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Environmental Risk: The Changing Climate: ‘A fiduciary duty’

Nina Röhrbein hears how forthcoming changes to asset allocation at the Environment Agency Pension Fund will build upon its long record in environment-sensitive investing

Global consultancy Mercer launched its ground-breaking report, ‘Climate Change Scenarios: Implications for Strategic Asset Allocation’, in February 2011 following an 18-month research project with 14 global investors. It analysed the potential financial impacts of climate change on investors’ portfolios, identified through a series of four climate-change scenarios playing out to 2030. The report suggested that institutional investors needed to enhance their approach to asset allocation by, for example, creating a risk-factor analysis and recommended investing as much as 40% of assets in climate-sensitive assets. In addition, the report encouraged investors to engage with policymakers.

A year later, Mercer’s follow-up report, ‘Through the looking glass: How partners are applying the results of the climate change scenarios study’, found that more than half of the participants in its original study were taking or planning action related to its findings.
One third of project participants had begun to allocate or planned to allocate more to climate-sensitive assets, identified in the original report as real estate, infrastructure, private equity, listed and unlisted sustainable equities, efficiency/renewables and commodities including agricultural land and timberland.

The UK’s Environment Agency Pension Fund (EAPF) – which runs an active and a deferred fund with combined invested assets of £1.9bn (€2.3bn) – was one of the sponsors of the Mercer report, although it was already well-placed in considering climate change within its portfolio construction, with the outcomes of the Mercer study only reinforcing its direction.

EAPF integrates climate change into its Statement of Investment Principles, asset allocation, manager selection, engagement and voting. It asks its fund managers specific questions on energy and climate change in all its expressions of interest (EOIs), invitations to tender (ITTs) and requests for proposals (RFPs).

“The fund has undertaken a climate change-scenarios analysis of its new investment strategy based on our current and potential future asset allocation,” says Howard Pearce, head of environmental finance and pension fund management. “The reduction of equity risk, a continued focus on ESG analysis and sustainably-themed equities, as well as the diversification of 10% of the fund’s investments into new asset classes such as sustainable property, infrastructure, timberland and farmland, are viewed positively in respect of reducing future climate change risks to the active fund. In fact, the active fund considers that it has a fiduciary duty to take account of financially material environmental risks and opportunities that could affect its current and future investment returns, such as climate change.”

EAPF uses environmental data provider Trucost to prepare environmental and carbon footprints of its equity and bond portfolios. After implementation of its new strategy, the environmental footprint of its active fund’s active equity investments was 6% less and the carbon footprint 25% less than those of the market benchmark. Its active bond portfolio performed even better, with efficiency improvements of 23% and 30% compared with its benchmark for environmental and carbon footprints, respectively.

Over the next two years, EAPF’s active fund plans to reduce its public equities from 63% to 50% but, within this allocation, increase actively managed emerging equities from 4.5% to 10%, maintain private equity at 5%, and increase corporate bonds from 13.5% to 28% and alternative real asset investments from 5% to 12% (via sustainable property, infrastructure and farmland and forestry). Within bonds there is a £10-20m allocation to opportunistic fixed income investments, which might include climate-related or sustainable bond funds.

The asset allocation change will also assist the active fund in moving towards its 2015 target of having 25%, or some £450m (€540m), of the assets invested in the green economy. As of 31 March 2012, the fund had nearly £250m – around 13% of the fund – invested in renewable or clean technology public and private equity.

The new allocations will most likely be invested via managed funds or possibly in collaborative ventures with other like-minded pension funds.

The focus of EAPF’s engagement work with policy makers is largely undertaken through collaboration with other investors through a range of groups such as the UN-backed Principles for Responsible Investment (PRI), including its links to the Carbon Disclosure Project (CDP), Forest Footprint Disclosure Project (FFDP) and Water Disclosure Project (WDP), as well as the Institutional Investors Group on Climate Change (IIGCC), the UK Sustainable Investment and Finance Association (UKSIF) and the Corporate Sustainability Reporting Coalition (CSRC).

As part of both the corporate programme and policy-working group at the IIGCC, EAPF contributes to and supports a range of communications with policy-makers across Europe. It drafted, for example, the IIGCC response to the UK department of environmental & rural affairs consultation on mandatory greenhouse gas (GHG) reporting regulations. The response included supplying figures from EAPF’s analysis of the environmental disclosures made in the annual report and accounts of the companies listed on the FTSE All-Share.

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