As specialist asset managers have found, selling the benefits of ESG investing is not as straightforward as might be imagined. Eric Borremans is head of SRI at Impax. He says, “Not every client wants it - pension funds are usually very keen and anyone else with longer term investment horizons would be among the early adopters. So we have to be flexible in our approach to selling the idea.”

Borremans says looking at performance data, the evidence is encouraging. “If you contrast companies where we have a positive recommendation and compare that to the wider universe, we observe a clear outperformance of the universe from which it is extracted. This shows that ESG adds value. Does it add a lot? No, less than 1% over a year, but this is nonetheless proof to those who need it. For example, in the banking sector, the ESG overlay really added value in 2008, eliminating some of the worst affects of the credit crunch.”

Impax is part of the BNP Paribas Investment Paribas stable, running thematic and specialized portfolios. Borremans says, “Environmental operations can be very technical and have to be monitored on a global basis. And it’s controversial from an investment perspective. There have been some investment bubbles in solar power, bio fuels and fuel cells. So it’s a tricky area, very exciting and high growth potential.”

The environment is a clearly identified theme for Impax. It appeals to institutional investors who have the ability to focus on the issues and opportunities. “We are not there yet, but certain issues like climate change are well defined in terms of the cost of co2 emissions for example. The environmental questions are making their way into the mainstream, and this is having a material impact on energy costs,” says Borremans.

In Asia, the environment is absolutely central to economic development in major parts of the region. “The Australian initiatives on water scarcity and the rapid take-up of emissions trading is a reality. Australia is heavily reliant on carbon exports to Japan. In China, local air pollution is a drag on the economy. The environmental techniques it is developing show the Government has understood that it can help prevent environmental problems. Korea is the star of the region in terms of stimulus. Fully 85% of stimulus packages are targeted at green tech.”

In terms of investor demand, Borremans feel the country that shows the most potential is Australia: “The mood among super funds and the general objective of the politicians and energy technologists is driving this trend.”

Building satellite equity portfolios is one way to exploit macro factors, particularly where you can benefit from some early mover advantage. A range of regional Environmental Opportunities (EO) indices were launched in June by FTSE in a collaboration with Impax. They are designed to measure the performance of listed companies with involvement in environmental business. Impax identify the index universe as global environmental technology companies with activities in (a) alternative energy, (b) energy efficiency, (c) water technologies and pollution control, or (d) waste technologies and resource management. They then analyse the financials of the companies in this universe. A company is considered an environmental opportunity if environmental technology: Revenues are > 20% of total, or Invested capital is > 20% of total, or Net income is > 20% of total.

The 20% bar means that established businesses can be part of the EO universe. Examples of these include 3M, Honeywell, Siemens and United Technologies in addition to more specialist companies. FTSE then apply their liquidity screens and free-float adjustment on these environmental opportunity companies to give the FTSE EO Index Series. There is a FTSE EO All Share Index, a global benchmark index of environmental technology companies with over 450 constituents. There are also four sector benchmark indices covering the company activities covered by the Impax analysis and listed above. Parallel tradable indices should encourage the growth in derivatives and Exchange Traded Funds in this area.

Watson Wyatt’s Chris Sutton says, ”We would argue that beliefs centred on the science of climate change are not actually a necessary pre-condition for a return-seeking allocation to Environmental Opportunities. Whichever side of the scientific debate you come down on, though, significant investment flows designed to create a low carbon economy are underway.”

Much of the investment is led by governments allocating economic stimulus monies in an attempt to simultaneously spark economic recovery and reduce the carbon footprint of creating that spark. HSBC estimate that G20 governments have allocated over $445 billion in ‘green stimulus’ (some 15% of total announced packages). China has allocated 40% of its RMB4 billion stimulus to environmental themes - with a notable emphasis on energy efficiency in the railways and electric grid infrastructure. The US government is alone in committing to a substantial investment in renewable energy. Overall the Obama administration is set to allocate $94 billion of the $787billion ‘American Recovery and Reinvestment Plan’ (ARRA) announced in February 2009 to environmental opportunities pending approval in Congress. In contrast the UK government has so far announced just over $2 billion of green stimulus with more than half of this in subsidies for low carbon vehicles. For those investors committing funds to environmental opportunities on the basis of the wave of intended investment flows, a thorough understanding of the diversity of businesses contained in the FTSE industry classification is key given the disparate intentions of national governments in this area.

The strong relative performance of many environmental technology stocks over recent years will therefore lead many to consider whether actually the early mover advantage has actually passed in this sector.

The performance also highlights the greater volatility in this sector compared to equities in general. This higher volatility is confirmed in a recent study from MSCI Barra. The paper goes on to show that the relative performance of renewable and alternative energy companies (84 stocks from 21 countries in their study) cannot be fully explained by the small cap, growth bias, nor by any country effects. There appears to be an additional ‘green’ factor on top of the eight factor Barra Global Equity Model. This in turn suggests that some ‘green beta’ is already in the price of these securities.