CHAPTER THREE

Allocate Assets

THE F. B. Heron Foundation, a private foundation focused on community economic development, describes itself as operating “at the intersection of community and capital markets” and seeks to use its investments as tools along with its grants to empower people and institutions in low-income communities. In 2019, to address the disjunction between the rich agricultural corporations operating in the San Joaquin Valley of California and the poor conditions of many workers there, it chose two fixed-income investments—loans and bonds—to support Self-Help Enterprises (SHE), a local nonprofit it viewed as equipped to play a key role in bettering the overall lives of these farmworkers. Fixed-income investments, especially when issued by the government and to support nonprofits, are particularly well suited to build baseline infrastructure and public goods that can produce positive outcomes.¹

Heron initially made a $1 million ten-year below-market-rate loan (a “program-related investment”) to the organization to establish a long-term base for SHE’s operations. Soon after, it identified a market-rate bond issued by the California Health Facilities Financing Authority that funded two of SHE’s projects along with similar initiatives in the region. So it added a $1 million slice of this issuance to its endowment’s market-rate portfolio.²

As far back as its founding in 1992, Heron had contended with the challenge of how to use its grant-making most effectively to achieve its community development goals. It first departed from conventional philanthropic norms by focusing on grants to support operating budgets rather than programmatic themes. Heron also began making what it calls “enterprise capital grants,” which channel substantial up-front funds to grantees for quantum organizational leaps, much as venture capital does in the for-profit world.

In 2005, it began considering how to use all the “tools in its toolbox” to better support this mission. A key component in this strategy became aligning the investment of its endowment’s assets with its grant-making. Between 2012 and 2016 it transitioned 100 percent of its endowment’s holdings to achieve community-focused outcomes. To make this shift in its equity investments, Heron developed its customized US Community Investing Index (USCII). The USCII sets a model for publicly traded companies for community-oriented management of four sources of stakeholder “capital”: human (employees and suppliers), civic (government, customers, and neighbors), natural (environmental inputs and outputs), and financial (boards and investors, and management).³

Using Asset Classes for System-Level Change

As seen in the Heron Foundation example, investors large and small can think creatively about how to use asset classes for social and environmental impact. The first step is always to decide what asset classes to use: stocks or bonds, venture capital or real estate, private equity or cash. Of course, investors want their money back with a return. Some asset classes historically have returned more than others, some are quite risky, and each serves different societal functions.

Conventional investors typically balance their desired returns with their tolerance for risk, and their need for income with their prospects for market appreciation. They don’t factor social and environmental risks and opportunities into the equation.

Sustainable investors, once having decided on their asset allocation, select individual securities within it that are aligned with their social and environmental goals.

System-level investors take one further step. They consider how to use each asset class to maximize the societal benefits it was originally designed to create. Fixed income, for example, can naturally create public goods when issued by governments. Public equities are well suited to influence incremental change in large firms. Venture capital is a disruptor of business models and services.

Two broad asset classes dominate the investment landscape: equities (ownership) and debt (lending). Each has variations. Ownership can take the form of public equities, private equity, and venture capital and can also include real estate and infrastructure. Lending consists of bonds, direct loans, and to a certain extent cash. System-level investors understand that each asset class provides specific societal benefits and that they can participate in these asset classes in ways that enhance their benefits.

Equities

Equities include public equities, private equity, and venture capital.

PUBLIC EQUITIES

Public equities are stocks in large corporations that facilitate the trading of ownership positions by institutions and individuals. Public equities are traded on public exchanges. The market for public equities was created in part so that investors large and small could share in these large corporations’ profits and so that these corporations in turn could raise funds from the full range of potential investors. Hence a first benefit: companies enjoying the efficiencies of their large scale can more easily raise capital and at the same time broadly share their profits. But since the public is involved, the government requires these companies to disclose their financials and business strategies. Hence a second benefit: investors now have data and access to pressure these corporations to operate efficiently and presumably in their and the public’s long-term interests.

Today’s conventional investors typically just want to buy stocks that will go up or pay a handsome dividend. They don’t see a particular benefit in considering corporations’ social and environmental behavior. In fact, they believe those considerations can often interfere with a company’s ability to maximize its returns.

Sustainable investors, on the other hand, intentionally add to their portfolios companies aligned with their own social and environmental goals and encourage managers of these firms to improve practices that can enhance their social benefits along with their profitability.

System-level investors use their public equity investments to set models for corporate behavior across all industries for key stakeholders and for industries’ overall management of issues that at a system level pose risks or offer rewards.

The California State Teachers’ Retirement System (CalSTRS) provides one example of what leveraging public equities at a system level looks like in practice. It has determined that climate change is a systemic risk and developed a multiyear, multi-asset-class, internally managed Low-Carbon Index (LCI) for passive equity management. Launched in 2017 with a $2.5 billion commitment, the LCI is made up of stocks in all industries in all markets (US, developed, and emerging) around the world. CalSTRS’s goal is for these holdings to have reduced carbon emissions and reserves in each market by between 61 percent and 93 percent in the coming years.⁴ Since passive index funds hold hundreds, if not thousands, of stocks across all industries, the CalSTRS index will paint a picture of what the future should look like in all companies around the world, in effect setting a benchmark and model for the environmental performance of large corporations on climate change.

Moreover, through its stewardship program, CalSTRS joins with its peers to urge emissions reductions by the most systematically important firms worldwide. It led, for example, the Climate Action 100+ collaborative engagement with Duke Energy in 2019, which negotiated that company’s commitment to reduce carbon dioxide (CO₂) emissions by more than 50 percent by 2030 and achieve net-zero CO₂ emissions by 2050. CalSTRS has also pressured oil and gas companies to cut their methane emissions, having filed ten shareholder resolutions urging action since 2015, half of which led to negotiated settlements.⁵ In addition, as part of its efforts to shift the balance of its active managers of stocks in this same direction, in 2019 it hired three new firms with proven expertise in sustainability issues.⁶ Although it uses divestment only as a last resort, in 2017 it ceased investments in companies deriving more than 50 percent of revenues from sale of thermal coal.⁷

CalSTRS is not the only large investor to use a low-carbon index to drive home the point about where large corporations should be headed. In 2019, the New York State Common Retirement Fund released a Climate Action Plan aimed at providing a road map “to address climate risks and opportunities across all asset classes.”⁸ It has established a $20 billion goal for its Sustainable Investment and Climate Solutions Program. A key component of this initiative is a $4 billion commitment to a broad-market passively managed equities index of low-emissions firms. This index fund is internally managed, and companies with poor performance are prioritized for engagement. In 2018 the fund pressured ten firms to set emissions reductions goals in line with the Paris Agreement.⁹

Establishing their own customized indexes of large, publicly traded companies as CalSTRS has done for climate change and Heron Foundation has done for community economic development is just one way that investors can look to move large corporations as a whole toward systemic change.

PRIVATE EQUITY

Private equity consists of direct ownership by investors—individuals or institutions—in for-profit enterprises. Owners, few in number, benefit from the freedom to run a firm as they will. They can reinvest profits in their firms or take them for themselves. They need not disclose their finances, business strategies, or management practices to the public.

Conventional investors typically allocate assets to large private equity funds that in turn buy and sell private firms and share the profits from these transactions with their investors. Alignment with social and environmental goals is not part of the picture.

Sustainable investors set out to find and use private equity fund managers that do incorporate such social and environmental concerns and impose them on the management of the companies they buy and sell. The portfolios of these funds may make investments that address aspects of poverty alleviation, renewable energy, food security, or other social and environmental challenges.

Among the steps that system-level investors take to enhance their impact and set new models for this asset class is to cut out the middleman—that is, the equity funds. Doing so gives investors in private equity full knowledge of and control over their investments’ business models and practices, as well as their social and environmental impacts. Not incidentally, direct investment also spares them the sometimes substantial fees that intermediary fund managers charge. These advantages represent a systemically important enhancement of today’s private equity investment model.

For instance, the Caisse de dépôt et placement du Québec (CDPQ), one of Canada’s largest pension funds, makes substantial use of direct private equity in a hands-on approach to promoting economic growth and resilience at a local level in the cities and regions in which its beneficiaries live.¹⁰ Among other investments, it has made a major multiyear commitment to private equity investment in the infrastructure of Montreal to boost the city’s appeal as a commercial and tourist destination. CDPQ is the primary investor in and general contractor for the construction of a rapid-transit extension of the city’s subway system that will connect downtown Montreal with the city’s airport. Simultaneously, it has made major commitments to the revitalization of the city’s downtown real estate, including investments in malls, hotels, and restaurants. It has also created a $250 million private equity fund earmarked for artificial intelligence businesses in Canada—with $170 million initially invested in three companies: Element AI, Dialogue, and Talent.com.¹¹ It has diversified its direct private equity holdings globally, stressing many of the same social and environmental themes. In Australia, for example, it has invested $150 million in a 24.9 percent stake in a partnership involved in the Sydney Metro mass-transit system.¹²

Institutional investors have the assets and in-house expertise to take advantage of direct private equity. Wealthy individuals may invest in private equity funds aligned with their sustainability goals or make direct investment primarily through family offices if they have personal knowledge of specific industries. Individuals can urge their pension funds or the endowments of the nonprofits to which they contribute to take a sustainable or systemic approach to this asset class.

VENTURE CAPITAL

Venture capital is an asset class designed for rapid disruptive change. In the hands of system-level investors, this approach to equity ownership, along with investments in some small-scale private equity and small-capitalization publicly traded stocks, can aim at creating business models that solve the most challenging systemic risks or create corresponding rewards.

Sustainable investors might remain content with simple alignment with a theme, such as one of the SDGs, but not seek venture capital investments that go to the heart of solving a systemic challenge. For example, to achieve alignment with the SDG of ensuring healthy lives, they might invest in early-stage firms with innovative solutions to treating a disease but without addressing the underlying nature of the disease’s causes. And conventional investors may not care whether an innovative, disruptive business model, although profitable, has systemic impacts as harmful as they are beneficial—for example, firms with business models relying on a precarious gig-economy workforce.

In practice, investors in systemically focused “solutions” funds can be large as well as small. Institutional investors, for example, have solutions-oriented funds targeted to renewables. As of 2019, CalSTRS, mentioned above with regard to its approach to public equities, had invested $691 million in a private equity clean energy portfolio and $505 million in “solar, wind, and other renewable power and LEED [Leadership in Energy and Environmental Design] certified assets.”¹³ In addition, numerous small and midsized investment managers offer renewable energy funds open to individual investors and investing in publicly traded companies.

Fixed Income and Loans

Bonds, along with direct lending, form the second large class of investments. Bonds and loans start with a simple purpose and from there branch out into an almost infinitely varied, flexible, and customizable world of products and services. Among their societal benefits is providing organizations and individuals with access to substantial chunks of up-front cash for expenditures that they can’t immediately come up with but can pay back over time. Both bonds and loans are of immense value in promoting economic activity, although the specific purposes to which borrowed funds are put may or may not benefit society.

BONDS

Bonds are securities that facilitate the trading of loans by institutions and individuals. These may be large loans to governments and corporations for general or specific purposes. Or they may be bundles of small loans made to real estate purchasers (e.g., mortgages) or consumers (e.g., credit card debt). These bonds promise a regular flow of payments to their investors (the “coupon”) and have evolved into a huge, diverse, and complicated asset class.

When issued by national or local governments or by nonprofit organizations, bonds are attractive to system-level investors because they can fund public goods such as affordable housing and small business development. They can also support basic physical and intangible societal infrastructures—such as those essential to transportation, water treatment, education, and healthcare—that build a long-term foundation for economic stability and hence for investment opportunities.

Conventional investors typically allocate assets to bonds based on their expectations for risk-adjusted returns, not their ability to support the government or create public goods. Sustainable investors, once they have decided on their allocation to fixed income, will often align the types and specifics of the fixed-income securities they select for their portfolios with their own social or environmental goals—for example, the UN Sustainable Development Goals.

System-level investors go a step further, participating in the creation of and standards setting for what are essentially markets for new types of bonds. The development of the green bond market illustrates this point. Starting in 2007, a handful of development financial institutions began issuing what they described as “green bonds” that funded projects such as renewable energy, water, and green buildings and transportation. What exactly qualified as “green,” however, was not clear. As investors’ demand for these bonds grew, the need for standardized principles for what in fact constituted “green” became apparent. This gap in the market led to the development of several sets of voluntary “principles” for green bonds devised by the financial industry and other stakeholders.

These principles were key to the market’s continued growth: approximately $250 billion in new green bonds were issued in 2019, bringing the total investments in this new market to close to $1 trillion.¹⁴ Bank of America (BoA) is an example of a financial services firm that participated systematically in this market’s development. From the outset, BoA played a prominent role as a lead underwriter of green bonds. Through 2019 it had also issued six green bonds of its own, funding $6.35 billion in clean energy initiatives.¹⁵ In addition, it participated in the creation of the International Capital Market Association’s voluntary Green Bond Principles and continues to sit on its executive committee.

Some investors, seeing the need for a governmental role to bring further systemization to the market, have supported the European Union’s current development of a universal taxonomy for green bonds, which will constitute a further step in the regularization and legitimization of this market. The Scandinavian financial services firm Nordea Group is one of the seven members of the Green Bond Standards Working Group, which is providing technical advice to the EU as it intervenes at this key leverage point within the complex fixed-income world of investments.

The success of green bonds has also prompted the emergence of a related market for “social” bonds and, when the pandemic hit, for “COVID” bonds in particular. In the first five months of 2020, $151.5 billion was raised globally through issuance of COVID bonds.¹⁶ This proliferation of socially and environmentally targeted bonds illustrates how demand from investors and participation in standards setting can bring about key changes in the fixed-income market.

SOVEREIGN DEBT

The ratings for sovereign debt—bonds issued by national governments around the world—are another area where investors are leaving their mark.

For conventional investors in sovereign debt, geopolitical and governance risk factors have long figured among their considerations. Sustainable investors in increasing numbers are integrating an additional set of environmental, social, and governance concerns. At the security selection and portfolio construction levels, ESG factors are now finding their way into the analyses of these sustainability investors, although as one 2019 report noted, “Few investors integrate ESG factors systematically into their sovereign debt portfolios” (italics in the original).¹⁷

Investors with an eye on systemic risk see ESG integration into portfolio construction, where pricing of risk is a primary concern, as a stepping-stone to a more holistic approach. For instance, the Swiss investment management firm RobecoSAM now incorporates evaluation of systemic risk factors in its Country Sustainability Ranking. Several of these risk factors touch on complex, difficult-to-value indicators such as governments’ natural capital management (e.g., ecosystem vitality, environmental status), human capital (e.g., gender inequality, confidence in government), and management of political rights (e.g., management of public goods, civil liberties).¹⁸

These systemic risk factors are not easily translatable into price. Their benefit to investors, though, is that they can become a lever for pressuring governments to address systemic risks and rewards. One starting point for applying such pressure is the creation of investable indexes based in part on these systemic factors. Along those lines, RobecoSAM’s Country Sustainability ranking, which includes these systemic indicators, is the basis for the S&P ESG Sovereign Bond Index Family.¹⁹

LOANS

Typically, institutional investors make limited use of direct loans as an asset class. They are, however, becoming increasingly vocal on the social and environmental risks implicit in how commercial and retail banks set about their lending.

Historically, major banks have been essentially agnostic as to the social and environmental impacts of their loans. That has started to change as investors with a sustainable and system-level perspective express ever greater concern. Banks are of course prohibited from doing business with criminal elements. But more and more they are being told to limit or are voluntarily limiting their financing for activities that can be viewed as posing systemic risks. Here are a few examples:

• Eight European countries have laws on their books that prohibit investments in production of cluster bombs, antipersonnel weapons, and similar armaments. Three of these—Belgium, Spain, and Switzerland—also prohibit their financing.²⁰

• As of 2016, six large US financial services firms—Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley, and Wells Fargo—limited to some extent their financing of coal mining firms.²¹

• In 2017, the Dutch bank ABN AMRO announced that it would make no new loans to tobacco companies.²²

More generally, in 2019 in conjunction with the United Nations Environment Programme Finance Initiative, 132 banks launched the Principles for Responsible Banking, which committed signatories to “continuously increase our positive impacts while reducing the negative impacts on, and managing the risks to, people and environment resulting from our activities, products and services.” Whether this first voluntary step toward a more systematic, firm-level approach to the implications of their lending will have practical impact remains to be seen, but at a minimum it represents a symbolic shift in these financial institutions’ public stance.²³

A NOTE ON CASH

Cash, though used only marginally as an asset class by institutional investors, is well suited to support local community development. Institutional investors tend to use cash only as a short-term, low-risk, low-reward place to park funds while waiting for attractive opportunities elsewhere to develop.

For individuals, by contrast, savings and checking accounts are often an important part of their assets. By placing these funds with banks or credit unions that are strong supporters of local communities and businesses, they can support sustainability goals. Certain credit unions, such as the North Carolina–based Self-Help Credit Union and the Mississippi-based Hope Credit Union, and privately held banks, such as the California-based Beneficial State Bank and the Arkansas-based Southern Bancorp, provide models for confronting systemic challenges such as poverty and discrimination.

Real Assets

Among other things, real assets consist of residential and commercial real estate and of infrastructure such as bridges, roads, ports, airports, mass transit, and the like.

REAL ESTATE

Real estate is an unusual asset class. For individuals, ownership of a home is often their primary investment, dramatically more so than other asset classes. As an asset, it is unique in that they live in and attend to it every day. In that sense their real estate investment can become the physical embodiment of their personality. Those committed to sustainability principles can, for example, directly invest in environmental commitments such as the use of renewable energy within that physical asset that surrounds them. By contrast, direct ownership of residential property is an investment to which institutional investors typically do not allocate substantial assets and, when they do so, can become controversial in that they are absentee landlords.

Commercial and industrial real estate is also a part of the built environment, and its environmental impacts therefore also become part of the responsibility of its owners. Sustainable investors—institutions or individuals—participating in this aspect of real estate have several options. Some are indirect: they can factor large corporations’ management of their properties into their equities investment policies, or they can invest in publicly traded real estate investment trusts that take the social and environmental concerns of their holdings into account (e.g., Vert Asset Management). They can also invest in the projects of real estate developers that focus on transit-oriented projects, employ union labor, or adopt other social and environmental practices. CalPERS, for example, is among those public pension funds with a “responsible contractor policy” with regard to the labor practices for those holdings in its real estate portfolio.

Individuals might be considered to be taking a system-level approach to their investment in home ownership if they were advocates for green energy or affordable housing throughout their neighborhood or region. Similarly, institutional investors can take a systemic risk management approach by promoting the adoption and implementation of environmental and social standards throughout the commercial real estate asset class.

INFRASTRUCTURE

Infrastructure is also part of the built environment and as such has profound social and environmental impacts. System-level investors can look beyond the financial or social returns of particular opportunities to the use of multiple, coordinated infrastructure investments to catalyze economic development and empowerment throughout a particular locality. For example, a city’s or region’s transportation systems can play a key role in economic prospects and similarly its environmental footprint.

Prudential Financial, which appears again at the beginning of chapter 4 as an example of how an investor can extend conventional and sustainable investment practices to encompass a systemic approach, has used a coordinated set of infrastructure and impact investments in a concentrated set of interconnected initiatives to help revitalize downtown Newark, New Jersey. As part of this $1.1 billion initiative, Prudential has made $500 million in infrastructure investments and $438 million in impact investments, which it has supplemented with $197 million in grants and corporate contributions.²⁴

Among its infrastructure projects in Newark are the headquarters for its Prudential Global Investment Management division; a nearly $50 million investment in the renovation of the former Hahne department store into a multiuse building including 160 units of affordable and market-rate housing, an arts and cultural incubator, a food supermarket, restaurants, and retail stores;²⁵ and a $6 million investment in the West Ward’s Georgia King Village 422-unit affordable housing complex. In addition, among its support for local business is a $5.25 million investment in AeroFarms, an innovative indoor farming company headquartered in Newark. Prudential supplements these investments with grants to build out the public and nonprofit infrastructure of downtown. For example, it contributed $2 million to the renovation of Military Park in downtown and has made $29 million in donations to the New Jersey Performing Arts Center, also in Newark.²⁶

Target Asset Classes to Leverage Points

Whether investors are foundations, pension funds, family offices, or individuals, the positive potential social and environmental impacts of the asset classes in which they choose to invest—and how those social and environmental impacts for which they are well suited can be enhanced—are important considerations. The more that investors can target their use of asset classes as a whole to key leverage points that allow systems to generate positive outcomes from the start, the greater their contribution will be to a rising tide of investment opportunities for themselves and for other investors—and the more closely they can align their policies and practices with long-term systemic goals.