Till, a principal, at Premia Capital Management, LLC, analysed several case studies and looks at risk management at large institutions, proprietary trading firms and at hedge funds. The research is a chapter dealing with commodity derivatives trading risk management in Risk Management in Commodity Markets: From Shipping to Agriculturals and Energy.

View this research here: Case Studies and Risk Management Lessons in Commodity Derivatives Trading

Throwing down the gauntlet was GMO asset-allocation team member James Montier, who outlined what he saw as the key flaws of finance to members of the institute.

The fallout from the financial crisis was a point debated throughout the recent 65^th Annual CFA Institute Conference in Chicago. Opinion was divided on whether the key building blocks of financial theory remained intact or had been fundamentally undermined by the events of 2008.

Montier told delegates that the four bads – bad behaviour, bad models, bad policies and bad incentives – explained the causes of the financial crisis and warned that the many of these key failings remained.

Montier honed in on the widespread use of risk measured by value-at-risk as an example of where investors were lulled into a false sense of security and/or ignored clear signs of growing risk due to an overdependence on finance modelling and theory.

“Using VaR is like buying a car with an airbag that is guaranteed to fail just when you need it, or relying on body armour that you know keeps out 95 per cent of the bullets,” Montier says.

“VaR cuts off the very part of the distribution of returns we should be worried about: the tails.”

He points to systemic problems if VaR is widely adhered to, with investors locked into pro-cyclical behaviour.

This would occur when the commonly used trailing correlation and volatility inputs to the model indicate lower risk or lower VaR, encouraging investors to increase leverage. Similarly, when VaR rises, investors are likely to collectively deleverage, further amplifying the market cycle.

The adoption of VaR by regulators encouraged bad incentives, according to Montier.

On the back of intense lobbying from powerful banking interests, VaR was extensively used as a means to determine capital adequacy and drove a surge in leverage in the banking sector.

Montier says volatility was a poor measure of risk, and pointed out the build-up of leverage in the financial system was also one indication of increasing risk.

In finding solutions to the causes of the financial crisis, Montier calls for investors to abandon their obsession with the concept of optimality. Rather than trying to construct optimal portfolios, investors should instead aim for robust portfolios.

He advised investors to treat financial innovation with suspicion and be mindful of the limits of financial models.

“All financial-model underpinnings and assumptions should be rigorously reviewed to find their weakest links or the elements they deliberately ignore, as these are the most likely source of a model’s failure,” he says.

To watch  Montier’s presentation to the the recent 65^th Annual CFA Institute Conference in Chicago, click here.

The strategy paper, presented to and endorsed by the board, explains the fiduciary framework the fund has adopted to integrate sustainability across the entire fund and sets out the themes and visions for the future.

Anne Simpson, director of corporate governance at the fund, says one of the interesting questions for a fund as big and complex as CalPERS is “how do you actually get this done?”

“This is a new strategy for a total-fund approach with practical impact. It has been a two-year project, it takes time, so be patient,” she says.

In developing a total-fund approach, it was essential to get buy-in from all aspects of the fund at the outset.

The fund’s corporate-governance program has been overseen by a working group that has representatives from all the key constituents in the business, including the chief executive, the president of the board, the chief operational officer and head of external affairs.

“This allows the fiduciary, investment and all aspects of the business to be across it. This is critical to develop this new strategy,” she says.

“There is a question in the industry about whether the governance people sit in the investment team, legal or in a separate division, the answer is yes, in all of them.”

The outcome of the report is that implementing environmental, social and corporate governance (ESG) is now a strategic goal for the investment office, and it is a board commitment, she says.

“This won’t work if we can’t get the F into ESG,” she says. “It sounds like I’m swearing.”

Until Christmas, Simpson’s corporate-governance group of around 20 people sat within the global equities asset class. That has now changed and they work across asset classes.

“Previously we were in global equities, but that didn’t allow us to connect on issues across other asset classes, such as private equity. This move was made just before Christmas, and it is one of the moves we’ve made internally to implement the sustainability plan.”

At the same time the sustainability plan was being formed, the fund conducted its triennial asset-liability-modelling review.

External matters

It now manages assets in three buckets: growth, which includes public and private assets; income; and inflation hedges. The management of ESG is done within these different buckets and the appropriateness of the strategy assessed on each.

“The working group across asset classes had a representative from each, and the commitment of each asset class and a critique of the vision was done on economic grounds. They assessed the vision and how to link that on to an investment strategy,” she says.

“We have an economic view that wealth creation is through financial, human and physical capital and that became the intellectual framework for ESG.”

Each of these three elements – financial, human and physical capital – was then assessed in each asset class.

CalPERS still faced the enormity of how to prioritise these forms of capital in ESG implementation, and for clarity it benchmarked the fund through an international group of peers.

It communicated directly with 11 funds, all of which had more than $200 billion, including Norges Bank, Government Employees of South Africa, Previ, Ontario, PGGM and BT.

From that process clarity of how to implement a strategy became clearer, it prioritised one mission for each of the different areas.

Climate change became the theme for the environmental consideration. The reasoning was it affects all asset classes and CalPERS believes as a mega-fund with long-term liabilities, it will be impacted by climate change.

For social issues, priorities and human capital, talent management and rewards, human rights and fair labour practices across the entire supply chain will be a focus.

And for governance, alignment of interest is the key focus.

“It’s not everything, but we can’t do everything. We had to do something that speaks to our size, global exposure and the long-term nature of our liabilities,” Simpson says.

“Each asset class developed a couple of specific things before now and the end of the financial year.”

Internal considerations

In addition, another project is underway, a “manager’s expectation” document across the total fund.

“We have a complicated structure with internal management of public assets as well as external managers. If we think ESG has the potential to effect risk then we need to be consistent with expectations of internal and external experts. An expectations document is the next project to start next week.”

“CalPERS is in a leadership role. Rather than small portions of capital to the space, we want managers to look at risks and opportunities,” Simpson says.

CalPERS will also issue a request for proposals next month to review the “evidence” of the effect of ESG on risk and return. This will set the scene to commission new research, which ultimately will identify data and create a matrix to integrate into financials.

The fourth project, in what Simpson describes as a “mighty amount of work to do”, is to review the more than 110 initiatives and statements across the CalPERS portfolio.

This will be developed into a unified statement of principles for the entire portfolio.

“We have been doing a lot of rethinking about the long term, the fear of sustainability of returns, and the fundamental ability to pay pensions,” Simpson says.

Simpson says CalPERS has been proactive in leading by example internally.

It has cut its own greenhouse gases by 30 per cent between 2008 and 2010, more than 90 per cent of its printing and writing paper come from recycled sources, and it has conducted a governance overhaul, which includes in an external-board evaluation this July.

“We are willing to take those things on,” she says. “Asset owners need to act and engage intelligently on market level reforms. We need a broader vision.”

As with any integration process, empowerment is crucial; for integrating environmental, social and corporate governance (ESG) into investment processes it is no different.

Mills is working on the premise that ESG information can be turned into alpha and it rests with empowering the investment decision-makers.

His solution is a labyrinth of players which are involved in a continuous multi-directional loop of information. But the secret, he says, is to leave the responsibility for decision making, with the fund manager.

The Highland Good Steward Global Bond Fund, which uses Pimco as the sub-advisor, has an emphasis on changing the behaviour of borrowers in a long-term sustainable way, but also to remain flexible enough to maximise short-term opportunities.

The key, Mills says, is to provide ESG signalling to the underlying manager in order to guide its long-term decision-making in sustainable companies without limiting its shorter term investment discretion.

The philosophy is that the outcome will be achieved by collaborating with the manager rather than replacing the manager’s judgement.

“Philosophically, we do want a sub-advisory based on traditional asset management with a track record. But we want to stimulate their thinking, not change their thinking, for ESG, but ask them to think deeper,” Mills says.

“What underpins all of this is that you don’t tell managers what to do. You hire the best managers, listen to them and work with them.”

There are a number of differences in this approach that distinguish it from simply overlaying a process with ESG information on a company.

How data signalling and engagement work
Highland Good Steward Management (HSGM) has developed a consortium of research firms that provide company ESG and socially responsible investment (SRI) information. This is fed to the manager as additional information for securities selection, of which the manager retains ownership.

The research consortium includes ECPI, Eco-Frontier, MSCI, CAER, EIRIS, and SocioVestix Labs, and produces a grading on 7000 companies for the individual elements of environment, social and governance, as well as a consolidated ESG rating.

“The data from these providers acts as a signal for the portfolio managers to use, alongside financial and other data used for analysis.”

“Highland will not limit Pimco’s investment choices by negative screening. Instead the aim is to collaborate with the manager in their search for additional alpha by integrating ESG considerations into their investment analysis.”

But it doesn’t stop there. Another element of the process is the use of a service, provided by Hermes EOS, to engage with corporations before and after the investment decision.

Colin Melvin, managing director of Hermes EOS, says engagement is a way of looking at longer term decisions and aligning the client.

“We have an engagement indicator that measures the quality of the company and its responsiveness to engagement. If you are considering it as part of the normal decision-making, then you want fund managers to do it as they do other things. But you can also use it to challenge managers on their decisions,” he says.

“For many, these issues have been taboo for funds managers. They have been overly impressed for too long by short-term decisions.”

Hermes engages this way with about 500 companies globally.

For this relationship, the engagement starts with investors suggesting themes. These currently include climate change, access to and utilisation of water, operations in troubled regions, supply chain, and access to medicines.

Hermes then suggests to HGSM certain companies that may have potential for engagement breakthroughs. This list is then taken to Pimco for the manager to analyse as possible portfolio holdings on the basis of their investment thesis.

If Pimco invests in these companies, which is at their discretion, then Hermes engages in focused impact engagement in order to accelerate the corporate and potential changes in share value.

It also works the other way: if Pimco invests in companies outside the HGSM research-consortium database, then HGSM can request that a research report on the company be performed by one of the research companies, and Hermes may also engage with that company.

“It is incorporating the manager in the process. We can take all the holdings in the fund and download them into research,” he says. “Over time we can see how the portfolio is moving towards E,S,G or not.”

Case studies on the HGSM platform
Mills points to the example of two companies as to how the process may work. On a corporate level, the companies would be analysed on a theme and how they engage with Hermes, and then ranked.

Say, for example, company A has improved its water management, which will be reflected in a good environmental score, but it has a tight yield spread. Compare this to company B, which historically hasn’t taken Hermes seriously on water engagement and has a low environment grade, but its yield spread is higher.

In recent times when Hermes engages with company B, it now wants its senior management to be involved, which is sending a different signal about how it is approaching the issue. HGSM sends the information to Pimco, instructing that it is a signal to be fed into the analyst’s process.

“They love that,” he says. “Everyone wants to prove ESG works. It entirely depends on the time frames, the same way for example value and growth does. We have been attaching the wagon to the wrong thing and setting ourselves up. The ideal way is corporate engagement – it is the only way to determine a company’s DNA.”

“You can be more explicit in engagement than data providers can be on performance. But the engagement partners are selected not with an eye to embarrassment but effective engagement.”

“We would go back to Hermes and say that water engagement is important to my client and Pimco bought 500 bonds on that basis. We will also share with the company we’re engaging with.”

“This is a long-term monitoring process that makes sense, it’s better than trying to prove alpha exists,” he says.

Mills is now transferring all the data from this platform to Microsoft Cloud, which makes it immediately customisable.

Scott, who spent his career managing the balance sheet at Microsoft, Dow Chemical, the Alaska Permanent Fund and now investment consultant Wurts, says institutional investors want to manage returns, which is impossible.

“Returns are a function of animal spirits. They swing between fear and greed. Do companies really change in long-term valuation over the weekend?” he asks.

And while he points to investors such as Warren Buffet who “thinks about risk constantly with his capital”, Scott says many institutions are not thinking about risk.

“There is poor governance, and poor risk management. A lot of losses experienced by funds throughout the financial crisis were a function of missing simple risk-management concepts like custody of collateral and liquidity. You didn’t need fancy mathematical risk models instead of common sense you can get in Omaha.”

Scott says that institutional investors are behind in their risk-management practices.

“Many asset-management firms and hedge funds have far superior approaches to risk management than institutional investors. There are steps to take and it has to start with governance, and then understanding the risks you are taking.

Change of hats
As chief investment officer of Alaska, Scott managed a number of strategic partnerships with service providers, and now has flipped to the other side of the table to be providing those strategic partnerships.

“It is the same hat and we have switched it around,” he says.

Scott says he works with funds at an organisational level discussing a new approach to asset allocation, that is really risk allocation, but before that there needs to be a discussion around knowing the funds’ risk tolerance, which is a lot more than standard deviation.

“Two different funds could have the same investment objective but the exposure for each is different because of what it “means” to them in the overall context.”

“We take the objective and liability of a total enterprise and manage a diversified portfolio relative to that,” he says. “We show them how we manage that, take an active risk budget around that and how we manage that risk budget and how investments change.”

While a few managers may have similar propositions, what Wurts does is have a service agreement alongside the investment-management agreement, whereby that knowledge will be applied at the portfolio level.

In other words, Wurts is transparent about the risk of the discretionary portfolio it manages, but it also communicates that thinking at the organisational level, feeding back advice on organisational and governance change management.

“We have an investment-management agreement and a service-level agreement, which defines in writing what the strategic partnership program is designed to accomplish and how it will operate.”

The key to good governance, Scott says, is a clear delineation between who has authority, responsibility and accountability.

Scott says some concepts applied during his tenure at Alaska were concepts and methods developed in treasury management learnt at Microsoft and Dow Chemical.

Resourcing was an obstacle to applying more than about 60 per cent of the concepts.

The current chair of the Microsoft investment-advisory committee chair is Mohamed El Erian, co-chief investment officer of Pimco, demonstrating the complexity in the portfolio.

Mark Wiseman, CPPIB’s executive vice-president of investments, told delegates at last week’s Milken Institute Global Conference 2012 in Los Angeles that the fund had chosen not to invest in the bonds of European governments.

“If we buy a German bund all we are really getting is the full faith and credit of the German government and we have all learnt that that isn’t worth much,” Wiseman says.

“On the other hand what we have is a hard asset, for example we will buy the gas distribution in Germany and we will make a substantial spread on a regulated asset that is essential to the operation of the German economy.”

Wiseman says that the fund can achieve a return of upwards of 500 basis points above German bunds.

“We will make a substantial spread over German bunds and, quite frankly, I would rather own the gas pipes than a promise from Angela Merkel. I think this is a better risk and we are getting paid 400 to 500 basis points over bunds.”

Make-up of the maple
Fixed income makes up 36.1 per cent of the overall portfolio, and includes marketable and non-marketable Canadian government bonds, corporate bonds, other debt, absolute-return strategies, money-market securities and debt-financing liabilities.

Infrastructure makes up around a third of CPPIB’s inflation-sensitive asset bucket, which also includes inflation-linked bonds and real estate.

Inflation-sensitive assets make up 17.7 per cent of the overall portfolio.

The long-term view
Wiseman told delegates CPPIB was a long-term investor that tried to formulate investment strategies around a 25-year time horizon but also framed decisions in terms of a 75-year outlook.

In keeping with its long-term outlook, Wiseman told the conference that the fund was much more concerned about the risk of inflation than deflation in the world economy.

To do this, the fund has extensive real estate and infrastructure holdings that act as a hedge against inflation and is also looking to innovative ways to invest in commodities.

“Being a Canadian fund, we are naturally long commodities, and are increasingly buying commodities in the ground and thinking about an investment program where we are actually buying reserves, literally in the ground, that will be extracted in decades to come.”

Sharing the stage with Wiseman was Joseph Dear, chief investment officer of CalPERS.

Both Dear and Wiseman pointed to a movement away from traditional asset allocation models, with investors increasingly looking use a risk-based approach.

“It amazes me that people still are talking about asset allocation. If there is one thing we have learned from the financial crisis, it is that assets – when you least expect it – all tend to behave the same way or all tend to behave differently. But when you care about it the most, they don’t behave the way you expect in normal circumstances,” Wiseman says.

“What we have done and been thinking about for quite some time – and others are beginning to follow – is trying to get away from asset labels.”

CalPERS goes the Canadian way
CalPERS’ Dear told the conference that Canadian funds had been leaders in adopting a risk-based approach, and noted CalPERS was not as far down the road as its Canadian counterparts but was heading in the same direction.

The $233.6-billion fund has implemented an alternative-asset classification that attempts to address major risks the fund could face and protect against significant capital loss as a result of a major market event.

The restructure of asset classes resulted in assets being classified in five main groupings: growth, income, inflation, real assets and liquidity.

The fund also has an absolute-return strategy component of the overall portfolio.

The new structure allows the fund to allocate according to how these particular assets perform in low and high-growth markets, and the prevailing inflation environment.

Both the liquidity and inflation-hedging portfolios have a 4-per-cent target allocation.

Dear says that CalPERS risk-management processes are now aimed at protecting capital during major market events and providing a framework for assessing the portfolio in its entirety.

“We are shifting the whole approach to our capital allocation from asset class, such as this much equity, this much fixed income and so forth, to really a risk-factor based approach,” he says.

“Now, our friends in Canada have been pioneering this and showing the way in how to move away from the classic approach of the past 30 years and trying to figure out how you construct a portfolio in an environment that is going to be much tougher than we have had before, and how to get a better understanding and management of risk to protect yourself against a big drawdown.”

Wiseman told the conference that traditional asset labels bunched different assets such as government and corporate bonds together, despite the fact that they may have very different underlying risks.

“A bond could be a US government bond or a corporate distressed bond, which is, essentially, equity waiting to happen. But you would put both of those in your fixed-income portfolio and you then used to say I have this much allocation to bonds. It is nonsensical.”

Likewise, Wiseman says that CPPIB does not make a distinction between private and public equities.

“We allocate 65 per cent of our portfolio to equities regardless of whether it is public or private and look through these asset labels. I think this has got to catch on, not just for institutional investors, because this isn’t a particularly complicated way of looking at the world.”

CPPIB typically thinks of private equity as having a 1.3 beta, according to Wiseman. Dear says that CalPERS looks for a return of about 300 basis points above its public market benchmarks as the premium for the illiquidity of private equity.

As part of celebrations of the 50-year history of the CFA Charter, a panel of eminent institute members discussed the future of the investing profession against a backdrop of recent scandals on Wall Street and the resulting lack of trust in investment managers after the financial crisis.

Participants included Abby Joseph Cohen, president of the Global Markets Institute and senior investment strategist at Goldman Sachs, who highlighted the globalisation of the industry as one of its greatest challenges and opportunities.

Cohen was part of a panel that included Morgan Stanley Smith Barney managing director and chief investment strategist, David Darst, and 29-year veteran of Greenwich Associates, Charles Ellis.

In a nod to some of the much-publicised failings of the investment-management industry, Cohen says the industry “sometimes forgot” to act as a responsible intermediary in the allocation of capital.

“We sometimes forgot that our role is to serve as an intermediary between those entities on this planet who are saving and those entities that need capital to grow further,” she told delegates.

The behaviour of Goldman Sachs and other Wall Street banks in the lead up to the financial crisis has attracted widespread criticism.

Cohen also noted that the spread of economic growth across the globe was increasing opportunities for the industry and also the demand for financial services.

“There will be a high level of financial services needed. The globalisation of this industry means we now need to operate in so many different locations, and we need to think about the right regulatory and professional structures,” she says.

Beware greed and fear

Ellis was another on the panel who called for the industry to reflect on its relationship to its clients, predicting that exponential growth in fees would lead to a stark reality check for the investment profession.

“Average fees for institutional investors have risen and risen, and are up from around 10 basis points to up over more than 100 basis points,” Ellis told delegates.

“There are a lot of different variables involved but this is an aggregation and it is much the same for individuals. While fees have increased, much to our enjoyment and satisfaction, the incremental returns over and above an index fund have come down, and they may have already passed [fees]. While I think they passed several years ago, if they haven’t, they will pass and there is very little preparation for this difficult reality.”

Ellis called for the managers to look for growth opportunities in the counselling component of investment advice. He says managers must better understand the psychology and behavioural nuances of their clients and specifically tailor investment strategies within this framework.

Darst was also taking a global outlook for the industry, describing the current challenges facing it as part of a period of “catharsis, cleansing and purging” from two decades of bullish markets.

He says investment professionals have to be concerned about the psychology of investing and human behaviour.

“As investors, we need to be aware of the fears that are deep in the viscera of our clients around the world,” Darst says.

After the financial crisis, Darst thinks clients are more worried about systemic risk and preserving capital than they are about asset allocation.

“Greed and fear – that is what makes or breaks fortunes – excessive greed and excessive fear and getting caught up in it,” he says.

A founding president of Morgan Stanley Investment Group, Darst believes the industry is in a period of epic change that involves both a baton pass to another generation of professionals and being rapidly re-shaped to meet the growing opportunities from an emerging middle class in developing countries.

Curry and Kama Sutra

He points to projected population growth in countries in Southeast and Southern Asia. Populations in this region, which includes Bangladesh, India, Indonesia, Malaysia, the Philippines and Vietnam, are projected to collectively grow by 1.3 billion in the next 40 years.

“It took 6000 years of eating chicken and rice to make 1.3 billion Chinese and in another 40 years of eating spicy curry and advancing the Kama Sutra techniques these countries are going to create another China,” Darst says.

Cohen and Darst told delegates that despite the financial crisis, the fundamentals of investing and the importance of valuation in making investment decisions had not changed.

The industry learnt the hard lesson of managing liquidity risk as a result of the financial crisis, Cohen says, but the foundations of investment theory remain intact.

“Has the theory kept up with what is going on? I would argue it has because most of the basic tenets of measuring valuation and risk properly are unchanged,” Cohen says. “But practitioners, all of us in this room, have the responsibility of updating the manner in which we do that measurement.”

Darst says clients want managers to have a clearly defined investment philosophy and points to his own key tenets of investing as:

1)      Asset protection is paramount

2)      Correlations are critical

3)      Reversion to the mean

4)      Assets are driven by fundamentals, valuation and psychology

“Don’t sell me a scenario, sell me a price. At the right price Greek bonds are safe,” he tells delegates. “At the wrong price, US Treasuries are one of the most risky investments known to humankind.”

A report on the progress that some of the world’s biggest companies are making towards achieving sustainability by 2020 has shown many US companies are failing to embrace sustainability at a pace necessary to meet the 10-year road map.

The 21^st Century Corporation: The Ceres Roadmap to Sustainability measures how companies are responding to environmental and social challenges such as climate change, water scarcity and supply-chain conditions.

Researchers found that some of the 600 companies assessed were showing leadership but overall there was significant need for improvement.

The report, conducted in conjunction with Sustainalytics, was launched at the Ceres annual conference in Boston last week.

President of Ceres, Mindy Lubber, and chief executive of Sustainalytics, Michael Jantzi, say companies are missing a big opportunity by not fully embracing sustainability.

“We see it as a world of opportunity for companies to improve competitiveness, realise large savings through energy efficiency, invest in their workers, strengthen their supply chains and, in many sectors, reap the benefits of the enormous investment opportunities in clean technology and clean energy,” they write in the report.

According to a press release, Anne Stausboll, chief executive of CalPERS, echoes the sentiment, saying: “The future will belong to innovative companies that understand that building long-term shareholder value and being an industry leader requires the integration of sustainability principles at every level, from the C-suite to operations and throughout supply chains.”

Ceres directs the Investor Network on Climate Risk (INCR), which includes more than 100 institutional investors with about $10 trillion in assets.

Andrea Moffat, vice president of corporate programs at Ceres, says there is an opportunity for institutional investors to proactively ask companies about their environmental, social and corporate governance (ESG) risks and opportunities.

“Companies respond when their owners ask questions but they are not hearing from enough investors. The Roadmap to Sustainability analysis indicates that investors have a significant opportunity to engage directly with companies on their sustainability disclosure in financial filings, annual meetings, investor road shows as well as ensuring that boards of directors have clear oversight,” Moffat says.

“If environmental and social performance was raised as part of every investor engagement with business, we would expect to see a much larger number of companies developing sustainable business strategies that account for their full range of risks and opportunities.”

Similarly, the EIRIS Sustainability Report looks at the sustainability performance of the 2063 companies in the FTSE All World Developed Index and applies its newly launched EIRIS’ global sustainability ratings to measure the extent to which those companies are tackling sustainability challenges.

The analysis reveals some significant differences in the extent to which companies are on track to tackle these.

“Investors need to be aware of these differences and also the initiatives, drivers and strategies which are likely to be the most effective in engendering improvements in corporate sustainability performance,” the report states.

For example, ExxonMobil, the world’s largest oil and gas company by market cap, only ranks 41 out of 84 companies in that sector and so does not show the same level of leadership as some of its smaller peers.

Similarly, Apple, ‘one of the world’s largest companies and a financial superpower’ scores D in EIRIS’ analysis, which places it among the worst performers of the technology hardware and equipment sector.

EIRIS works with more than 100 asset owners and asset managers globally to create customised ESG ratings, engaging with companies and creating specific funds for their clients.

Facts and figures

In the Ceres report’s four-tier assessment system, just a quarter of all companies surveyed were in the top two tiers for progress on governance, while 24 per cent achieved some degree of meaningful stakeholder engagement.

On corporate-performance metrics, only 13 per cent of the companies evaluated on human rights policies and programs were ranked in the top two tiers. And just a third of the 600 companies had time-bound targets for reducing greenhouse gas emissions in direct operations.

However, there were some companies that stood out for their leadership.

Alcoa, Xcel and Intel were noted for sustainable corporate governance practices; Baxter and Ford were setting a high standard in stakeholder engagement; and Exelon, Nike and the Coca-Cola Company were ahead of the pack in performance on metrics for reducing environmental impact and improving workers conditions.

Intel is cited specifically for linking executive and employee compensation to company environmental goals such as reducing energy use and greenhouse gas (GHG) emissions; in the two years since it started the program, the company has cut energy use by 8 per cent and GHGs by 23 per cent.

Coca-Cola is credited for being on track to meet its ambitious performance goal of improving water efficiency by 20 per cent by the end of this year (against a 2004 baseline).

Other cutting-edge performance examples: Nike’s new partnership to implement a water-free fabric dyeing process, Kohl’s Department Stores achievement of net-zero greenhouse gas emissions at its stores, Pinnacle West using recycled urban wastewater (about 20 billion gallons a year) to cool its Palo Verde nuclear power plant and EMC building a new energy-efficient “virtual data center” to move data from physical storage to an entirely virtualized IT infrastructure (the shift has already saved the company more than $23 million).

The top 10 global sustainability leaders

EIRIS has applied its sustainability-ratings research methodology to measure the sustainability performance of 2063 companies from the FTSE AWD Index.

It identifies the top 10 leaders and their business categories as:

Puma, personal goods, Germany

FirstGroup, travel and leisure, UK

National Australia Bank, banks, Australia

GlaxoSmithKline, pharmaceuticals, UK

Roche, pharmaceuticals, Switzerland

Novartis, pharmaceuticals, Switzerland

Phillips Electronics, leisure goods, Netherlands

Deutsche Boerse, financial services, Germany

Novo Nordisk, pharmaceuticals, Denmark

The GoAhead Group, travel and leisure, UK

A recent OECD report looks at some of the barriers facing investors wanting to invest more in the sector, with regulatory uncertainty and a lack of suitable financial products key hurdles.

Sharan Burrow, the head of International Trade Union Confederation (ITUC), is one of those calling for more investment from pension funds.

Burrow says that green investment will lead to green jobs and the ongoing viability of pension funds themselves.

The ITUC recently released research claiming that 48 million jobs could be directly created if green investment was lifted to 2 per cent of GDP in 12 countries over the next five years.

It is “sound business management” to consider how investments would impact jobs and, therefore, future inflows into the pension industry, Burrow says.

“If you see diminishing jobs in your own industry and backyard, which means less money is flowing into your industry, then that has got to be a consideration of risk that would feed into any notion of fiduciary responsibility,” she says.

“It would, therefore, stand up that funds must be conscious of where their own investments may drive a more secure environment for the industry itself.”

The ITUC has identified a tipping point of a 5-per-cent allocation of portfolios to green investments, which it believes would provide enough critical mass to ensure confidence in green investments.

Burrow says the ITUC is pushing to reach this 5 per cent allocation target by 2020.

OECD lowdown

The OECD report handed down in late 2011 reveals that the industry is a long way from this goal.

The Role of Pension Funds in Financing Green Growth Initiatives by Raffaele Della Croce, Christopher Kaminker and Fiona Stewart, reports that pension funds represent $28 trillion in combined capital. But despite the recent growth in socially responsible investing, green investments represent less than 1 per cent of portfolios globally.

The authors find a lack of regulatory certainty, with unsupportive government policies and ongoing subsidies of fossil fuel-intensive industries make most green investments uncompetitive.

“Pension funds and other institutional investors will not make an investment just because it is green – it also has to deliver financially,” the paper finds.

Estimates of how much money would be required to mitigate the effects of climate change vary wildly. The World Economic Forum has estimated that the clean-energy investment necessary to restrict global warming to less than 2°C would be $500 billion per year by 2020.

Another barrier to investment is the lack of financial instruments that would enable long-term-focused institutional investors to make these types of investments.

The market for green investments remains small and illiquid, with investment opportunities concentrated around small start-ups and higher risk venture capital-type opportunities, the report finds.

Researchers find governments could play a role in this regard by ensuring an adequate flow of investment-grade deals at appropriate scale are available.

Public finance could also be invested alongside private capital and there are a range of partial guarantees or subordinated equity and debt arrangements that could make green investing more attractive.

The report identifies green bonds as a particularly effective way of tapping institutional capital, while meeting funds’ investment requirements.

The market size of green bonds is approximately $15.6 billion with these fixed-income securities typically issued as AAA-rated securities by the World Bank, development banks and other entities focused on raising capital for green investing.

The current market in green bonds represents 0.017 per cent of the capital held in bond markets.

“There is clearly scope for scaled-up issuances of green bonds (at least in the tens of billions per year) but if this capital is to be raised through a thriving and liquid green-bond market, transparent politics based on long-term comprehensive and ambitious political commitment is needed,” the report states.

How to go green

However, some of the problems around investing in green infrastructure are not particular to this sector of the economy and are shared by the broader asset class.

Researchers make the point that problems around high fees, a lack of transparency and additional social, political and regulatory risks associated with infrastructure investments also hold back further investment in green infrastructure.

Governments can play a role in this by encouraging infrastructure investment through a range of regulatory and investment incentives.

The report notes that there is potential for countries to leapfrog the development of others through attracting capital to allow them to nimbly make the transition to a green future without the constraint of being tied to old fossil fuel-hungry infrastructure.

The focus on ESG and socially responsible investment and the growing push from asset managers to meet this demand is also muddying the waters of what is a green investment.

The OECD has started working on defining and measuring foreign direct investment as a way of offering support to governments in evaluating the effectiveness of policy.

The researchers say this has the potential to assist pension funds to arrive at a common understanding of what a green investment is.

A potential solution to this problem could involve a recognised ratings agency that could provide analysis of green bonds or funds to ensure that monies are used for green investments.

A backdrop to push for more green investments is the question of the role of pension funds and what their fiduciary duty is when it comes to ESG investments.

Burrow is unequivocal when it comes to what trustees’ fiduciary responsibilities are.

“The world has no choice to change. There are simply no jobs on a dead planet and that means no industry and investment is irrelevant,” she says.

“We need to look at the risk element of fiduciary responsibility, which is a traditional notion, and one that hasn’t played out if you look at the financial crisis and the lack of fiduciary responsibility around the question of analysis of risk that drove us to the brink based on simply accepting somebody else’s word on what products were secure. So, from our point of view fiduciary responsibility, particularly for workers’ capital, has to include risk. If it doesn’t, then fiduciaries are not doing their jobs. The second thing fiduciary responsibility is set up to do is to deliver a return on capital.

Fiduciary duty and green jobs

Expanding fiduciary duty to take in consideration of ESG issues and the broader impact of investments is a hotly debated topic in investment circles.

At a UN-backed investor summit in January, CalPERS chief executive Ann Stausboll called for funds to look beyond just returns to members and push for broader environmental and social action on such issues as climate change.

Other investors, such as Swedish buffer fund AP7, go as far as saying that returns are a secondary consideration to ensuring that investments meet the ethical values of members.

Opponents of this broadening of fiduciary duty beyond the aim of maximising financial returns for members within acceptable risk parameters point to the difficulty in making assumptions around what the values and ethical standards of members are.

Funds may also be taking on an unseen opportunity cost through allocating capital to green investments when other types of investments may generate better returns to members.

Like the OECD, Burrow sees a much bigger role for government in providing a catalyst for investment, saying they must drive a new “new global stewardship” of the world economy.

“We believe that the combination of patient capital and regulatory certainty, where government has to play a role, will mean that these investments will indeed be secure, but also profitable, and contribute to a future where our world is much more sustainable,” Burrow says.

“The issue is what the role for government is, and governments must find a new stewardship of the global economy. We are not suggesting that all of this money should come from government. Obviously, it must come from investors and a mix of private and public capital, depending on the context.”

The ITUC-commissioned research Growing Green and Decent Jobs , which identifies the potential impact of green investing on job creation, was conducted by the Millennium Institute.

The researchers attempted to construct a “green job creation benchmark” for particular industries that could act as a guide for the effectiveness of green investment.

The analysis looked at low, middle and high-income economies, with the institute analysing green-investment scenarios in seven industries.

These included energy, construction, transport, manufacturing, agriculture, forestry and water. The number of jobs created was measured through what researchers describe as quantitative simulations that looked at direct job creation.

A simulation of green investments for a particular country involved a 2 per cent of GDP investment in four key industries over a one-to-five-year time frame.

Industries selected vary via country and the research did not take into account potential job losses resulting from a reallocation of capital on this scale.

The Dutch pension-fund service provider claims it is developing a methodology to measure what it calls “sustainable returns” – the non-financial, societal and environmental benefits derived from its investments.

PGGM will then report to institutional clients how its investment portfolios positively affect the broader society and the environment generally.

Marcel Jeucken, managing director of responsible investment at PGGM, says the fund has been working with Erasmus University in Rotterdam to develop a method to measure the sustainable returns generated through targeted-ESG investments totalling €4.73 billion in 2011.

The measurement of these returns looks to capture both the return on current investments and the expected return on an annual basis of long-term investments.

“This can be done for our focused ESG investments, and this year we are also trying to think through whether we can use this idea to capture societal returns for all the assets we manage,” Jeucken says.

“This is very complicated and will start with some pilot projects, but we think it is increasingly necessary to be able to communicate to our wider stakeholders and especially the beneficiaries of the pension funds we work for.”

Measure for measure

The methodology for targeted-ESG investments aims to measure the impact across eight key areas: employment, local development, capacity building, empowerment, health and safety, material use, ecosystems, and waste and emissions.

The expected impact of each environmentally focused fund is reflected in a score on a scale of -3 for highly negative to +3 for highly positive. Reporting also discloses the social impact of every investment over €1 million in a specific fund.

Its first pilot project to try and measure the sustainability returns in its broader portfolio of investments will be in real estate. This year it has one other pilots planned but PGGM has not decided which asset class this measurement program will be expanded to.

PGGM is a founding partner of the Global Real Estate Sustainability Benchmark (GRESB) database, which records the sustainability of a number of real-estate funds around the world.

The benchmarking system will form a valuable basis from which to measure its sustainable returns generated through real-estate investments.

Jeucken says that government bonds and derivative-type investments will be areas where measurement of sustainable returns will prove challenging.

“This will be a project over multiple years and will be very complicated, but we are also hoping to develop this with others, going forward,” he says.

“We could collaborate or we could go to the market with our thoughts and ask for feedback and wider consultation within the principles for responsible investment, for example. This is a journey and it will take some time to do this.”

The fund will also extend ESG considerations to its broader asset-allocation decision-making processes, Jeucken says.

Previously, asset allocation had been limited to issues around climate change. Work on this included participation in Mercer’s Climate Change Report.

This year PGGM plans to expand the ESG factors it considers when setting its strategic asset allocation.

“Which assets are more prone to ESG risks or opportunities than others and what does it mean for your asset allocation? This isn’t about implementing within your portfolio from a portfolio-management perspective, but more talking about the role of asset owners in terms of how they allocate assets within their strategic benchmark,” he says.

PGGM started a project last year and is applying what it has developed with a view report its progress more fully by the end of this year.

“We will look at expected risk and return and also expected risk and opportunities in ESG factors in the context of achieving our objectives in asset allocation, which is not just high returns but higher and stable returns,” he says.

“Now, we are adding responsible returns to these key asset-allocation objectives and that is quite interesting for us and why we are looking at ESG in terms of asset allocation.”

The environment-focused investment funds include three infrastructure funds. and one offshore wind-power park. In private equity, PGGM works through a fund-of-fund mandate with AlpInvest, which invests in companies developing innovative and proven clean technologies.

PGGM also supports alternative energy through structured credit that finances a range of initiatives including solar and wind projects.

In real assets PGGM invests in carbon credits and sustainable-forestry funds.