "Do you think climate change is a real risk to our portfolio," almost everybody says yes. And then I asked my peers, "So how are you hedging it?" Nobody had the idea how to do it. We have been taught how to diversify a portfolio to hedge the risk of the capital market, but we never know how to hedge or how to prepare our portfolio of this kind of huge systemic risk. We don't know exactly how it affects each portfolio company or each portfolio holding.

So we need to think very differently. Two key concepts that we came up with about four years ago was one is universal ownership. It is easier for GPIF to convey this message because we own the capital market. So we are owner of a universe. So we have to pay attention to what's happening to the market, not only what's happening to the portfolio we own. But I must say regardless of the size, as soon as you invest in index, you are as a universal owner as ourselves. Even if you're a retail investor, as soon as you invest in the stock index, you own the universe because your performance is more dictated by what happened to the whole universe. What we have learned as the finance professional and what we are told by the finance department of the business school is how to optimize the portfolio we own, but we never learn how to make the whole universe better. So the concept of universal ownership is a one game changer.

And the second key concept is the cross generational investment. We are a guardian over long termism and because the other pension fund managers, we are responsible for the longterm performance of the portfolio. But first year or two of my tenure here, I really struggled to have a constructive discussion on ESG, whether it's relevant to the performance or those kinds of things, is that against a fiduciary duty to integrate ESG into our portfolio construction? The major reason why we never have been able to agree on those debates is that everybody has a different time horizon when they came into that debate.

One time when I was actually on the panel discussion with the other PRI board members, I couldn't really figure out what kind of a timeframe everybody has in their mind. So I asked the other panelists, what's your definition of long term? And the answer ranged from three years to 100 years. And then one time when I was talking at the CFA Institute annual conference, I asked a young guy sitting in the front row, what's your definition of long term? And he is a young guy. He said, "My boss told me, never think anything beyond three days."

So I needed to change the definition, the other vocabulary to describe the real long term time horizon. And when I spoke to Pope Francis at the Vatican, he used the term cross-generational responsibility. And I said, "Wow, this is it." So ever since we started calling ourselves cross-generational investors, now we are in agreement. We are talking about 20, 30 years minimum. These actions I have taken is all about how to make sure we pay attention to what's happening to the universe, and also we're trying to optimize the performance for a cross-generational timeframe.

Climate is one of the ESG factors, which is most common. I mean, GPIF, we have very little resource. Everybody has a high expectation, as an ultimate owner or principal investor, asset owner should step up to take responsibility. But in reality, asset owner, we have very little resource.

One of the observation I totally agree is that we are underpaid. In this industry, very strangely, who makes the most important decisions are paid the least. So we just need to make sure that we pay attention to, but we don't have a resource. So what we did first is we asked all our incumbent asset managers, what do you think is the most material and also critical and relevant ESG factors to manage our portfolio? And climate change and climate risk is the most popular one. So we said that we are going to hold you accountable. So make sure you integrate that into your investment and also the other, make sure you engage with the company and exercise proxy voting accordingly. So that's the background of all these actions. So if you understand what we are trying to achieve, we are trying to promote the long termism in the capital market and make sure everybody in the investment chain take their own responsibility to solve those problems. Because if we fail to solve those problems, we are going to get a huge hit.

Vikram Gandhi:
So Hiro, you mentioned the long term, short term, and Ron in the previous panel also mentioned that, which is I remember, and I'm sure you all do too, when I was here at business school too, we were talking about long term, short term. And when I was here it was how the Japanese are very long term thinking and the Americans are all short term, et cetera, et cetera. How do you see that getting resolved? Because this is a topic which is constantly discussed. Shouldn't, as a passive manager, you have a new business model in terms of pushing the passive managers to be more activist? And how do the economics there work?

Hiro Mizuno:
We needed to come up with a different strategy for the active and the passive managers to pursue the same goal. For the active, they have a natural conflict between their performance and this long term sustainability, because they need to beat the market. They need to beat the competitor to remain as our active managers. So we decided not to push the active manager on that front, and in reality, they only own a fewer number of the companies. So they can get deeper into that company in terms of analysis and engagement. But on the other hand, we cannot depend on the active manager to push a system forward. So we decided to work more closely with the passive managers who own the capital market or who own the whole equity market. We started asking the passive managers to become active.

And when I first said that at the Milken conference, I only confused everybody, saying like, "I want the passive managers to be active." What I meant was passive manager means managing portfolio passively. It doesn't mean not acting as the active owner. So what I tried to say was, we now expect the passive managers to still continue to manage portfolio passively, but we expect you to become active owner of the portfolio. And when it comes to the voting power, the passive manager owns the lion's share of voting power, and we want them to use it responsibly. So for the passive managers, I said that, and some of them pushed me back saying, "We are not paid enough. The fee is too little." But come on, you actually have a much bigger mandate. And the second is, I know you are making money by lending stock too.

Vikram Gandhi:
You stopped that too, I believe.

Hiro Mizuno:
I stopped that too, yeah. But we stopped that too, because I don't think it was consistent with the long term agenda, but also we have been offering passive manager, come up with a new business model to pursue the active ownership. We decomposed the passive management into index selection, index building, or index compulsion, index tracking and active ownership. Index selection is not their job. It's not the asset manager's responsibility. It's the asset owner's choice. And index composition, which actually dictates what we ended up owning, not even made by the other passive manager. It's made by the index providers. But historically, this asset owner hasn't spent much time with the index providers. We spend much more time with the other passive managers, although actual performance dictated by index provider's selection of the stock. So now we spend more and more time with directly with the index providers.

And index tracking, I think it should be cost free. We can create a machine to do it. But the active ownership, they can add a lot of value if they wish. So we suggested, if you come up as a new business model, you can prove you can add value through the active ownership, we pay you extra layer of fees. And after three years of waiting, so far two passive managers came up with a new proposal, which gave us a new screening process, KPI and et cetera. We agreed to pay them extra fee for their stewardship activity. I think the point is, if you just take it for granted, passive manager's fee is this little, and also passive manager is not hiring enough people, I think you're not going to change the system. We no longer look for the passive manager who provides the lowest tracking error at the lowest cost. We want the passive managers who are stepping up as the active owner.

Vikram Gandhi:
A lot of discussion on carbon pricing, we talked about that a little bit for the panel. But as an asset owner, what is your view on carbon pricing and implementing basically a tax on externality? And how do you think about that and the impact on your portfolio, if we actually implement things which get us to the Paris Agreement?

Hiro Mizuno:
Carbon taxation is a powerful tool if it becomes a universal taxation, but if each country comes up with their own carbon pricing, carbon taxation, it will be very difficult. And at the moment it's not going to happen unless you change your president. But anyway, with the US and not supporting it, I don't think the other ... It's totally unrealistic for us to expect the other global carbon pricing will be implemented. I had a discussion with Warren Buffett two weeks ago on ESG issues. And he also argued that it shouldn't be invested as a responsibility to take care of climate change. It should be done by the policy makers. And my argument against him is, as we cannot assume the market is always perfect, we cannot expect the perfect government either.

The way I look at my fiduciary duty and also the asset manager's fiduciary duty is if you don't believe in climate change, that's a totally different ... You live in a different world. But if you believe in climate change, but don't take that into the portfolio management, I don't think you are satisfying your fiduciary duty. People just use a lack of the standardization as an excuse not to do it, but I think that's where the human intelligence comes in. Because if you have the perfect information set, if you still believe in the perfect market, the efficient market hypothesis, there's no way for you to make an extra return. So this is exactly the timing. Human wisdom can make a difference, can bridge that gap. Someday the carbon taxation will be implemented and it would make everybody's job easier, but for the time being, I shouldn't expect that to happen in the foreseeable future. And I just cannot wait [for]ur asset manager and our own portfolio manager to start thinking about it. And that's exactly what the other humans should be able to just the play a role. [RLO 00:14:33].

Vikram Gandhi:
Great. Let's open this up or questions. Let's talk, and we go with this. Yes, right here.

Speaker 4:
I'm an MBA and a retired consultant and looked at this climate change issue for many years. I think a key missing ingredient is leadership. So, I applaud your leadership and thank you for what you're doing. And the question is, you mentioned we can't have many different forms of carbon tax, or I prefer to call it carbon fee and dividends so that it goes back to the people and doesn't end up being a regressive tax. But who should offer the leadership to get the world united on this? Should it be the UN, should it be institutions like Harvard Business School, or what?

Hiro Mizuno:
This is exactly the point I discussed with Warren Buffett. I don't think that we can expect one particular actor or actress who will solve the problem. Everybody has to take up their responsibility. Having said that, I attended Davos World Economic forum this year. And there is very little presence of the political leadership this year, but while, a lot of the business leaders step up to make the other promises or a commitment on these climate issues. And one of my challenge for the last, I mean, my ambition for the last 18 months is this is what we succeeded in Japan, but not outside of Japan, to make the ESG as a business buzzword. ESG started at the PRI as the technical jargon for investor, but in Japan, we intentionally promote ESG throughout the business community.

So in Japan, everybody uses ESG, starting from the consumers to corporate executives. Of course, investors. Over the last 18 months, I worked very close with the Harvard Business School, and I also worked with the World Economic Forum, trying to make it happen outside of Japan. And I think this year's Davos, I sensed and I felt the sense of the achievement because at the opening remark, Professor Schwab mentioned explicitly ESG in his remark. So that means now ESG become the universal, the business buzzword. One of the innovative part of the other SDGs is the realistic recognition that we cannot just depend upon the policy maker to change the world. Some people argue changing the world is not my job. My argument is because of the universal ownership concept and the philosophy, we'll only be able to make our portfolio sustainable for long term by making the whole world more sustainable.

Vikram Gandhi:
How are you then trying to bring the carbon down of the companies that you own? Again, it gets back to the asset managers, or what's the strategy?

Hiro Mizuno:
Well, the two. The one is obviously, as I said, we hold our asset manager accountable for their engagement and proxy voting. So that's a way to indirectly put the pressure on the company to transform their business model. And the second is, as we shift the portfolio from the conventional or traditional market cap weight index to the ESG index, we are effectively doing the partial divestment of the company who doesn't perform well in an ESG, in climate, the carbon intensity. And the two newest ESG indices, we invested last year was the SNB carbon efficient index. That basically, without divesting, in each industry, we extremely over-weighed the company who has the highest carbon efficiency and we under-weighed quite significantly the company who has the least carbon efficiency. Two, they are the same service.

Because I don't think, if some industries do exist, there's a reason for their existence because then some people need it, but we just need to promote the improvement in the carbon efficiency. So we actually are trying to approach that through the changing of our indices to put it. And every time we introduce new indices, we ask our index provider to disclose their scoring methodology. So the portfolio company, when they miss it, they understand exactly what they have to achieve. So that's more directly a way for us to affect the market. And the engagement actually has a powerful impact.

Vikram Gandhi:
That disclosure too was kind of a first, right? I mean, most times people don't disclose how the indexes actually-

Hiro Mizuno:
Yeah, that's right. That's right. And also, the diagnosis of 3.5 degree is going to remain as a litmus test because we have the most sizable and the most diversified global portfolio.

Mike Toffel:
That's it for this episode of Climate Rising. Next time.

Speaker 5:
Physical climate risk is actually studying heat, drought, wildfire, hurricanes, floods, access to water, what that looks like and how that's going to impact the companies that you invest in, because companies ultimately create an economy which ultimately creates a society. And so that's not limited to emissions. It's actually looking at your real estate and whether it's in a compromised position or looking at your mortgages or your muni bonds.

Mike Toffel:
Thanks for joining us. I'm your host, Mike Toffel. This is Climate Rising, a podcast produced by the Business and Environment Initiative at Harvard Business School. You can subscribe on Apple Podcasts or wherever you listen, and please leave us a review. We appreciate the feedback. You can also find show notes and links to resources discussed on this episode on the Climate Rising website, climaterising.hbs.edu.