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Environment Agency plans sequel to £1.5bn SRI success

Fund investment committee to consider sweating the assets to take advantage of strong performance at lower risk.

Howard Pearce, head of pension fund management at the £1.5bn (€2.1bn) UK Environment Agency Pension Fund has led a remarkable recovery at the scheme since it began a wholesale shift three years ago towards responsible investment with a 100% environmental, social and governance overlay on all assets.
Prior to his arrival, the fund was suffering from poor investment returns that had led to a solvency decrease from 116% to 94% of liabilities. Then in 2002, on the day Pearce moved within the Environmental Agency to take up the pension fund’s reigns, it was hit by negative press coverage over extensive investments in BP and Shell, which were accused of poor environmental records. Pearce says he heard the reports on the radio as he was driving to work for his first day.
After a 12-18 month review carried out with a mix of consultants including Mercer, Watson Wyatt and Rathbone Greenbank, which included an asset liability study and performance attribution research, the fund concluded that targeting companies with good corporate environmental governance could help to deliverbetter financial returns and was consistent with prudent and responsible investment.
As a result, it replaced three balanced managers running a portfolio split of 75% in equities, 20% in bonds and 5% in cash with ten specialist managers employing the new ESG overlay strategy. (Environment Agency Mandates.pdf) Research for the overlay strategy was divided between Trucost, Innovest, GES in Sweden and some in-house capabilities within fund managers. In addition, the fund decided to allocate a portion of investment management fees based on performance. The investment split was adjusted to 31.5% in UK equities, 31.5% in overseas equities, 13.5% in gilts, 13.5% in overseas bonds, 5% in property and 5% in private equity.
Returns blossomed. In the first year of the new strategy, the fund beat its benchmark by 0.8% and increased its solvency margin by 4%. Its best performing manager, Sarasin, returned 9%. The fund also increased its governance presence, lodging 50 shareholder resolutions over the year, an increase of 80%.
Year two was better. The fund was 1.2% up against its benchmark and recorded a further 3% increase in solvency. Eight of the fund’s managers exceeded their benchmark and four beat their performance targets. During 2007, the fund extended its manager roster by appointing Royal London Asset Management to manage a £55m (€81.5m) UK corporate bonds mandate with an SRI overlay provided by Eiris. Pearce says the outcome of its 2007 triennual fund valuation is likely to bring a slight increase of risk based on healthy investment performance and fund solvency: “Our trustee investment committee has noted that we are getting better performance with less risk than we were before and is mindful to up the risk allocation, which if it delivers good returns might enable us to fix or even reduce contributions to the fund. They want to sweat the assets a bit more.” He says the fund has been particularly pleased by the return on its investments with Sarasin, Morley, Robeco and Standard Life in UK equities. But he feels there is still a lack of investment choice amongst fund managers that fully combine ESG concerns with existing strategies that outperform. “There is an also an absence of investment potential out there, particularly in areas like energy efficient property portfolios. While currently it is perhaps viewed as a niche area, I think there is real scope for products on sustainable property. We are pleased there is now more awareness of investment themes such as climate change and sustainable resource use, which are interesting to us, and there has been new product coming through, particularly in private equity. However bond and currency products have a long way to go.” Pearce says the fund could extend its exposure to responsible real estate investments into Europe as itembarks on its tri-annual strategic review.
The fund will also carry out reviews of infrastructure, sustainable forestry, private equity and clean tech to decide if it could invest more or make new allocations.
Pearce said: “Currently we have a UK property mandate invested with Morley. Our investment committee is due to review this and look at extending our investments into Europe and possibly other markets in 2008.” He said additional research into various types of infrastructure and sustainable forestry was part of a necessary learning curve: “Some of our committee members are nervous as to whether some of these investments are totally compatible with our environmental overlay strategy” Regarding private equity, which already makes up 5% of the fund’s portfolio via a segregated fund of funds mandate with Robeco, the Dutch fund manager, Pearce said: “Our 5% allocation was originally £50m and due to the overall growth in our fund will soon be £80m, so our commitments have risen considerably. We’re very keen on the asset class, particularly as new innovative companies are looking to access the main stock markets via the private equity route. We already approach cleantech through our private equity arrangement, and as these companies grow there might be more opportunities in the quoted small cap sector that are worth looking at also.” Carbon trading is another theme where the fund is very carefully assessing its policy and options: “It’s not yet proven as an investment product in our eyes and as the UK administrator for the EU Emissions Trading System we might have some probity issues to take care of first”. Pearce said the fund was unlikely to make allocations to responsible hedge funds because of question marks over performance.