ESG gains wider acceptance

ESG has moved to the mainstream of institutional investing from the fringes.

Investment strategies that incorporate environmental, social and governance criteria have been thriving despite the recession, gaining momentum globally in the past several years as investors put a higher premium on extra-financial risks.

“Interest (for ESG) might have been delayed a little through the financial crisis, but it definitely didn't wane and is now on the increase,” said Craig Metrick, U.S. head of responsible investment at Mercer LLC based in New York.

In the U.S., sustainable and socially responsible investing assets — broadly defined as investments that integrate ESG factors, involve the filing of shareholder resolutions or have a mission of community investing — grew 13.3% to $3.07 trillion in the three years ended Dec. 31, 2009, according to the latest figures available from the Social Investment Forum Foundation.

Recent data show even more spectacular growth in Europe, with such assets growing 85% to €5 trillion ($6.5 trillion) from €2.7 trillion in the two years ended Dec. 31, 2009, according to the European Sustainable Investment Forum. Asia lags in comparison, with about $20 billion in sustainable assets, according to a 2010 study conducted by Vontobel Holding AG. However, Asia's sustainable assets are set to grow to about $4 trillion by 2015, according to Vontobel.

“Investors no longer think that there's a trade-off between responsible investing and performance. This is a powerful idea that's taking hold around the world,” said Colin Melvin, CEO of London-based Hermes Equity Ownership Services Ltd., which advises clients on ESG investing with aggregate assets of about £60 billion ($95 billion) globally. EOS is a division of Hermes Fund Managers Ltd., the asset manager owned by the £33.9 billion BT Pension Scheme.

But the shift toward returns and away from the traditional value-based ethical investing has been a cause for concern of some managers.

“I worry that by pushing the performance argument, we're losing the impact argument, which is also very important,” said Paul Hilton, director of sustainable investment business strategy at Calvert Investments, Bethesda, Md. “It is possible to achieve both, but both have to happen simultaneously for (ESG investing) to be meaningful.”

Few institutions have shifted assets into specialist ESG strategies from other asset classes, consultants said. Rather, many pension executives have been implementing ESG overlays, expanding proxy-voting policies and considering other ways of taking into account ESG trends within existing investment portfolios.

Global multiasset managers including Aberdeen Asset Management, F&C Asset Management PLC, Goldman Sachs Asset Management, Newton Investment Management, RCM Capital Management LLC, Schroder Investment Management and SSgA have all expanded their investment teams within the last several years in order to meet client demand for ESG integration, according to interviews with company officials.

“ESG, for us, is risk and opportunity,” said Ulrik Dan Weuder, head of inflation-linked physical assets and social responsibility in investments at the 450 billion Danish kroner ($80 billion) ATP, Hilleroed, Denmark. Over the past several years, ESG has been integrated into ATP's entire investment portfolio, including alternatives such as private equity and infrastructure.

“We don't believe that investments can be judged on ESG factors alone, but as part of an evaluation process,” Mr. Dan Weuder added. “We seriously think that good stewardship and good governance heightens the value of our investments.”

APG Asset Management — manager for the €231 billion Stichting Pensioenfonds ABP, Heerlen, Netherlands, among other clients — began a program to systematically integrate ESG criteria in 2007. That team has since grown to 10 investment professionals — from just one — to address ESG issues “in every part of the portfolio,” said Rob Lake, head of sustainability and governance at APG, Heerlen.

“We don't take a mechanical "tick-the-box' approach, neither is it based on automatic signals,” Mr. Lake said. “On a case-by-case basis, we consider the extent to which the (ESG) characteristics might affect the financial returns of a particular company or even wider issues such as reputational risk for our clients.”

“ESG as an investment proposition is so diverse, so complex, it would be a mistake to look for simple solutions and answers,” he said.

U.S. pension funds are generally viewed by industry experts as lagging their European counterparts in ESG integration, broadly due to higher regulatory and social pressures in Europe to integrate the factors. However, the $226.6 billion California Public Employees' Retirement System, Sacramento, and the $140.1 billion California State Teachers' Retirement System, West Sacramento, have led the nation in using ESG to improve investment returns. (See related story on page 13.)

Corporate defined benefit plans generally do not take into account ESG factors to the extent that public plans do, with some exceptions such as the BT Pension Fund in the U.K. Consultants and managers said the difference is partly due to the higher level of social pressures to invest sustainably on public plans. In the U.S., corporate plans also must contend with ERISA regulations, which are “somewhat unclear in terms of incorporating ESG concerns,” said Chris McKnett, vice president and head of ESG Investing at State Street Global Advisors based in Boston.

“There's a gray area that is holding back (U.S.) corporate DB funds,” he added.

Institutional demand has led more managers into the arena, including alternative managers. Kohlberg Kravis Roberts & Co. launched its Green Portfolio Program with three companies in 2008 and now has 16, or about 30% of KKR's private equity investments, said Elizabeth Seeger, an associate who helps manage responsible investing activities at KKR based in New York. The initiative began through a partnership with the non-profit organization Environmental Defense Fund, where Ms. Seeger was previously a fellow before she joined KKR, to improve sustainable practices at portfolio companies. In 2010, KKR recorded total savings of $160 million as a result of changes to reduce the environmental impact at the companies.

“How (Green Portfolio Program) is differentiated from other environmental management programs is that it focuses very clearly and very carefully on the link between financial performance and environmental performance,” Ms. Seeger said.

Last year, KKR introduced the Responsible Sourcing Initiative, a separate program addressing human rights, labor issues and other ESG factors linked to outsourcing activities in Asia. Carlyle Group also teamed up with the EDF in 2010 to introduce EcoValuScreen, which helps to identify opportunities to improve environmental and financial performance before making investments.

Once mostly confined to developed market stocks, ESG integration is being considered in emerging markets equities, fixed income, private equity, real estate, hedge funds and other alternatives, consultants said. For example, Calvert is working to introduce a green bonds strategy. Several hedge funds, including GLG Partners LP and Auriel Capital Management LLP, are trying to find alpha in ESG.

Daniel Summerfield, co-head of responsible investment at the £28 billion Universities Superannuation Fund, Liverpool, England, see potential in applying ESG criteria to alternative investments in certain circumstances. “One recent initiative at USS is to conduct a due diligence process on the governance structure of hedge funds prior to committing to an investment,” Mr. Summerfield said. USS employs a team of five investment professionals to integrate ESG into the entire portfolio.

“In an ironic way, the financial crisis has been very helpful in terms of what we do. Much of the cause (of the financial crisis) was poor corporate oversight,” said Clifton S. Robbins, CEO of Blue Harbour Group LP, a hedge fund that runs an active ownership strategy based in Greenwich, Conn. Launched in 2004, Blue Harbour has about $1 billion in assets under management mostly on behalf of institutions. The hedge fund invests “through a private equity lens,” holding large minority stakes in companies with the aim to work collaboratively with management in order to unlock value, according to Mr. Robbins. The holding period is usually about 18 months to three years.

Blue Harbour's strategy returned 22.5% net of fees in 2010, according to an investor in the fund. During the same period, the S&P 500 index gained 12.8%.

Specialist ESG manager SAM Group Holding AG, which had €11.8 billion in assets under management as of Dec. 31, has been pursuing U.S. clients in addition to its stronghold in Europe.

Neil Johnson, head of Americas at SAM based in New York, said the firm has a pipeline of new mandates totaling about $400 million from U.S. institutions, including university endowments investing in specialist ESG strategies in global equity and sustainable energy. Existing U.S. clients include the $3 billion Dallas Police and Fire Pension System and the $1.6 billion Fort Worth (Texas) Employees Retirement Fund.

Since the introduction of the United Nations Principles for Responsible Investments in 2005, more information on ESG activities has become widely available, making it more effective to integrate it into the portfolio management process, sources said.

“We're seeing genuine changes that we didn't see five years ago in the way that ESG data is being integrated into the decision-making process coming from asset managers,” said Emma Hunt, senior investment consultant in the sustainable investment team at Towers Watson & Co., London. “I think we're going to see a lot more opportunities around sustainable investing.”