FRANCE - Fonds de Reserve pour les Retraites, the €27bn French national pension fund, has published a working document on investment policy which reveals just how complex it is for pension funds to consider whether environmental issues should be factored into investments.

The first draft of a paper - entitled How should the environment be factored into FRR's investment policy? - was put together in June but has just been published to help explain the "relevant environmental problematics" that long-term investors face when trying to include environmental issues in their investment decisions and is written so the findings can be shared with the industry.

"Far from purporting to offer definitive answers to the questions it raises, this working document will have achieved its aim if it stimulates more in-depth work on these issues of capital importance," said FRR.

The document says in order to assess the criteria under which investments should be treated, it is necessary to break them down first into four key issues - climate change, exhaustion of fossil fuel resources, loss of biodiversity and aggravation of water shortages - as these are deemed likely to "make the economic environment of tomorrow more uncertain, more constrained and more unstable".

Issues must then be broken down into their economic and global impacts, as well as geographical and sectoral positions, so the basics of the decision-making process are established prior to any analysis of stock types and on stock and bond picking.

It sets out by noting that any long-term investor will have to consider how investment sectors and the individual entities are able to adapt to climate change and whether they can enact a "policy of mitigation".

More specifically, it argues there are three climate scenarios - median, high-risk and green - alongside five economic scenarios - median (a point of reference for the other four), extended fossil, more rapid climate change, green constraint and green growth - which allow the investor to describe the different isues that may surface by the year 2040 but provide what is says is "a simple grid for reading the major possible economic impacts of climate change" before the next stage of assessment can begin.

FRR notes that developing countries are more exposed to environmental risk so this should be taken into account in any decision-making, while a KPMG matrix for assessing business sectors would assist when deciding whether assets are subject to physical risk, regulatory risk, reputational risk on revenues and legal risk.

It supposes that equity investments, for example, are exposed to extended fossil, more rapid climate change and green constraint risks but are boosted under the green growth scenario. Any upward revision in this level makes risky assets less attractive - as it does in the case of real estate - and "leads to a decline in their valuation and hence their return".

Similarly, bonds would see the effects of green scenarios "trump" each other, but the extended fossil scenario could be beneficial as the negative effect of growth could be offset by higher uncertainty on growth and inflation.

Commodities, which is deemed to include carbon trading according to FRR, will see returns determined by fossil fuels regardless of volatility, but are unlikely to benefit from green scenarios.

Looking specifically at environmental assets, FRR found forestry is a low return, decorrelated assets but is not a particularly liquid market in terms of investment. It noted the sector is subject to exceptional events while yields are dependent on land values, but their environmental benefit could be in carbon credits and in the fight against the loss of biodiversity.

Carbon credits, meanwhile, are still a highly volatile asset correlated to commodities in part because they are subject to regulatory constraint, but which investors find are better suited to being managed through carbon funds, said FRR.

Any stock-picking conducted will therefore need to take into account:

The level of environmental performance The potential for improvement in environmental performance The position in the value chain, And whether there is the basis for corporate dialogue.

The 32-page report was compiled with the assistance of the Association for the Promotion of Research into the Economics of Carbon (APREC) and specialist consultancy I Care Environnement.

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