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Responsible Investment in the Post-Crisis World: How pension funds in Europe are responding to the challenge of sustainability

By Sean Kidney. First published in Corporate Citizen magazine, November 2008

Four months ago, as many Londoners were preparing to abandon a wet and cold summer for holidays in the Mediterranean sun, an unusual meeting was being held in the City’s opulent St James’s Palace.

The heir to the British throne, Prince Charles, was hosting a meeting of CEOs of some of the world’s largest pension funds, representing over US$3 trillion under management, to discuss what they could do to get the world’s governments to see sense on climate change and so protect long-term investment returns. People had flown in from the US, the Netherlands, Japan – and Australia. This was a very serious do.

Pension funds are not usually associated with the idea of pressing governments about climate change; it seems only recently that funds have been grappling with the idea of “socially responsible investment” (SRI) but clearly things have obviously moved on.  Why?

A boom in “responsible” investment

Recent years have seen massive growth of responsible investment activity and the related industry: there were at least 10 new conferences on responsible investment in the US and Europe last September alone. There are now SRI advisors and consultants galore, not to mention Green Funds galore.

A recent survey by the European Social Investment Forum estimates that “sustainable investments” represent 8% of the portfolios of high net worth individuals in Europe , and predicts this will grow to 12%, or one trillion euros, by 2012. Greater acceptance of sustainable performance is cited as a motor for market growth.

SRI assets under management in the Dutch market, for example, are said to have increased by a massive 816% in just two years , fuelled by public concern aroused by media investigation of investments in companies making land mines or using child labour.

But what has really changed?

AXA Investment Management’s Director for Responsible Investment, Raj Thamotheram, says “When we organised a public meeting in London in 2001 to make the case for action on climate change by mainstream investors, there were serious concerns about whether investment professionals would even come!”

“Unquestionably, there has been a huge growth in awareness of sustainability issues in general and climate change in particular by the financial sector since then.”

Thamotheram added that there has also been a massive increase in sophistication of the SRI field.  “But SRI still only accounts for 1% of the retail equity market.  The dominant funds  – green tech, water, best in class – simply aren’t suitable for absorbing the other 99% of equity assets.  And interest in sustainable fixed income, private equity, real estate and infrastructure – some of the asset classes where arguably climate changes is an even a really material factor – is pretty rudimentary.”

Rory Sullivan, Head of Responsible Investment at HBOS's Insight Investment, one of the largest asset managers in the UK, is a prolific writer about responsible investment. He argues that much of the money that has flowed into green funds has been driven by enthusiasm about the potential for stocks in this space to outperform, rather than any fundamental rethink. He commented:

“There’s an open question about whether investors will maintain interest in this area in the tougher market environment we now see. Clearly this has implications for the valuations of these stocks.”

Sullivan adds: “Most fund managers have ethical or green funds. The real test of a managers' commitment to responsible investment is how they incorporate environmental, social and governance indicators into their wider investment portfolios — the manner in which they use their influence as an investor to encourage high standards of corporate governance and corporate responsibility in the companies in which they invest.”

Some of the larger, industry-leading pension funds, like Holland’s ABP (US$314 bn ) or the California public service fund (CalPERS) (US$254 bn), are taking this direction.

Rob Lake, senior portfolio manager for environmental, social and governance at ABP, says  that their investigations have made them more and more concerned about the link between financial performance of investment funds and “the sustainability quality of the underlying companies”.

With a few more years of data now available it seems the SRI advocates of the 90s may have been right at least in some of what they were arguing.
There certainly are people producing research along these lines. For example, a recent OECD paper  on “Pension Fund Governance: Challenges and Potential Solutions” details several studies showing that good pension fund governance lowers costs and improves investment performance, generating at least one to two percent of additional earnings.

Lake says ABP is now systematically incorporating environmental, social and governance issues right across their mainstream investment processes.
Is this is merely a political response to member activists? Lake is careful to note that ABP “can’t relax (legislated) financial rules in the interests of pursuing purely sustainability driven objectives”. ABP decisions on investments are based on assessments of investment risk, informed by a range of hard data, with sustainability reports used as supporting information. On top of this ABP does exclude companies in conflict with accepted laws (and, coincidently, the views of the Dutch public), such as companies that make anti-personnel landmines that are illegal under international law.

SRI or system reform?

A demand for improved governance is one of the central planks of the SRI movement. There is debate about whether this is a matter of reform company-by-company, or whether something bigger is at issue – a debate only heightened by the systemic crisis financial markets have faced.

The new Network for Sustainable Financial Markets , with a multinational membership of SRI luminaries, is focused on systemic sustainability as the key SRI issue; they believe markets need a system that strikes a better balance between short and long-termism. Like Watson Wyatt, they argue that a “better alignment of financial interests is needed to reduce agency costs”.

A think tank in Geneva, L’Observatoire de la Finance , explains further. They argue that the key systemic problem is that western countries have “linked their promises of pensions and retirement benefits to investments that depend in sustainable liquidity — and the long term viability of this model is dependent on the profitability of financial instruments. This has exposed the rest of the economy to the vagaries of finance, producing an increasing need to devote more and more added value to the remuneration of savings invested and more and more self-nourishing complexity.”

In July 2008 consultants Watson Wyatt released a report, Defining Moments, on the pensions and investment industry of the future. The report was frank about systemic reforms required: “We are crisis-prone because of poorly structured incentives and other excesses” and “participants are incentivised to act in ways that will ensure the system remains prone to periodic crises”. As a result, “the vast majority of investment products carry too much cost for the value they deliver”. Three months later a new crisis was unfolding.

Big funds being responsive to constituency concerns

ABP is clearly finding ways to be responsive to member concerns while keeping within boundaries of fiduciary duty.

The biggest investor funds generally have a close relationship with either governments, like the South African pension fund, GEPF, (US$103 bn), or with a large pool of politically aware members, such as CalPERS.

Greater scrutiny of investment portfolios, as happened when the Dutch current affairs program, Zembla, investigated the industry, is generating political pressure in such funds for a stronger SRI stance.

Norway’s Ministry of Finance, for example, recently invited public submissions on reforms to ethical guidelines for its Government Pension fund, now the world’s second largest (US$370 billion). Norway’s largest institutional investors have also announced plans to push the country’s top companies to report to a public set of standards on issues such as the environment, labour and human rights

Some people are arguing that such changes are less about values than about a broader understanding of fiduciary duty.

Helen Wildsmith is the Head of Ethical & Responsible Investment at the UK’s CCLA Investment Management and former Director of the UK Social Investment Forum. “With threats being bandied around about legal action against companies who have, despite knowing the evidence, failed to take appropriate action in the light of climate change, we have entered a new era.”

Volkswagen, for example, is being sued in Germany for knowingly developing larger cars with high emissions despite having signed OECD climate change mitigation guidelines . In the US an Alaskan native village is suing nine oil companies (including ExxonMobil), 14 power companies and one coal company for damages related to climate change . A range of other US cases are pending.

Mark Campanale is a co founder of the sustainability funds businesses at Jupiter Asset Management and Henderson Global Investors and a founder director of the UK Social Investment Forum.

He says “the extraordinary weight of science detailed by the International Panel on Climate Change makes very clear the sort of future we can expect under different carbon emission scenarios. Every director and trustee is duty bound to consider that clear evidence in making decisions about where to invest assets. If they make decisions that directly or indirectly lead to poorer outcomes for beneficiaries or shareholders, they risk being judged to be liable for the outcomes.”

Nick Robins, head of HSBC’s Climate Change Centre in London, is intrigued by the development of this view. “This would turn on its head the traditional reluctance to pursue SRI objectives, citing concerns about the UK’s Prudent Man Rule, the US Exclusive Benefit Rule, or Australia’s Sole Purpose Test.”
“In the face of accepted evidence of climate change, trustees and directors may end up having to manage their assets differently. This isn’t so much SRI, as simply reviewing portfolios in the light of new evidence about future market directions.”

No substitute for engagement with assets

Insight Investments Rory Sullivan believes that "there is no substitute for engagement with assets"

"People thought existing modes of risk protection were adequate; they were not. We create moral hazards when we transfer risk to somewhere else where we don't know how it's managed.”

“There is no substitute for engagement. Investors must take responsibility for ensuring the integrity of their assets, ensuring that businesses are run responsibly and in the long term interests of their investors. Ripping off customers is rarely a long-term success strategy.”
Engagement is happening, although progress seems slow.

Bloomberg reported recently that US shareholders filed a record 57 climate-related petitions with US companies this year as they pressed for a higher value on the environment.

A global-warming resolution at Pittsburgh-based Consol Energy Inc., the third-biggest US coal producer, was backed by almost 40% of shareholders, the highest vote ever for this type of petition. In 2008, 26 resolutions were proposed at companies that included ConocoPhillips and Exxon Mobil Corp. and won support from an average 24 percent of shareholders.

The shareholder revolt at ExxonMobil over the firm’s hardline approach to global warming was led by the billionaire founding Rockefeller family. It won the support of pension funds on both sides of the Atlantic. The firm has refused to follow rival oil companies in committing large-scale capital investment to environmentally friendly technology such as wind and solar power. A resolution to limit the company’s greenhouse gas emissions secured an unprecedented 31% support. 

They didn’t win. But, on the other hand, twenty five shareholder resolutions were withdrawn after companies, including Ford Motor Co, the second-largest U.S. automaker, made climate-change commitments . Ford agreed in April to reduce by 30 percent new vehicle greenhouse- gas emissions linked to climate change by 2020.

In Switzerland, a group of nine pension funds have been pursuing a series of shareholder resolutions about executive remuneration at AGMs for ABB, Credit Suisse, Nestlé, Novartis and UBS.

In the UK, two of the country’s biggest pension funds, the £30bn Universities Superannuation Scheme and the £1.5bn Environment Agency, are pressuring investment managers to sign up to the United Nations Principles for Responsible Investment.

Growth of voluntary Principles of Responsible Investment

The United Nation’s Principles for Responsible Investment  (PRI) project (an investor initiative in partnership with UNEP Finance Initiative and the UN Global Compact) has been pressing this case for some time. Executive Director James Gifford (an Australian) says that institutional signatories to its charter increased 65% between January and August this year, despite the global credit crunch.

But is this a case of asset owners trying to look good when things are bad, or a genuine movement?

Donald MacDonald, chair of the BT Pension Scheme (US$74 bn) and chair of the PRI said, “The tough environment for investors has increased interest in responsible investment as a driver of long term value.  For many investors, and particularly institutional investors such as the BT Pension Scheme, our duty is to endeavour to ensure stable long-term returns whether markets go up or down. We believe that proper consideration of environment, social and governance issues is the way to deliver those returns. 
“I think the increasing support for the PRI despite the credit crisis shows that investors in general have taken a long hard look at the credit crunch, and some of the practices that caused it, and decided they can benefit from more comprehensive analysis of investment risk, one which incorporates environmental, social and governance issues into decision-making and ownership practices. 

“It may be cold comfort at the moment, but the credit crisis could be the catalyst for a switch to more sustainable market practices with benefits for both investors and society at large”. 

Roland van den Brink, managing director of investments at Pensioenfonds Metalektro (US$32 bn), which recently became the symbolic 400th signatory to the PRI added, "The current volatile financial climate only makes it more important that our investments support the sustainable development of societies. We believe this is the only way to ensure good long term results.”

Being a PRI signatory can count with institutional investors. In September, for example, the UK Environment Agency’s Active Pension Fund (£1.5bn) made being a signatory to the PRI a criteria for awarding £185m in mandates . Incumbents Capital International, State Street Global Advisors and Legal & General were replaced with RCM, Generation Investment Management and Impax Asset Management.

Asset owners are clearly aware they are under scrutiny to walk the talk. They know that attention will shift to the actual changes they are making in the mandates they give their internal and external staff, how they monitor hidden risks and incentivise performance over the longer-term— namely all the things which really define long-term, responsible investors.  So far at least, most asset owners don’t want to talk about these practical details and PRI is taking a softly softly approach based on self-reporting.

Campanale, however, is a sceptic: “Voluntary change through initiatives like PRI is too slow. It tends not to lead to a reduction in the quantum of capital deployed into fossil fuels or their main users. If SRI factors really are important to long-term sustainability of the capital markets themselves, and I think they are, they need to be enforced by regulatory reform. One measure would be for the IPO documents of the companies in the fossil fuel space to simply disclose the magnitude of the embedded C02 in the reserves they are bringing to market.” Even the top-ranking McKinsey & Company asked in a recent report  on curbing climate change and sustaining economic growth “How can we create a system with the institutional stability required for businesses to make long-term decisions?”

Getting involved in public policy

Some asset owners have gone beyond engagement with companies to express their concerns about the future health of the economy in which they earn their returns.  The fancy technical phrase for this is “universal investing” but the principles are well accepted with heavily diversified asset owners.

Major funds in the US have started calling on the their government to take steps to mitigate the effects of climate change, on the basis that this will be essential to protecting the economy from negative impacts that would depress earnings. The importance of the government’s role in ensuring a healthy economy has been boosted by interventions in this year’s financial crisis.

At the end of July, for example, a group of 43 investors with $1.5 trillion in assets, organised as the “Ceres Investor Network on Climate Risk”, were lobbying Congress to extend renewable energy and energy efficiency tax credits.

Ceres has also led a group of U.S. investors who want more information on climate-change risks and they have petitioned the Securities and Exchange Commission to force companies to disclose global warming risks to profit. They were supported by New York Attorney General Mario Cuomo and the comptrollers of New York State and City; the California state comptroller and the huge California state government and teachers’ pension funds; and Florida’s chief financial officer.

In August Xcel, one of the largest builders of coal-fired power plants in the US, signed an agreement with the New York Attorney General to provide investors with detailed warnings about the risks that global warming poses to its business.

This is the first of its kind in the US. It could open a new front in efforts by environmental groups to pressure the energy industry into reducing emissions of the greenhouse gases that contribute to global warming.

The policy settings make all the difference to investments.

As ABP’s Lake says “If companies faced tougher limits on their carbon dioxide emissions or there were stronger incentives for energy efficiency then a whole panoply of attractive new investment opportunities might open up. In that sense we are very interested in the policy environment and we are starting to have discussions with policy makers about exactly those things.”

Insight Investment’s Sullivan says investors believe the required changes can be made. “The EU gives us hope that it can be done. It has proven you can have a $30 per tonne carbon price and the world won’t fall in. Investors are supportive of the EU position on climate change.”

Kevin Parker, global head of Deutsche Asset Management, argued in the Financial Times earlier this year that “A carbon price of €100 looks inevitable. A higher carbon price will force companies to make radical changes to their business models (this has already begun in the European utility sector).”
Bruce Duguid, head of investor engagement at the UK’s Carbon Trust, said changes to the Kyoto protocol due next year will force many companies to take the climate change more seriously.

"There will be some ambitious targets and changes that will have to take place across industry. Climate change could start the next industrial’s both an opportunity and a threat," he added.

Governments seek funds to retool their economies

Governments are looking to those long term investors to fund the works required to address climate change.

Globally, the amount of money needed to meet carbon reduction targets has been estimated in the trillions of dollars with pension funds considered a prime source of potential investment. Their long-term investment horizon is seen as ideal for investing early and consistently in the companies that will produce profitable clean energy solutions.

In June, UK Prime Minister, Gordon Brown, announced plans to build up Britain’s clean power supply in order to reach the EU-imposed target of producing 15% of the country’s energy from renewable sources by 2020. He said it would require £100bn of investment from the private sector, which the government will encourage with financial incentives.

In July the European Commission’s Institute for Energy floated a €340 billion plan for solar energy generation around the Mediterranean, linked to Europe via a major new power grid. Within weeks rumours were circulating that France’s Sarkozy was courting private capital so he could announce a sustainability initiative during his term as President of the EU. 

Important as this aspect is, what governments and asset owners haven’t even started to consider is that pension funds and especially national retirement funds are fundamental to the economic well being of their countries – they are the economic backbone for a large part of the population. If there is a "carbon crunch" because governments leave things too late and then are forced to act quickly because there simply is no alternative, the shock to the investment system could be very serious. Lessons need to be learnt from this year's crisis, in particular how known regulatory weaknesses were addressed only after the sub-prime meltdown had started.

A changing mindset

The Prince’s P8 initiative is just the latest manifestation of the trend among pension funds to take a macro view of their role in the economy.
Pension fund assets continue to grow rapidly. According to Watson Wyatt, the assets of the world’s 300 largest pension funds  stand at US$12 trillion — and this figure is rising by 14% a year , compared to a total of global assets under management of some US$62 trillion . The Conference Board reports that institutional investor ownership of companies in the Fortune 1000 has increased to 76 percent. As an Oct 2008 OECD submission by the NSFM  says “Pension fund management decisions now not only affect the best interests of fund participants but of the majority of our planet's population”.

As these funds own a larger and larger slice of the global economy they are beginning to see that the sustainability of returns depends on the sustainability and health of financial markets.

At least some are now embarking on a new approach; not just the odd SRI fund or celebratory company engagement, but investing with an eye on their responsibility for the health of the overall economy from which they get their returns. 
Some will say “about time”, and they may be right, but the shift is far from secure. Everyone who cares has an interest in tending these green shoots.

What does the financial crisis mean for responsible investment?

Responsible or sustainable investment is about getting returns over the longer term, about avoiding short-term benefits that sacrifice the medium and long-term.
Most commentators agree that the current crash is rooted in the focus on short-termism over long termism. Of rapidly expanding sub-prime portfolios with, it's now clear, not enough focus on the sustainability of returns; of incentive schemes that demanded sacrificing long term outcomes by maximising quarterly results; of pushing leverage to the max without allowing for inevitable market shocks.
We need incentives, governance and regulation aligned to recover the balance between sustainable investment and the necessary energy of liquid markets.
The crisis has shown that longer term horizons require looking at the ecosystem supporting investments and at ensuring economies will be robust enough to continue to give us returns. We know that improved governance gives, on average 1-2% better returns over the longer term ; we know from the Stern Report that tackling climate change will costs the economy 1-2% of growth versus not tackling it costing us 10% of growth.
The crash is more likely to push back the extreme short-termist virus that has infected society, and shift funds to responsible investment.

The Prince’s P8 mission

The P8 program – echoing both its target, the G8, and its sponsor, the Prince – is being run out of the University of Cambridge Programme for Industry and the Prince of Wales’s Business and Environment Programme.

Prince Charles has taken a personal interest in climate change issues and how they can be solved with the help of capital.

In September, 2007 he brought together a group of 37 UK insurance companies to launch ClimateWise, an initiative to tackle climate change and encourage responsible environmental behaviour by insurance clients.

P8 in fact now has 10 funds from five continents involved (but they’re keeping the P8 name): three from Europe, three from Asia, three from the US and one from Australia.

Each fund is huge; so big that they don’t have many opportunities to try and stock pick their way out of downturns; they are acutely aware that the health of the financial markets will parallel their own health. They see climate change as a major threat to the health of markets, and thus to long-term returns on investments.

Aled Jones, Co-Director of the Prince of Wales's Corporate Leaders Group, says that the lead funds are now planning to recruit others through a series of regional meetings of funds, with the aim of developing a larger “P80”.

Global policy makers are being lobbied to develop the best possible regulatory and financial environment that would enable pension funds to start using their financial muscle as long-term investors to increasingly take stakes in companies developing sustainable energy solutions.

The action plan is expected to outline the scale and type of investment needed in companies specialising in renewable energy and carbon dioxide emission reduction technologies in order to meet international targets. It will then suggest how private investor capital could start to meet some of these investment objectives given the right legal framework.

Norwegians shows the way

The Norwegian Pension Fund – Global - is the world’s second largest (US$370 bn), funded with petroleum tax, licence and royalty revenues. Global is classed as a Sovereign Wealth Fund (SWF).

Sovereign wealth funds (SWFs) are funds controlled by national governments and invested in international securities, against which the government does not have any liability.

At end of 2007 the total money in SWFs was estimated at $3 trillion . This is forecast to reach $10-12 trillion by 2012, or over 15% of the global equity market capitalisation.

Global actively engages in improvement of the ESG behaviour of its investees. It also has a negative screening and divestment policy, which, for example, led to its divestment from Wal-Mart, the US supermarket giant, due to labour issues.

Funds such as the Norwegian and New Zealand SWFs cite both higher returns and national values as the reasons for their ESG focus.

In September Global put Rio Tinto on its investment black list and sold its €600m worth of shares because of allegations of serious environmental damage at the world’s largest gold mine, Grasberg, in Indonesia.

The Norwegian Ministry of Finance, which oversees the exclusion of companies from the fund’s investment portfolio, said it had lobbied the company, but had been given no indication Rio Tinto would change its policy.

Its boycott of Rio Tinto will be followed closely by institutional investors worldwide, many of whom regard its well-researched exclusion decisions as a proxy on companies they should avoid investing in.

On another front, a group of Norway’s largest institutional investors in August launched the “Sustainable Value Creation” project . Their aim is to influence Norwegian companies to develop sustainably while creating long-term, value. The group has a massive €2,700 billion under management, of which €1,000 billion is invested in Norway.

Amazing stats

- Assets of the world’s 300 largest pension funds  are US$12 trillion — and rising 14% a year , compared to a total of global assets under management of US$62 trillion.
- Total funds under management of the world’s largest 500 investment managers reached US$63.7 trillion at the end of 2006.

- In 2005 institutional investor ownership of companies in the Fortune 1000 increased to almost 70%

- At the end of 2007 assets of the top 11 pension markets amounted to 82% of global GDP, up from 64% 10 years ago .

- “Sustainable investments” represent 8% of the portfolios of high net worth individuals in Europe . This will grow to 12%, or one trillion euros, by 2012.

- SRI assets under management in the Dutch market have increased by a 816% in just two years ,

- Economist Sir Nicholas Stern estimated, in his landmark 2006 report into climate change, that global warming could shrink the global economy by at least 5%, up to 20%. He also said that taking action now would cost just 1% of global GDP (US$0.65 trillion).

Get It Right Dad!

The finance industry loves an acronym at the best of times. To impress your colleagues you’ll need some basics:

SRI = Socially Responsible Investment
ESG = environmental, social and governance
SWF = Sovereign Wealth Fund
P8 = Prince of Wales’ pension fund alliance
PRI = UN’s Principles for Responsible Investment