A few years ago, the Pension Consulting Alliance (PCA) noticed a sea change in the environmental consciousness of the public pension fund investors they advised. The following report accounts for the mechanisms by which institutional investors should consider the environmental risks and opportunities associated with the venture capital market. The report illuminates the double bottom line afforded by green investment and paves the way for a large new flow of investment into green spaces. VerdeXchange News is pleased to present the following report, written by Sarah Bernstein, Allan Emkin, and John Charley for PCA.
CalSTRS is exploring the concept of establishing an investment program that would make sustainable investments in public securities. As part of this exploration, CalSTRS Staff requested that PCA provide an overview of environmentally responsible investment opportunities. To meet this request, PCA (i) reviewed the existing literature, (ii) conducted a survey of environmentally screened products, and (iii) analyzed the investment performance of funds that include an environmental screen in their investment process, and compared their results with those of their respective peer groups by asset class.
This report provides our key findings on the options available for environmentally responsible investing in public securities. CalSTRS Staff supported and provided input to this report.
Summary Conclusion
We draw two broad conclusions from this review. First, in our opinion, double bottom line expectations are achievable in this market. In our opinion, an environmentally oriented public security investment program can be built in the current marketplace that seeks to achieve reasonable financial return and environmental bottom line results. To pursue an environmental bottom line in addition to a financial bottom line, the program’s environmental objective would need to be defined. Second, because this market is multifaceted and emerging, there is more than one way to make investments in environmentally oriented public securities. Therefore, any program development would need to consider a range of questions to specify the objectives of the program.
Key Findings
• Financial markets appear to be expressing increased interest in environmental factors and in rising concerns over the financial risks and opportunities of environmental issues for companies globally.
• Most public security investment funds that employ an environmental screen also use other socially responsible screens in their investment decisions. Eighty percent of the funds in this survey (84 of 105 funds) market their product with a Socially Responsible Investor (“SRI”) mandate that is broader than environmental responsibility.
• A growing number of managers screen specifically for environmental issues rather than incorporate a broad range of SRI screens into the investment process. In 1990, we found zero environmentally specific products. In 2005, we found 11 firms that offer 21 environmentally specific products.
• Environmentally screened funds are offered by a range of firms from large global financial institutions, to specialty firms focused primarily on socially responsible investing, to very small independent firms
• Environmentally screened assets under management are heavily concentrated among a few firms. Six of forty firms in our survey manage 72% of the assets in these products. However, there is recent growth in the number of new entrants into these markets. The new entrants include many global financial institutions that avoided SRI/environmental investment mandates until recently.
• The vast majority of environmentally screened assets under management are managed as retail products (mutual funds) for individuals. The data indicate that a growing number of products are designed to address the needs of institutional investors.
• The market opportunities to invest in environmentally screened products are expanding across asset classes. The preponderance of environmentally screened assets under management concentrates on U.S. equities. However, global, non-U.S., and Canadian equity funds; U.S. and international balanced funds; hedge funds; and exchange-traded funds are also available.
• The investment approaches to environmental screens have evolved. Today managers use both negative screens that exclude companies deemed to have a negative impact on the environment, and positive screens that only include companies that are judged to be environmentally sensitive. The market has also evolved to include the ranking of companies based on their environmental behavior. These rankings are then used to overweight or underweight individual securities, rather than completely include or exclude specific stocks. The environmental rating systems are developing to encompass more sophisticated financial implications of environmental issues.
• PCA reviewed the recent investment performance of SRI products that include an environmental screen in their investment process. The general conclusion from the survey is that the environmentally screened U.S. equity products, U.S. fixed income products, and the balanced funds appear to fall, on the whole, near the median of their respective peer groups for the recent performance periods. For these asset classes more than half of the managers often outperformed their specific benchmarks, with differences for the one-year, three-year, and five-year periods for each asset class.
• The results for environmentally specific U.S. equity products as a group are mixed during the one-year, three-year, and five-year periods ending June 30, 2005. The excess return results of the environmentally specific mandates, or the product return gross fees minus the product’s specific benchmark, indicate that half or less of the managers outperformed their specific benchmark, for each of the one-year, three-year, and five-year periods under review, with the best performance in the five-year period.
• For the period studied, the global, non-U.S., and Canadian equity, and the non-U.S. fixed income environmentally screened products appear to have produced risk-adjusted returns, and absolute returns somewhat below their respective peer groups (global equity products, international equity products, Canadian equity products, and similar appropriate fixed income peer universes). For these asset classes, more individual managers underperformed their respective benchmarks than outperformed their benchmarks overall in the one-year, three-year, and five-year periods under review....
Introduction—The Universe and the Marketplace
PCA’s survey covers $27 billion in assets under management today that are environmentally screened. The 2003 Report on Socially Responsible Investing Trends in the United States by the Social Investment Forum found $28.9 billion in assets were screened for environmental concerns.
Institutional interest in environmental products is growing.
PCA’s review found that institutional investor interest in environmental products is broadening, mirroring heightened concerns over environmental issues. For example, a new coalition of investors —the Investor Network on Climate Risk (“INCR”)—formed in November 2003 with ten institutional investors representing $600 billion in assets under management, had grown by May of 2005 to over 40 members representing $2.7 trillion of assets. CalSTRS is currently a member of this organization.
Another indication of the widening interest in environmental investment products is that the market for environmentally responsible products is expanding beyond the socially responsible investor network. We found mainstream financial institutions making the case that environmental risks and opportunities pose potential risks and opportunities for almost every company and can carry financial implications. For example, a Goldman Sachs 2005 report cautions that environmentally related issues are not just a Socially Responsible Investor (“SRI”) issue, but are an important theme for fundamentally based investors as well. Environmental factors are expected to become increasingly important to investors.
Multiple factors suggest that environmental screens will become increasingly important to investors as environmental concerns become ever greater financial and competitive concerns for companies. Such factors include:
• Regulatory requirements for stronger environmental performance, particularly related to climate change issues, are tightening at the global, national, and regional levels. The enactment of the Kyoto Protocol on emission standards marks one significant global shift in the regulatory environment.
• The globalization and intensification of industrial competition is increasing the level for environmental and social risk for major corporations and investors. Notably, rapid economic growth in China and India is driving strong energy demand, while geo-political events in the Middle East, exacerbated by recent devastating hurricanes hitting U.S. oil producing, refining, and distribution centers, have contributed to a dramatic increase in oil prices. These developments have fueled concerns over energy use and levels of energy intensity among companies, and heightened interest in alternative “clean energy” sources and technologies.
• There are growing pressures from international non-governmental organizations. For example, the United Nations Global Compact was launched in 2000 with the aim of promoting responsible global corporate citizenship. Under this mandate, the International Finance Corporation Draft 2005 report —“Who Cares Wins –One Year On”—states that, to date, more than 2,000 companies and other stakeholders from over 80 countries have now joined the Global Compact’s Network. The aim of the “Who Cares Wins” initiative is to develop guidelines and recommendations on how to integrate environmental, social, and corporate governance (“ESG”) issues in asset management, securities brokerage services, and associated research functions, and to suggest ways in which various financial sectors, such as stock exchanges and pension funds, consider ESG issues.
• The institutional community is experiencing a substantial broadening of what is considered to be the legitimate fiduciary responsibility of investors to include addressing companies’ social and environmental performance. (A number of European countries have enacted laws stipulating this enlarged view of fiduciary responsibility.)
The environmentally screened investment market is evolving rapidly. Our research indicates that as institutional investor interest climbs, the market opportunities for investing in environmentally screened products are evolving rapidly. The earliest environmentally screened product that we found was launched in 1971. The product was managed under a socially responsible mandate that included an environmental screen. Environmentally screened products have evolved significantly over time in a number of dimensions including:
• Environmentally screened products have emerged that are independent of broader SRI screened products
• The objective of funds have shifted to include “double bottom line” results
• The types of environmental screens have expanded and become more sophisticated
• The range of environmentally screened asset classes has widened and deepened
• More products are being designed for institutional investors
Environmentally screened products have evolved significantly over time to include products that screen specifically for environmental concerns, rather than for multiple social responsibility issues including clean environment criteria. The early generations of funds concentrated on adding the “green” to broader socially responsible screens. The first environmentally specific investment product was not launched until the 1990s. We found 21 products in the market today that are marketed as environmentally screened, rather than as socially responsible products.
The early genre of SRI funds marketed their products as being socially and environmentally responsible, but were not necessarily expected to outperform other products in their respective asset classes. The general approach was based on the presumption that it was worth giving up some alpha to invest in a socially responsible manner. A second generation of products and studies find that environmental screens (and, more broadly, socially responsible screens) are not an automatic detriment to generating positive alpha. Most recently, a broader array of approaches seeks to generate a positive “double bottom line”—to generate positive alpha and invest responsibly from an environmental and social point of view. Recent literature includes studies that find a positive alpha for environmental and sustainability screens, such as Innovest (2003) and West LB Panure (2002.)
The number of different types of environmental screens is growing, and the screening processes are becoming more sophisticated. Some strategies utilize a negative screening process to identify and avoid investing in environmentally irresponsible companies. Today’s environmental products encompass investment strategies that utilize a “positive” screen to identify and invest in environmentally responsible companies. Positive screens are used, for example, to focus on companies that have policies aimed at reducing harmful emissions or companies that are developing “green” technologies such as renewable sources of energy. The screening research encompasses a range of methods with some firms concentrating more on financial indicators of responsibility than others. Financial impact considerations are becoming more widespread. New developments include strategies that use screens to assign environmental risk measurements to securities and then use those environmental rankings to overweight and underweight the specific securities in any underlying investment mandate. Products are also now available that invest based on “sustainability” factors.
The range of equity and debt products that are environmentally screened is expanding and deepening to encompass more detailed sub-asset classes. Environmentally screened hedge funds and exchange-traded mutual funds are being launched. Eco-Indexes have appeared. Investment exposure to “clean environment” can be captured in new carbon-trading markets in which emission allowances can be bought and sold, allowing participants to engage in strategies based on their view of the price of carbon emissions.
Finally, we found a recent growth in products designed specifically for institutional investors. Today, the vast majority of environmentally screened assets are under management on behalf of individual investors. Many institutional investors with a fiduciary responsibility to focus on investment results, such as pension funds, avoided SRI products because of the potential for the SRI products to produce uncompetitive performance results. In recent years, the data indicate that there is growing interest on the part of institutions in environmentally oriented products, and growing attention to environmental products designed specifically for institutions that seek competitive investment performance while attaining environmental objectives.
The proliferation of environmentally screened products encompasses widely varying definitions of environmental responsibility. Therefore, some products that are marketed as environmentally responsible may or may not meet a particular investor’s concept of environmentally responsible. For example, the Natural Capital Institute published a 2004 report on the current state of socially and environmentally responsible investing. The report takes a critical look at the SRI mutual fund industry, and suggests that the industry has no standards or definitions, is unregulated, and largely invests in the same companies as non-SRI mutual funds.