Compelling evidence is emerging that strong financial performance and sound financial management are increasingly linked. Much has been written over the past few years about the presence or absence of a relationship between the environmental and financial performance of companies.
On balance, most evidence suggests that a positive relationship does exist. In particular, environmental responsibility is increasingly linked to management quality.
Supporting this view we have launched a global clean future strategy (GCFS) to exploit the positive correlation between environmental sustainability and financial performance. The strategy differentiates itself from traditional environmental or socially responsible approaches, however. The primary objective is to optimise risk-adjusted returns. A second dimension is to fully integrate environmental sustainability into the investment process through rigorous stock selection techniques.
Our challenge is to ensure that the two objectives are compatible and effective.
There has been a fundamental shift in investors’ perceptions of environmentally responsible corporate behaviour. Historically, corporate environmental initiatives were considered burdensome. The necessity to comply with regulations, for example implementing pollution control systems or site remediation, increased costs and bureaucracy. The ultimate result was weaker financial performance.
Negative perceptions are changing, however. Investors recognise that for leading companies, the focus of environmental management is actually driven internally by a desire to optimise eco-efficiency. Improving eco-efficiency can involve a wide range of product improvements. Through new product and process development, companies create value by doing more with less.
Eco-efficiency is not only associated with a culture that promotes product and process innovation, but one capable of creating shareholder value through many other sources. Forward-looking managements are more likely to proactively shape an organisation’s other critical functional areas.
The accumulation of evidence to link environmental credentials with superior financial performance has led to the creation of the GCFS strategy. A measure of environmental performance is used as one indicator in the overall investment process, not as the sole determinate of stock selection. As a diversified global equity product, the strategy is benchmarked against the MSCI World Index.

The portfolio consists primarily of large established companies, with leading market positions and durable earning growth. However, these companies must also demonstrate above average environmental credentials relative to their competitors. Also included are small companies that are pioneering new technologies and services, which have the potential to protect and improve the environment.
A twin-track stock selection process is employed (see box). The first step in the investment process involves our global team of large cap portfolio managers and analysts who take both a regional and industry sector perspective to identify the most attractive opportunities. Each of our analysts is an industry specialist with responsibility for following a wide range of companies. The analyst’s role is to assess the quality of the business franchise and the earnings character of the company, and to make a judgement on whether the stock will outperform the market.
From the universe of approximately 1,500 global equities with market capitalisation over $3bn (x3.3bn), 200–250 companies are identified as having sustainable earnings growth of 10–15% or greater and reasonable valuations. Each of these stocks is expected to perform well in the market. This opportunity set of attractive investments is reduced to about 80 large cap companies based on further detailed financial and business analysis combined with their environmental ratings.
On a parallel path, a team of small cap analysts and portfolio managers identifies young companies that are developing new technologies and services to improve the environment. Some of these companies may have technologies that are directly involved in improving the environment such as windmill power generation or solid waste services. We may also consider investing in smaller companies that help the environment, although their products are not environmentally focused. For example, we may include companies developing energy-saving, flat panel computer screen technology. By looking broadly at environmental benefits, our small cap holdings are well diversified by industry and region. The small and mid-cap portion of the portfolio is approximately 10% of the fund, slightly less than the weighting in the MSCI World Index.
The second step is to evaluate the environmental credentials of our large cap investment candidates. To assist in this process, we use research and ratings provided by Innovest Strategic Value Advisors, a New York-based environmental finance and investment advisory firm.
The ratings methodology is particularly appealing to an investment management firm like ours. Assessments are based on how well a company can convert its environmental initiatives into profit opportunities, thereby boosting financial performance. Furthermore, research by Innovest and its advisers has confirmed that a large, broadly-diversified portfolio that is overweighted with eco-efficient companies can be expected to outperform, by a significant margin, one comprising less efficient competitors.
However, what differentiates the GCFS from its competitors is its primary focus on financial criteria, to identify the highest quality investments. This list is then refined so that those companies with best-in-class environmental ratings are selected. A strategic flaw of many environmental and SRI funds, past and present, has been the pre-eminence awarded to ideological considerations over financial criteria. Traditional socially responsible investment (SRI) funds are less definitive in their objectives and values. They screen on a broad array of corporate sustainability issues, which are often intangible – such as charitable giving, employee relations and environmental initiatives – and exclude certain companies on the basis of moral judgements (for example, alcohol, tobacco, firearms). The blind exclusion of companies that contravene an ethical stance, many investors believe, harms investment performance. By the same token, some purely environmental strategies may hold financially weak companies that dampen performance, but nonetheless feel compelled to own them because they fit the investment strategy.
In contrast, our strategy has no front-end screens (ethical, moral or environmental) that limit the universe of potential investments.
Our new strategy is neither an ideologically driven eco one, nor is it a typical SRI. Environmentally sound business practices can be an indicator of superior management, which is a leading driver of strong financial returns and stock outperformance.
Darrell Riley is a vice president at
T Rowe Price in Baltimore

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