In this episode of the McKinsey Global Institute’s Forward Thinking podcast, guest interviewer Jonathan Woetzel talks with Ron O’Hanley, president and CEO of State Street Corporation, a major servicer and manager of institutional assets.
State Street has committed to making its portfolios carbon neutral by 2050, and O’Hanley talks about how his own organization is trying to meet that target but also helping customers to develop sustainability strategies. Among other topics on his mind are the pandemic, which dramatically illuminated vulnerabilities in societal linkages; the growth potential of digital finance; and the importance of affordable housing. He answers questions including the following:
- What will it take to make State Street’s portfolios carbon neutral by 2050?
- How will advances agreed at COP26 in Glasgow affect the climate agenda and State Street’s business?
- How does stepped-up investment in digital finance lead to growth?
- Is there a trade-off between growth and inclusivity?
- What are policy unlocks needed to create a sustainable, inclusive growth cycle?
Michael Chui (co-host): Janet, when you think of the business response to climate change, what kind of companies do you immediately think of?
Janet Bush (co-host): Well, energy companies, oil and gas, mining; they are the ones that immediately come to mind. Obviously, they need to migrate to clean types of energy if the transition is to be a reality. But I guess it involves every individual and every company in some way.
Michael Chui: Indeed, and the role of finance is going to be critical. According to our own MGI research on the net-zero transition, capital spending on physical energy and land-use systems in the next 30 years needs to be about $275 trillion. That’s equivalent to about half of global corporate profits in 2020 on an annual basis. Financial institutions in particular have a pivotal role to play in supporting large-scale capital reallocation.
Janet Bush: In that context, we are delighted to have our colleague Jonathan Woetzel as guest host. He is in conversation with a US financier who has a great deal to say about the net-zero transition. So let’s hand over to Jonathan.
Jonathan Woetzel: I’m here with our esteemed alumnus Ron O’Hanley, president and CEO of State Street Corporation, one of the world’s largest servicers and managers of institutional assets. It’s fair to say that Ron has been walking the talk when it comes to sustainable, inclusive growth. He’s deeply involved in industry efforts around climate, around corporate governance, diversity, and inclusion. He leads the task force for asset managers and asset owners as part of the Sustainable Markets Initiative, which is aimed at deploying institutional capital to accelerate the transition to a net-zero world.
He also has a leadership role at Focusing Capital on the Long Term and is a guardian of the Council for Inclusive Capitalism. So we’re very pleased to have him today for a conversation about sustainable, inclusive growth. Thank you, and welcome, Ron.
Ron, let’s start with talking about sustainability. Last year, you committed to make State Street’s portfolios carbon neutral by 2050, and you said that that will be a hard thing to do. Tell us more about that and what it will take for you to get there.
Ron O’Hanley: Well, we have made that commitment, and made it for a couple of reasons, but primarily [because] we are a very long-term investor. Almost by definition, in the public markets if your portfolios are index-dominated, as long as a company is in the index, we are going to invest in the company. For us, given the long-term nature and the long-term value creation that we think is associated with climate-friendly portfolios, this was an important commitment to make. The reason I said it was hard is that as much work as has been done, it’s actually still fairly basic today.
You think about the leverage that we have. One is engagement with company boards and management. And that’s more than just jawboning. It is really trying to understand what’s going on and using our oversight function and stewardship to figure out where they are.
Second is selective divestment. Basically saying, “I’m no longer going to own this.” Again, limited in an index portfolio. Third is enhancing the carbon profile of the portfolio. It’s basically by saying we’re not just going to divest but we’re going to go towards those low-carbon or, from a carbon perspective, well-behaving companies.
And then lastly is advocacy, both public advocacy and then advocacy around reporting. Reason why this is difficult is there’s really not an agreed-upon methodology to calculate carbon baselines and targets. The world is getting closer on that. COP made some real advances there that we can talk about, if you’d like. But there’s still not a whole lot of data that’s available such that one can definitively say, “I’ve lowered my carbon portfolio by this.”
But having said that, we are working at it in our active portfolios. We’ve already factored and have long factored ESG and climate risk into what we’re doing. In our passive portfolios, as I said, our real option there is to engage with companies and to get them moving towards the right place.
We’re working with others in the industry because this is one case where we’re all in the same boat and we’re all aligned. And it’s not just asset managers and asset managers, but also the owners of the assets. So this is one place where we’re working very closely. It’s hard work. It’s not impossible work. And it’s something that I think it’s important that the industry work towards.
Jonathan Woetzel: You mentioned COP and advances that were made there, changes that happened. You were at Glasgow. Maybe we just go into that a little bit more in terms of—both on the financial disclosure side and any other observations on how that’s affected the climate agenda more broadly, and specifically for State Street.
Ron O’Hanley: Notwithstanding some of the media that you have seen come out of COP, I do believe there were some real advances. Sure, the statement at the end wasn’t what people wanted. But COP went on for two weeks, and there was a lot of work in the run-up to it. There’s a couple things I would talk about.
One was the deal between China and the United States to work together on reducing emissions. A carbon market. I will talk about that. The new standards now around how to think about ESG reporting and some harmonization. Because even in the run-up to COP, what was clear was that the business community worldwide had reached its tipping point. And by that I mean that there was very, very little “this can’t happen”, “we can’t do this,” and “we shouldn’t be talking about this” and much more around “what we need to and let’s get consistency in standards around this”.
The new International Sustainability Standards Board was established really to start to bring together all of the different accounting standards and develop a baseline of global standards.
The agreement of China and the US to basically abide by that is actually a very big deal. And to say, “OK, what comes out of that, we’ll use and incorporate that into the accounting standards of our countries.”
There was just much less talk about “here’s the risk of climate” and much more on “what are we going to do about it?” And again, I think that was a very big and important change.
There was movement beyond emissions. And emissions are very important. But also much more discussion on biodiversity and, for lack of a better term, nature as a capital investment than I’d seen before. That’s very important.
Twenty-two countries, 23 I think, actually, made commitments to phase out coal and to stop funding coal, with focus on methane. You know, methane’s a big deal. It doesn’t get the same kind of attention, but 105 countries joined the methane pledge. And this was a US- and EU-led kind of thing.
And then even on the carbon markets, while we haven’t gotten to the point yet where select countries, particularly the ones that matter, like the US and China, are agreed on a carbon price or carbon pricing mechanism, they all came together in terms of what the framework for that is, which I think, ultimately, is where we need to get to. Ultimately, carbon needs to be priced in as an externality. And while we didn’t get there, we made some progress there.
And then lastly, I would say, the role of India. Everybody’s complaining India didn’t do enough. But they joined it. They joined the club. And I think that’s actually quite important, because as we think about this global problem that we have called climate and carbon remediation, India has to be part of the solution here.
So all in all, could it have accomplished more? Yes. Did it accomplish a whole lot more than people are talking about? Yes.
And maybe the most important thing is that usually these things happen and there’s the great silence afterwards. Well, there’s a lot of work under way about, what are we doing next? What are we going to do before Egypt, COP27? So we don’t think anybody views this as anything more than a milestone on the way to getting to where they need to be, in terms of anybody serious about this.
Jonathan Woetzel: That’s great to hear. And I think we share the view that a lot was done. Particularly the net-zero principle as an operating principle for companies globally. So really there now, in terms of the boardroom’s focus.
Maybe talk a bit then about what work has been done, is getting done at State Street. You made a lot of acquisitions to help your clients, tools to help track and score how companies are managing their carbon emissions. Thoughts you could share on that?
Ron O’Hanley: At State Street, basically, we’re a fairly straightforward company. We have two businesses. One is an asset management business, which has been on the forefront of this now for a while, and all the things that I talked to you before about.
Our larger business, about 80 percent of what we do, is investment servicing. In other words, we help asset managers and asset owners with their portfolios. Everything from, at the back end, custody and accounting, all the way to pretrade risk analytics, the trade itself, post-trade compliance, the risk analysis and performance measurement around a portfolio. And what’s happened is the center of attention has moved to that. Back ten, 12 years ago, just a few asset managers were thinking about this. Now everybody is. And they’re all saying, “OK, but I need tools.”
We’ve developed some tools inside what we call ESG risk analytics to help clients address either the regulatory requirements that they’re going to be put under, or their own requirements that they’re putting on their portfolios. If they’ve taken an investment view and now have a policy that says X, that has to be incorporated into their post-trade compliance.
We’ve also developed some tools in terms of financial disclosures and how do we think about measuring the carbon intensity of a portfolio. There’s some great, great firms out there that are doing terrific stuff. S&P Global would be one. They have a true-cost product that we’ve now incorporated into our ESG analytics to take what we think is a real state-of-the-art bit of analysis and incorporate it into broader ESG analysis.
And then more recently—because remember, most of the world focuses on, when they have these discussions, on public investment. But private investment is at least the same size now, if not bigger than public markets. And so how do you think about, as an investor, what you hold in private equity, private credit, et cetera.
Earlier this year, we bought a firm named Mercatus, which is basically a data management provider for private market managers. And we’re using that to basically bootstrap the same kinds of tools that we use for ESG and public markets for private markets.
Jonathan Woetzel: Well, that’s, first of all, a lot of advances and methodologies that didn’t exist before. You also mentioned that part of this is about your decision making, part of it is engaging with the portfolio companies and with your investees. Maybe speak a bit about that. What are you telling them? Or how do you help them shape a more compelling and high-impact sustainability strategy?
Ron O’Hanley: Let me speak about it first in terms of how we engage with a portfolio company. We’re the first to admit that we are not management of these companies. And ultimately, management and the board of these companies know what’s the right thing to do.
We take this from the approach, firstly, of what is the board doing, and what is the board doing from its oversight perspective? And what we ask the board is, what are you asking your management on this? We take it from the vantage point of long term.
If you think about index investing, it really is long-term investing. As long as the company’s in the index, we’ll be invested in it. And so we make that point to these portfolio companies that we’re thinking about this in five-, ten-, 15-year horizons here. And how were you thinking about it from that perspective?
What we then urge companies to do is recognize you don’t have all the answers. But part of your job and part of your role is working with others to figure out who’s got those answers. So what we ask the board is, how are you thinking about this? What’s the data that you’re receiving from management? Recognizing that ESG data is fragmented and it’s not complete, what are you doing to try to fill that in? What are you doing to make judgments of the data that may, in fact, itself be incomplete?
And then lastly, we really do focus on governance.
Think of the climate side of ESG as nothing more than a risk. And you and I sitting here—I’m sitting here in Boston, looking out the window. I don’t know what’s going to happen to sea levels in 20 years from now, in 30 years from now. But is there a risk that it could be different? Absolutely. And so it’s thinking about climate, how it factors, how an investor looks at your company in terms of what is the climate risk that’s embedded in this company or could be embedded in this company and how do I think about it?
And that’s how you then need to feed back to your investors in terms of, here’s how we’re thinking about it. We own real estate in lots of coastal cities, and this is what we’re going to do about it. Or we’re tied to a supply chain that uses these ports, that has perhaps some risk in the future.
So rather than this debate about a point-certain sea level rise means this, or the temperature’s going to rise to this, it’s like any other risk. The definition of risk is more things can happen than will happen. So understanding that range of things that can happen, and what are you doing to, either as management to manage it, or as the board to oversee it?
Jonathan Woetzel: Makes a lot of sense. And in the world of climate, very few things are certain. So that better information base will definitely, I think, create a better conversation with the board and, ultimately, with management. So, great.
One of the things that very few people saw coming was, of course, a pandemic. And so turning to inclusivity, last year, you wrote that “Like a bolt of lightning against a night sky, COVID-19 has dramatically illuminated vulnerabilities in linkages that we, as a society, can no longer afford to ignore.” True words. Could you, perhaps, tell us a bit about those linkages as you see them, and how to address them?
Ron O’Hanley: I think it’s fair to say that the multiple crises that started in 2020—but first and foremost, the pandemic—really did highlight both strengths and weaknesses that are in the public and private sectors. And I think it also highlighted the linkages and connections between corporate resilience and ESG.
If you think about it, sitting prior to March of 2020, would we have imagined that in fairly short order we’d be seeing all sorts of shortages of basic household items, including food? Would we have thought about that? What we’ve done is we’ve optimized supply chains, but not with an eye towards resiliency and vulnerability. And you have to ask yourself, why were so many developed countries in the 21st century unprepared for an epidemic that turned into a pandemic?
I can’t think of a country in the world that can thump its chest and say, “Yup, our public health system did exactly what it was meant to do.” You think about the shortages suffered by hospitals, governments, and manufacturers as they were trying to respond to all this.
What it’s highlighted is that as we think about risk and as we think about capital in the broadest use of that term, we, as a society, need to think differently. In some respects, my part of the world, the banking world, got its wake-up call and its knock on the head back in 2008. And the regulatory response in most parts of the world was swift and said that this was a system that was running with way, way too little capital. And we can no longer afford to do that.
And so you’ve got a system now—I think it’s properly capitalized. What I know is it’s way more capitalized than it was in the past. And it’s to protect us from X, but it’s to protect us from a range of things that can happen, going back to the risk thing. And as we think about industries, and as we think about the response of various governments, there was a giant, giant bailout that went on in all sorts of different forms there.
We can say that’s OK. I don’t think we really know the fallout of this yet, in terms of what it’s meant to government debt. Not to pick on them, but I would just ask, how we can have a situation where the airlines, every ten years or so, go through some kind of crisis and need some kind of a bailout?
You go back to 9/11, you go back to the financial crisis, and now you go to this. And, again, very important employers. I use our airlines. I’m just making the point as an illustration that we need to be thinking about what resilience really needs. And at some point, who’s going to pay for that? Should it be the shareholder? Should it be the customer? Should it be government?
My vote is a combination of the shareholder and customer. If I want to have a plane available to me, and I want to have the convenience of planes, and if the airline needs to carry more capital to make it through those kinds of things, I, as a customer, probably do need to pay for that in the cost of the ticket.
I’m using that as an illustration of how this highlighted the link between preparedness and these ESG kinds of factors. And I think it’s fair to say that as serious as the—to tie it back to the climate theme—as serious as this pandemic has been, as Rebecca Henderson at HBS [Harvard Business School] has said that COVID was the pop quiz. Climate is the real final exam in terms of, are we prepared for that? And have we built in enough resiliency? Both in terms of new technology, but also adaptability to what some believe is going to be inevitable here. I think that’s how you get these kinds of linkages there.
Jonathan Woetzel: I can see the risk theme coming through. It’s sort of having that broader view on what’s possible, and investing to be prepared for that. Let me ask one other question, sort of related. On the active side, in particular, you are, of course, building capabilities and sustainability. You’ve also been investing in areas for economic and social benefit, including affordable housing–a topic near and dear to MGI. Love to know more about how you think about that active investing side and how that creates economic value.
Ron O’Hanley: We are strong believers in the economic benefits of affordable housing. It’s really basic. You ensure that people can feed themselves, that they can provide themselves shelter, and they have a job. And those things, by the way, are very much related.
What we’re finding increasingly is that we have this somewhat destructive cycle of attractive areas to live, people flock to it, employers flock there because people want to be there, not enough housing is built, the cost of housing goes up, homelessness goes up. And all of the sudden, the place isn’t quite that attractive anymore.
You’ve seen this cycle occur on the West Coast. Some would argue that it’s happening in places like Austin now. In our mind, it’s just very, very important that we think about mechanisms to grow affordable housing. We do it through—we’re a credit extender. We’re not a big one, relative to most, but we’re a credit extender. We do it through some municipal finance activities.
But the other way that society really needs to think about this is how they think about zoning. It’s an irony that if you look in many parts of the world, that, on the one hand, people say, “Yeah, we need more affordable housing.” But through zoning and zoning restrictions, it actually makes it very hard to put in things like affordable housing.
So it’s very important here, you’re not going to break the cycle, you’re not going to create the virtuous cycle without being able to bring together this idea of food, shelter, and jobs.
Jonathan Woetzel: Words very close to my heart, Ron. Thank you. Well, none of this is going to be possible without growth. And we’re going to need to—the motive engine of capitalism still needs to tick over. Maybe say a few more things about where you see growth for State Street. What are the top opportunities, in your mind? You’ve recently made a big set of moves around digital finance. It would be great to hear a bit more of your thoughts about how growth comes out of this.
Ron O’Hanley: We’re in a very competitive industry, our little patch of financial services. On the one hand, it’s very competitive. And lots of pressure on pricing. On the other hand, it’s just got some great built-in fundamentals. We’re tied to markets and investments. And financial markets typically grow at a multiple of underlying economies. So as long as you believe economies will continue to grow, financial markets tend to grow. It’s a multiple of that.
So given that, and given that as wealth grows, and as wealth, more importantly, broadens, and you see growth in the middle class, we’ll move from just, in effect, paycheck to paycheck to “I’m going to put a little bit away.” That also helps propel the industry.
Lots of things going on as a result of that. Firstly, because investing has long globalized itself, there’s a lot of complexity from that decision of a portfolio manager to “I want to invest in this” to it actually showing up in the portfolio and being reported back to the actual asset owner, whether that’s an individual or an institution.
We see growth and actually linking those things together, everything from pre-trade analysis all the way through to the actual reporting that comes back to them. There’s a lot of friction in the system. And that friction becomes important to eliminate, particularly as regulators take down trading times.
What we’re all familiar with is, it used to be five days to settle equity, now it’s three days. The debate now is around two, one, and zero. There’s lots of instruments right now, though, that—if you think about things like traded bank loans—we’re looking out there for 15, 16, 18 days of settlement. Regulators don’t like that. We shouldn’t like that as participants in the market. So to get that kind of settlement period down, you need technology.
And some would say, “What do you mean? I mean, we’re digital already.” But the true digitization of what we do—if you think about it, a big part of what we do is, we’re in the securities movement and control business. A security is either moving because there’s some kind of transaction in place, or it’s at rest and needs to be controlled and custodied.
We do it today largely the way we did it 200 years ago, except it’s not paper. It’s in a book-entry form. But if you think about it now, and what digitization enables us to do, it’s actually going to enable us to basically tokenize everything. So we’re no longer actually custodying the asset, but we’re custodying basically the keys to that token or to that digital footprint there. It’s got great promise in terms of democratizing investments that are really not available to the general public.
So you think about real estate investing. Right now, that’s for the wealthy. And you typically will make investments in some kind of real estate partnership. There’s a minimum to that. Lots of paperwork around it. Well, why can’t we take this building that I’m sitting in now and tokenize that? And break it up into little pieces. It’s got great promise. It’s got great promise in terms of continuing to eliminate the frictional costs in the movement here.
We’re at the very early innings on this. I mean, everybody talks about, oh, this game’s been under way for a while. It’s been largely under way in payments, in terms of how are we going to pay, either retail or wholesale. Securities movement is a new frontier for this. There’s lots of open ground here. But it’s something that I think will rapidly see the same kind of digital intervention as we’ve seen in the payment side.
For us, it was very important that we set this up as a separate division for a couple of reasons. One, we wanted to have focus, real R&D focus on not what are we doing today, but what should we be doing tomorrow? What if we were designing this from a clean sheet of paper?
Secondly, we wanted to be in a position to actually disrupt ourselves. It’s the defender’s dilemma. If you’re number one in market share, you kind of like the way things are. You don’t really want somebody coming and saying, “Hey, I’ve got this idea that’s going to disrupt everything,” because we know that we’re making lots of money off that. So the idea is, let’s be prepared to disrupt the market, and if required, disrupt ourselves.
Jonathan Woetzel: Love that. I totally agree, early days. And cannibalize yourself, if that’s what it takes. I also love the link back to inclusivity. Some would say, though, that all the stakeholder capitalism—doesn’t it come at a cost? Creating that tokenization, does that, ultimately, slow growth down in some ways? What would you say to that? Is there actually a trade-off here between growth and inclusivity?
Ron O’Hanley: I don’t think so. And I think that if you accept the premise that most investing is or should have a long-term horizon, then I think it becomes a lot easier to think this way. The irony of investing and this supposed focus on the short term is that if you think about most investors, whether they’re retail or institutions, they’ve got very long horizons here.
The liabilities that they’re trying to offset with these investment assets, it’s a retirement fund, it’s somebody saving for a child’s education, it’s a sovereign wealth fund saying, “We want to put aside money for the next generation.”
When you start to have time frames like that, you recognize that the lens of things that you need to be concerned about actually necessarily grows. Can you get away with abusing a labor force for a quarter or a year? Probably you can. You can’t get away with that, and you’re not going to be able to survive, if in fact you have the reputation of an abusive employer or an employer that’s not paying people properly.
Is that stakeholder capitalism, that now we’re starting to think about employees? Maybe. I just think about it as, you’re opening the lens to a broader set of concerns.
Similarly, if you’re ignoring the community in which you operate, you’re just not spending any time thinking about what your corporate citizenship obligations are, simply because you’re saying, “I’m here to exploit this place and get out”—again, if you’ve got a quarter or a couple years’ horizon, maybe. But over the long term, to me, stakeholder capitalism is nothing more than a recognition that over the long term the success of a company has more to do than just how many products are they going to sell over the next couple of years.
And if you start to think about it like that, you start to think about long-term growth in a very different way. That it needs to be just more accommodating of all these different stakeholders that are involved with what you do as a company.
Jonathan Woetzel: Makes a lot of sense. And I love the unlock is a perspective on duration.
Ron O’Hanley: Maybe just a little bit more on ESG. I do think this is changing the way investors invest and therefore the way capital is being allocated.
Some evidence of this already. We did a little bit of work in the run-up to COP. We took a look at institutional portfolios. We took a snapshot of the portfolios in 2019 and a snapshot of essentially the same portfolios, meaning that they were for the same clients, et cetera. And what you found was the carbon content, if you will, had dropped by almost 30 percent in the portfolio. Recognizing, by the way, all the things I said earlier, that this is hard to measure, but if it was wrong, it was wrong in both cases.
Let’s just say that directionally it was correct. Lower-carbon kinds of assets have become more valuable than higher-carbon assets. Makes sense.
But the other half actually was, in fact, not related to that. It was that the same companies had taken steps and had lowered the carbon intensity of what they’re doing. To me, that is suggesting that what we’re seeing now is the beginning of what should be a fairly significant reallocation of capital.
Jonathan Woetzel: Makes a lot of sense. And if I can, then, one last question. These are all market phenomena we’re talking about. What about the policy unlocks? What do you see coming down the line here? And what’s needed to come down the line in terms of creating that sustainable, inclusive growth cycle?
Ron O’Hanley: I’ll start with carbon. In some circles, this is not a popular statement, but I think the biggest unlock we need there is, we need a global price on carbon.
Because ultimately, we have to recognize what carbon is. It’s a massive externality that’s been pushed out on this. If Milton Friedman were alive, he’d be a climate warrior here. I think he’d be saying that we need to internalize these externalities. So that is an unlock that we’re moving towards, but we’re not completely moving towards it.
This is a global problem. And carbon doesn’t know borders. So until we have a uniform way of looking at that, whatever we do is going to be inefficient, including the allocation of capital.
An area where we have seen an unlock that I think that the Biden administration should be proud of is the Department of Labor. They oversee the retirement funds of US investors. And they have changed their fiduciary role such that climate kinds of portfolios and ESG portfolios can actually be a factor in the choosing of an investment. This is really important, because it enables a big, big block of money. All of the retirement investments now in the US are eligible to be invested in an ESG-friendly kind of way, which I think was a great unlock.
So more to do. Policy makers, again, going back to climate, post-COP, they now have to catch up. They were out in front. And business was being dragged along. I think business now has moved ahead. Lots of people have moved ahead. And now the policy makers need to catch up. And they will. They will. I’m confident in that.
Jonathan Woetzel: Pricing in that externality. Well, thank you, Ron. This is an honor, one Bostonian to another. It was great to see you. And I think this is a really robust conversation that’s going to put a new frame on what is the actual integration of sustainable and inclusive growth in a long-term perspective–both from an investor’s point of view and, ultimately, from management. So I really want to thank you today for spending your time with us.
Ron O’Hanley: Thanks, Jonathan, I enjoyed it.