Howard Pearce has some advice for investment managers. Don’t bring along a Starbucks coffeee during a manager selection interview. Do bring some fresh and innovative ideas.

Pearce is head of environmental finance and pension fund management at the Environment Agency Pension Fund (EAPF), the pension fund of the environmental regulator for England and Wales.

Their active fund is the twentieth largest member of the Local Government Pension Scheme (LGPS) and one of the largest 100 pension funds in the UK. Over the past two years, the fund has won plaudits for its environmental overlay strategy, which is designed to enable it to manage its assets in a financially robust and environmentally responsible way.

The EAPF is part of a growing number of public pension funds, including Calpers, other large state funds in the US, the French pension reserve fund (FRR) and the French civil servants pension fund (ERAFP), who are squaring the circle and incorporating environmental issues in their investment strategies.

Pearce believes that integrating financially material environmental issues - that is, issues such as climate change and the cost of pollution clean-ups that could harm the fund’s returns - are part of a pension fund board’s fiduciary duty.

“People are failing their fiduciary duty if they know about financially material issues that are affecting their financial returns, and they have a duty to minimise that risk to their returns,” he says.

“The economic impact of climate change is now very significant, and if pension fund boards and trustees are ignoring this then potentially they are in breach of their fiduciary duties.”

Asset managers, too, should be prepared to integrate environmental issues into their investment decision making, Pearce says he was surprised by the mixed response from asset managers when the EAPF tendered for a range of equity and a specialist environmental mandates in 2005.

Leaving aside the discourtesy of uninvited coffee cups, he and his colleagues on the investment committee were disappointed by the lack of new thinking, he says. “We offered investment houses an opportunity to do something slightly different from normal.

“Some companies didn’t respond to that, and offered standard and rather old fashioned negatively screened ethically based products, which we didn’t want. We wanted something more positive and innovative”.

However, attitudes have changed since then, he suggests. “More people are aware of issues like climate change and its impact on performance than they were two years ago, and I’m sure that if we re-tendered today we would get a stronger more positive response.”

EAPF’s specialist environmental mandate and its environmental overlay strategy were both part of a broad new investment strategy launched in 2005.

The need for a new strategy, which involved a switch from balanced to specialist management was prompted by a number of factors, says Pearce. “We had had some disappointing returns from our balanced managers, and the investment strategy hadn’t been reviewed for some years.”

One of the main aims of the strategy was to reduce unrewarded investment risk. In 2004, the proportion of assets held in equities was 70% of total fund assets.

“In our previous balanced management arrangement we were actually running quite a high risk,” Pearce points out. “There was a degree of overlap in mandates, and we had very high exposure to just UK equities. So our aim was to reduce risk and increase return by diversification.” It was decided to reduce the proportion invested in equities and bonds to 63% and 27% respectively, and to make new allocations of 5% each to property and private equity. The strategic allocation to equities was split equally between UK and global equities. Similarly, the allocation to bonds was split equally between index-linked gilts and corporate bonds (see figure on facing page)

At the same time, it was decided that some 40% of the assets should be managed passively. “Part of the risk management strategy was that we wanted to leave a significant amount of the assets to be managed passively,” Pearce says. “So the split was decided at 40% passive and 60% active.”

Finally, it was decided that the new investment strategy should tackle environmental issues and the financial risks they represented to the fund

The EAPF had earlier been criticised for investing in highly polluting industries. Its response was to launch a responsible investment strategy to ensure that its investment managers take account of environmental issues and other long term risks and opportunities that can affect financial returns.

This decision was taken on purely financial grounds, Pearce emphasises: “It is our view that businesses that manage their environmental risks and opportunities tend to be more sustainable and therefore better to invest in. So a responsible investment strategy was introduced purely on logical investment grounds, and not for any ethical or moral reasons.”

As part of its responsible investment strategy, the EAPF has applied an environmental overlay across all the asset classes and investment activities within its portfolio. The effect of this is that managers must integrate environmental issues into their research, stock selection, and all investment decision-making, as well as their engagement with companies, and voting at shareholder meetings.

“Essentially the environmental overlay strategy is an extension of our investment philosophy set out in the Statement of Investment Principles,” says Pearce. “It’s really setting out how we think financially material environmental considerations can be built into the investment process.”

The EAPF’s investment managers are expected to adopt and comply with these principles, something they should have little difficulty doing, Pearce says. “The overlay strategy is setting out some very high level principles and we selected managers that we felt could take those principles and build it into their more detailed investment processes,” Pearce says.

How they do this will depend on the assets they are managing, he adds. “We recognise that the ability to take account of environmental issues is different between different asset classes, and there are specific requirements for each asset class.”

The equity managers, which include Standard Life Investments, Capital International and State Street Global Advisors, use external or in-house environmental, social and governance (ESG) research.

The manager of the SRI global equities mandate, Sarasin Chiswell, integrates sustainability and environmental considerations into a selection of best-in-class companies in best-in-class sectors. Here, sustainability is a key criterion for stock selection as much as economic considerations.

The corporate bond manager, European Credit Management, will not hold bonds issued by companies where it thinks there could be a liability, such as litigation risk, arising from ESG issues. Companies involved in asbestos and contaminated land would fall into this category.

The property manager, Morley Fund Management, which manages a segregated fund of funds, carries out environmental risk assessments across all the 12 UK based property funds it invests in. The EAPF also invests in its Igloo fund that is focused on brown-field site re-generation.

The private equity manager, Robeco Alternative Investments, which manages a sustainable private equity fund of funds, will only invest in funds where the funds and the underlying companies sign up to a set of responsible entrenepeurship guidelines.

The private equity funds have a bias towards renewable energy, water treatment, waste management, specialist materials and health sectors, and almost a third of the mandate is allocated to environmental technology or ‘clean-tech’ funds. That proportion might be increased in the future, Pearce says.

The EAPF also requires managers of equities to vote at shareholder meetings, when feasible, for all equity holdings on behalf of the fund. It also makes them aware of its preferred voting positions.

The EAPF can monitor its managers’ decision through Votex, a system operated by its custodian Northern Trust. This has not led to any difficulties so far, says Pearce. “On the whole their voting recommendations are how we would have voted although on some occasions we have had to suggest that we would prefer to vote a different way. But it’s not often that we have to do that.”

Where the EAPF does require investment managers to vote in line with the fund is on environmental-related issues. Here the pension fund itself decides how its investment managers will vote. ” What we ask them specifically to do is that when there is a an environmental resolution to refer that to us. Then we advise them what stance is to be taken,” says Pearce.

In 2006, the EAPF voted on 49 US company environmental shareholder resolutions, 80% up on the year before.

One way in which the EAPF has ensured that its aims and intentions are aligned with those of its investment managers aligned is by drafting its own form of investment management agreement (IMA). This has enabled the EAPF to take the initiative, Pearce says.

“Historically, we have had IMA’s supplied by the fund managers. These told us what they wanted to do and how they wanted to go about managing our money. We felt we should turn that around. We wanted a standard IMA that said how we wanted them to manage our money. Now it’s our contract with them rather than their contract with us.

“We were also trying to make our re-tendering process more efficient. A negotiation around a number of different IMA’s would have been inefficient and costly. By issuing a standard IMA, an Environment Agency standard agreement based on good practice, we were able to speed up our ability to implement our new investment strategy.”

The new investment strategy is bearing fruit, Pearce says. Last year, the pension fund’s overall return was 22.8%, 0.8% above its benchmark. This year the EAPF is likely to outperform by around 1%. “Overall we are achieving what we set out to achieve. We’ve got a better return at lower risk and we’re exceeding our fund-specific benchmark,” he says. The performance of the investment managers has also been encouraging. Last year, seven managers exceeded their performance benchmarks and four beat their performance targets. The best performer was Sarasin Chiswell, the environmental specialist SRI manager, which returned 9%.

Pearce says. “We’re only two years into this strategy and so far we’re content with what we’re doing and we’re sticking with it.” However the EAPF will formally review the triennial performance of its managers next year.

The EAPF does not intend to rest on its environmental laurels. Pearce and his team are looking at the ‘ecological footprint’ of the fund - in other words, to assess the impact environmental impact of its investment activities.

“This is potentially the most innovative idea of all and it’s an area where we are still developing and evolving our thinking and strategy. At one very simple level we could identify and track how we invest in different geographical regions and in different business sectors, and use that information to construct a measure of the environmental impact of our investments.

“At a more sophisticated level there are specialist advisors like Trucost and Innovest which can analyse your portfolios and your weighting to make that more sophisticated and to develop a so-called carbon footprint. That’s the area where we’re doing some thinking about and working out how to go about this. Although a number of other people have looked at foot printing, at the moment there isn’t a standard way of doing this. Clearly, it is easier to do this for equities than for some other asset classes like property, where it’s harder to get information.”

The purpose of ‘fund foot-printing’ is to see what effect the new investment strategy has had over the long term, he suggests. “We would like to be able to do year-on-year comparisons of both the financial returns and environmental footprint of our investments. The aim would be to see whether the investment strategy delivers good returns, preferably with a decreasing environmental impact.

Pearce believes it is important to keep members and the outside world informed about what the EAPF is doing: “Our investment philosophy has always been research-based and evidence-based, and we’ve always put the results of any research on our website. We’ve tried to publish information as we’ve gone along on the lessons that we’ve learnt from implementing the new investment strategy.

“This year we plan to upgrade our website and more information on our website about the performance of our fund, environmental overlay strategy, and our voting on environmental resolutions.

In this respect, the EAPF can act as an information exchange for other pension funds that are considering closer involvement with issues like SRI, ESG, and shareholder activism, he suggests. “Part of our philosophy is being transparent and sharing what we do with other people, to spread the word, if you like. Hopefully we can learn from other funds as well and why the EAPF has signed up to the UN PRI and CDP and is a member of UKSIF and the IIGCC.”

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