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CERES BLUEPRINT FOR SUSTAINABLE INVESTINGJune 2013

Authored by

Peter Ellsworth, CeresKirsten Snow Spalding, Ceres

THE 21ST CENTURYINVESTOR:

THE 21ST CENTURY INVESTOR:CERES BLUEPRINT FOR SUSTAINABLE INVESTINGJune 2013, first printingJune 2014, second printing (with updated fund performance, page 41)

Authored by

Peter Ellsworth, CeresKirsten Snow Spalding, Ceres

ACKNOWLEDGEMENTSWe would like to thank the members of the INCR 21stCentury Investor Working Group who provided invaluableguidance and feedback as we developed this InvestorBlueprint: Bob Arnold (New York State Common RetirementFund); Bruno Bertocci (UBS Global Asset Management);Matt Filosa (MFS Investment Management); Julie Gorte(Pax World Management); Dan Hanson (Jarislowsky Fraser);Paul Hilton (Trillium Asset Management); Donald Kirshbaum(Consultant); Nancy Kopp (Treasurer, State of Maryland);Mike McCauley (Florida State Board of Administration);Chris McKnett (State Street Global Advisors); Craig Metrick(Mercer Consulting); Meredith Miller (UAW Retiree MedicalBenefits Trust); Brian Rice, (CalSTRS); Christopher Rowe(Prudential Investment Management); and Jimmy Yan(Trustee, NYCERS).

We also want to recognize the expert advice and commentsprovided by Klaus Chavanne (MEAG); Kelly Christodoulou(AustralianSuper); Sarah Cleveland (Consultant); Tim Coffinand Robert Fernandez (Breckinridge Capital Advisors);Mike Garland (New York City Comptroller’s Office); KeithJohnson (Reinhart Boerner Van Deuren); Adam Kanzer(Domini Social Investments); Tom Kuh (MSCI); Ian Lanoff(Groom Law Group); Ken Locklin, (Impax Asset Management);Tim MacDonald (StoneBridge Partnerships); Jameela Pedicini(CalPERS): Elizabeth Seeger (KKR); Tim Smith (WaldenAsset Management); Nick Stolatis, John Wilson and PandaHershey (TIAA-CREF); John Stouffer (New York StateComptroller’s Office); and David Wood (Harvard Initiativefor Responsible Investment).

This report was made possible, in part, by support from theKresge Foundation.

Report design by Patricia Robinson Design.

DISCLAIMERThis publication has been prepared for general guidanceand does not constitute legal, accounting or investmentadvice. Investors should not act upon the informationcontained in this publication without obtaining professionaladvice. No representation or warranty (express or implied)is given as to the accuracy or completeness of the informationcontained in this publication.

© 2014 Ceres

The opinions expressed in this publication are those ofCeres and do not necessarily reflect the views of any of ourdonors, member organizations or advisors. Ceres does notendorse any of the organizations used as examples orreferenced in the publication, or their products or services.

FOREWORD . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

LETTER FROM THE PRESIDENT. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4

THE BUSINESS & INVESTMENT CASE FOR SUSTAINABLE INVESTING . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

FIDUCIARY DUTY & ESG FACTORS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

21ST CENTURY INVESTOR: CERES BLUEPRINT FOR SUSTAINABLE INVESTING. . . . . . . . . . . . . . . . . . . . . . . . . . . 12

THE CERES INVESTOR BLUEPRINT: 10 STEPS TOWARD SUSTAINABLE INVESTMENT PRACTICES . . . . . . . . . . . . . 13

STEP 1: Establish a Commitment to Sustainable Investment Through a Statement of Investment Beliefs . . . 14

STEP 2: Establish Board Level Oversight of Sustainability Policies & Practices . . . . . . . . . . . . . . . . . . . . . . . 16

STEP 3: Identify Sustainability Issues Material to the Fund . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

STEP 4: Evaluate Asset Allocation for Material Sustainability Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

STEP 5: Select an Investment Strategy & Integrate Sustainability Criteria . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

STEP 6: Require Sustainable Investment Expertise in Manager & Consultant Procurement . . . . . . . . . . . . . . 23

STEP 7: Evaluate Manager Performance Against Sustainable Investment Expectations . . . . . . . . . . . . . . . . . 25

STEP 8: Establish Engagement Strategies & Proxy Voting Guidelines. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27

STEP 9: Support Policies & Market Initiatives that Promote a Sustainable Global Economy . . . . . . . . . . . . . 30

STEP 10: Integrate Sustainable Investment Criteria Across All Asset Classes & All Strategies . . . . . . . . . . . 33

CONCLUSION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38

APPENDIX A: THE BUSINESS CASE FOR INTEGRATING ESG ANALYSIS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39

APPENDIX B: EXAMPLES OF INVESTMENT BELIEFS THAT INCORPORATE ESG . . . . . . . . . . . . . . . . . . . . . . . . . . . 42

APPENDIX C: EXAMPLES OF ESG QUESTIONS IN RFPS. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46

APPENDIX D: FLORIDA SBA INVESTMENT PROTECTION PRINCIPLES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48

REFERENCES & NOTES. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50

THE 21ST CENTURY INVESTOR: CERES BLUEPRINT FOR SUSTAINABLE INVESTINGTable of Contents 1

TABLE OF CONTENTS

FOREWORD

THE 21ST CENTURY INVESTOR: CERES BLUEPRINT FOR SUSTAINABLE INVESTINGForeword 2

I am pleased to introduce The 21st CenturyInvestor: Ceres Blueprint for SustainableInvesting. This report outlines 10 steps that willhelp institutional asset owners and managerssteer a sustainable investment course—one thatsatisfies fiduciary responsibilities to act onbehalf of our beneficiaries in an ever-changing,increasingly interdependent global economy.

The New York State Common Retirement Fundis a highly diversified, global portfolio investedacross multiple asset classes traditionallyfound in institutional portfolios. Ultimately, ourgoal is simple. We seek long-term sustainableeconomic growth to meet the obligations of ourpension fund for current and future members,retirees and beneficiaries, and to minimizeattendant costs to taxpayers. It has been ourexperience that integrating relevantenvironmental, social and governanceconsiderations into the investment decision-making process enhances our ability to achieveour objectives.

Investors face new risks in the 21st centurythat challenge our customary understandingof economic and investment risk. One suchrisk is climate change. Respected economistsand scientists warn that without significantworldwide reductions in greenhouse gasemissions, climate change will produce severeeconomic disruption in the coming decades.Already, a series of destructive climate-relatedevents have produced unexpected devastationand recovery challenges for significant economicsectors around the world.

The Blueprint’s 10 steps provide asset ownersand investment managers with a frameworkfor reviewing their investment policies andpractices to better manage risk, protectprincipal and enhance investment return.

The Common Retirement Fund is activelypursuing a number of these recommendations,applying them in our decision-making wherethey are appropriate to the investment andconsistent with our fiduciary duty. Allorganizations will find similar value in applyingthe Blueprint’s guidance to their own uniqueneeds and policies.

Investing for both the present and the futurein our fast changing world requires freshthinking and comprehensive, foresightedanalysis. This means accounting for risks, someof which are unprecedented, many of which arenot identified in financial statements, and allof which are here for the foreseeable future.

Through strategic actions and dailyimplementation, we fulfill our roles asresponsible stewards of the assets we mustmanage and grow for the benefit of ourcurrent and future retirees, members andbeneficiaries. I urge you to read this valuablereport and to add your voice to criticallyimportant discussions taking place within theinvestment community about how we canachieve long-term sustainable growth.

Thomas P. DiNapoli

New York State Comptroller

INVESTORS FACE NEW RISKS IN THE 21ST CENTURY

Thomas P. DiNapoliNew York StateComptroller, Sole Trustee, New York State CommonRetirement Fund

“Our goal is simple: we want long-termsustainable economicgrowth. And we havefound from experience that comprehensivelyintegrating environmental,social and governanceconsiderations into theinvestment process isessential to achievingthat goal.”

THE 21ST CENTURY INVESTOR: CERES BLUEPRINT FOR SUSTAINABLE INVESTINGLetter from the President 3

LETTER FROM THE PRESIDENT

The task of building a sustainable economy—one that meets the needs of people todaywithout compromising future generations—is a monumental undertaking, and an essentialone. Today, rapidly accelerating climate change,dwindling water supplies, supply chainbreakdowns, population growth and othersustainability challenges pose enormous,unprecedented risks to the global economy.But they also have created enormous economicopportunities in renewable energy, efficiencytechnologies, resilient infrastructure and othersolutions to these challenges. Thesesustainability-related risks and opportunitieswill continue to have far-reaching implicationsfor businesses, consumers and investorsthroughout the 21st century.

One of Ceres’ four strategic priorities is totransform the functioning of our economicsystems with the goal of a sustainable economy.This requires the engagement of all capitalmarket players from corporations to stockexchanges, credit rating agencies to policymakers. But, critically, it also requires thatinvestors, whose capital shapes the world inmyriad ways, integrate sustainability deeplyinto their investment policies and practices.

For 10 years, through the Investor Network onClimate Risk (INCR), Ceres has been leadinga growing movement of institutional investorswho recognize that sustainability challengesare, fundamentally, economic challenges andthat successful investing in the 21st Centurywill require investors to fully account for thesustainability risks in their portfolios and inthe economy in general.

What we call “sustainable investing” is not aradical departure from traditional investmentprinciples, though it will require investors tothink more broadly about risk and opportunityacross all asset classes. What prudentinvestor can afford to ignore the impacts of

climate change on the food and agriculturalsector, or the economic costs of increasinglycommon severe weather events? What prudentinvestor can ignore the estimated $5 trillionmarket for global clean energy investment?

Simply stated, sustainable investing is aboutthe integration of a new set of risks andopportunities into investment decision-making, and a shift from short-term thinkingabout earnings and profits to long-term valuecreation. It means going beyond traditionalfinancial analysis that fails to account forsustainability risks and opportunities anddeveloping new analytic tools that will.

In 2010, Ceres created The 21st CenturyCorporation: The Ceres Roadmap forSustainability, a tool kit now being used bymajor corporations worldwide to help thembecome more sustainable enterprises. Thisdocument, The 21st Century Investor: CeresBlueprint for Sustainable Investing, offers 10key action steps to help investors build thecapacity to be successful long-termenterprises that protect their beneficiaries,current and future, in a world facingunprecedented environmental and socialchallenges. In so doing, investors will bedoing their essential part in building asustainable 21st century economy.

Mindy S. Lubber

President, Ceres

SUSTAINABLE INVESTING

Mindy S. Lubber President, CeresDirector, Investor Network on Climate Risk

“Sustainable investing…means going beyondtraditional financialanalysis that fails toaccount for sustainabilityrisks and opportunitiesand developing newanalytic tools that will.”

INTRODUCTION: SUSTAINABILITY RISKS &

THE 21ST CENTURY INVESTOR: CERES BLUEPRINT FOR SUSTAINABLE INVESTINGIntroduction 4

This Blueprint is written for the 21st Century investor—institutional asset owners and their investment managers—whoneed to understand and manage the growing risks posed byclimate change, resource scarcity, population growth, humanand labor rights, energy demand and access to water—risksthat will challenge businesses and affect investment returns inthe years and decades to come.

These risks can and do influence financial performance andinvestment returns, yet they are often not considered wheninvestment decisions are based primarily on traditionalfinancial analysis.

This Blueprint is designed to help concerned trustees or boardmembers advance a process for better oversight and decision-making that enhances sustainable risk-adjusted returns. Itoutlines the critical decisions that trustees must make regardingboard policies and implementation, and specific steps in theinvestment process that will benefit from trustee involvement.

It is intended to prompt asset owners and asset managers toconsider their investment strategies in light of new systemic risksand to think more comprehensively about risk management andnew investment opportunities. The audience for The 21stCentury Investor: Ceres Blueprint for Sustainable Investing (“theCeres Investor Blueprint”) is any trustee, board member, CEO,CIO, portfolio manager, governance staff, analyst or consultantcommitted to evaluating material risks, maximizing risk-adjustedreturns and promoting sustainable long-term value creation.

Even though asset owners and asset managers bear fiduciaryresponsibility, “the buck stops” at the highest level of fiduciaryauthority for the asset owner. That may be a board of trusteesof a pension fund or the board or investment committee of afoundation, endowment or Taft-Hartley fund. For convenience,we will use the term “trustee” throughout this Blueprint withthe understanding that we’re also referring to any person in a role with primary fiduciary responsibility.

Trustees are empowered and obligated to serve the bestinterests of the fund, its members and its beneficiaries. That

empowerment can take many forms, but if there is no clearcommunication from the trustees concerning investmentobjectives and beliefs that should guide investment decisions,the trustees cede important decision-making for the fund to theconsultants, managers and staff, who will manage the fund’sinvestments based on their own predispositions and judgments.

Even though much of this document is directed toward thetrustees of institutional investors and the staffs they direct,many of the key action steps that support sustainableinvesting require continual interaction between asset ownersand their managers and consultants, and consequently applyto all three.

This Blueprint has been developed based on a decade ofworking with institutional investors and after extensiveconsultation with a broad cross-section of asset owners andasset managers. It includes 10 key action steps that mostinvestors are familiar with or already doing—and reframeseach in the context of a sustainable investment strategy:

1. Establish a commitment to sustainable investment thougha Statement of Investment Beliefs

2. Establish board level oversight of sustainability policiesand practices

3. Identify sustainability issues material to the fund

4. Evaluate asset allocation for material sustainability risks

5. Select an investment strategy & integrate sustainability criteria

6. Require sustainable investment expertise in manager andconsultant procurement

7. Evaluate manager performance against sustainableinvestment expectations

8. Establish engagement strategies and proxy votingguidelines consistent with sustainable investment goals

9. Support policies and market initiatives that promote a sustainable global economy

10. Integrate sustainable investment criteria across all assetclasses and strategies.

Ceres defines “sustainable investing” as investing to meet the needs of current beneficiaries without compromising theability to meet the needs of future beneficiaries. It is about sustaining the fund’s ability to meet its multi-generationalobligations by taking a broader perspective on relevant risks and opportunities. It is not a new method of investing, but a more comprehensive approach to investment analysis, decision-making and engagement that includes fullconsideration of environmental, social and governance (ESG) risks and opportunities that can impact investment returns.

OPPORTUNITIES WILL SHAPE THE 21ST CENTURY ECONOMY“Environmental and other sustainability issues are core to business performance in the 21st century.”

Anne Stausboll, CEO of the California Public Employees’ Retirement System (CalPERS)

THE 21ST CENTURY INVESTOR: CERES BLUEPRINT FOR SUSTAINABLE INVESTINGThe Business & Investment Case for Sustainable Investing 5

THE BUSINESS & INVESTMENT CASEFOR SUSTAINABLE INVESTING

RETHINKING RISK-ADJUSTED RETURNS The Ceres Investor Blueprint is designed to help institutionalinvestors and their investment managers and advisors bettermanage the emerging risks and opportunities of investing inthe 21st century.

Risk is hardly new, but the nature of risk facing investors,communities and businesses in the 21st century is different—even unprecedented. Even now, as economies and financialmarkets rebound from the 2008 meltdown that took manyfinancial institutions to the brink of insolvency and reducedthe value of investments in all asset classes, another suite ofrisks remains embedded in almost every investment portfolio.These risks are the result of a rapidly growing global populationthat is stressing water availability, demanding more energy andresources, pressuring supply chains and accelerating climatechange, which has already triggered widespread physicaldisruptions and caused hundreds of billions in economic losses.These emerging risks—which we refer to as “sustainability”risks—will almost certainly have more severe and longer lastingeconomic consequences than the recent financial crisis.

In the run-up to the recent financial crisis, too many investorsfailed to adequately account for, or even understand, therisks of subprime mortgages, credit default swaps and otherderivatives. The pressures to achieve strong short-termreturns and invest in instruments the market had judgedcredible deflected attention from material and longer-termrisks. Today, investors face new risks, some not readilyapparent, that could have equally disruptive consequences.

When evaluating their portfolios, asset owners and managersshould be asking: what environmental and social risks am Itaking—or ignoring? What risks do my portfolio companiesand investment structures have that I should be aware of? Inlight of these risks, what is the appropriate investment timehorizon for measuring and rewarding investment performance?What analytic tools exist that can add another dimension toour understanding of company, industry, asset, portfolio andfund risk? Does the integration of such additional analysisoffer a richer and more comprehensive understanding of risk-adjusted returns? Is our approach to investing contributing toa sustainable economy, which underpins our ability toachieve sustainable long-term investment returns?

Sustainable investing is about making sure thatinvestment decisions are made with a fullunderstanding of risks and opportunities, over theshort-term and the long-term. Awareness of materialenvironmental, social and governance (ESG) issuesenhances that understanding.

Financial Analysis + Sustainability (ESG) Analysis =Comprehensive Investment Analysis

A common misconception is that ESG analysis, a keytool for sustainable investing, is not compatible withoptimizing investment returns. To the contrary, whenESG analysis and conventional financial analysis areintegrated, the prospects for maximizing sustainablerisk-adjusted returns are improved because morematerial information is examined as part ofinvestment analysis.

SRI, or sustainable and responsible investing, isanother conceptual framework for sustainable investing.Many mainstream investors think of SRI as a stand-alone strategy that subordinates investment returns to considerations such as alcohol, tobacco, gambling,weapons, pornography and genocide. The connectionto financial performance has not always been clearand the use of exclusionary screens, which caneliminate large segments of the investment universe,has encountered resistance.

While such strategies remain important to manyinvestors, the mainstream investment community hasgravitated toward an approach to sustainable investingbased on positive attributes (i.e., “best-in-class”assets with positive traits), shareholder advocacy, andgeneral integration of ESG risks and opportunities intobroad investment analysis and portfolio construction.

Sustainable Investing

“Environmental, social and governance factors can affect the risk and return performance of investment portfolios

to varying degrees across companies, sectors, regions and asset classes.”

Anne Simpson, Senior Portfolio Manager and Director of Global Governance of the California Public Employees’ Retirement System

Earthquake Mexico, 20 March

Earthquakes Italy, 20/29 May Earthquake

Iran, 11 August

Severe storms, tornadoes USA, 2–4 March

Severe storms USA, 28–29 April

Severe storms USA, 28 June –2 July

Hurricane Isaac USA, Caribbean 24–31 August

Hurricane Sandy USA, Caribbean 24–31 October

Floods, flash floods Australia, Jan – Feb

Flash floods Russia, 6–8 July

Floods China, 21–24 July

Drought USA, summer

Cold wave Eastern Europe, Jan – Feb Cold wave

Afghanistan, Jan – March

Floods United Kingdom, 21–27 November

Typhoon Bopha Philippines, 4–5 December

Floods, flash floods Australia, Feb – March

Typhoon Haikui China, 8–9 August

Floods Nigeria, July – Oct

Floods, hailstorms South Africa, 20 –21 October

Floods Pakistan, 3 –27 September

Floods Columbia, March – June

Hailstorms, severe storms Canada, 12–14 August

Number of events: 905

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“E” – Environmental analysis reveals strategies for energyefficiency, better water and waste management, reductionof greenhouse gases and other pollutants, and deploymentof renewable energy alternatives. It also reveals businessimpacts on the local, regional and global environmentthroughout the product and business life cycle, fromsourcing to disposal. A full environmental analysis canalso reveal company and portfolio vulnerability toregulatory changes and preparedness for extremeweather trends. In the process of revealing risk, it canalso highlight new investment opportunities based onadaptation strategies and innovative solutions to energy,water and pollution control demands.

“S” – Social analysis reveals a company’s commitment tohuman rights and well being that extends across globalsupply chains, from worker health/safety and labor rights,to stakeholder engagement and preparedness for reducingcritical operational risks that can adversely impactworkers, the company and the community. As competitivepressures increase in a resource constrained globaleconomy, ongoing attention to labor and societal demands

will elevate company, consumer, community and investorawareness to sub-standard labor practices, productintegrity and disregard for community values. Socialcriteria, which often elude traditional investmentanalysis focused on financial metrics only, can havesignificant consequences for a company’s reputationalrisk and license to operate.

“G” – Governance analysis reveals the strength of a company’s management systems and its standardsand practices for holding itself accountable. This includesboard and management commitment to social andenvironmental performance expectations that reduce risk and reinforce brand integrity from the board room tooperations to supply chains; accountability at the boardand C-Suite levels for anticipating and managing risksand opportunities, including social and environmentalones, that can affect sustainable business growth andprofitability; executive compensation linked toachievement of sustainability goals; and board diversity;gender equality; and transparency and alignmentconcerning policy positions and political contributions.

E, S & G: Essential Elements of Sustainable Investing


Some investors are beginning to grapple with these risks andincorporate them into the investment process, but manyinvestors are either ignoring them altogether, in part becausethey’re hard to quantify, or acknowledging them only as extra-financial factors that don’t yet warrant serious analysis. Theseinvestors will discover at their peril that traditional financialanalysis, by itself, no longer provides an adequate assessmentof these portfolio risks—nor does it shine sufficient light onthe substantial investment opportunities in solutions to theseglobal challenges.

Financial analysis is being supplement by analytic tools thatbetter identify sustainability risks, including those associatedwith greenhouse gas emissions, energy, water, supply chains,human rights and natural resource scarcity. Data concerningenvironmental, labor and operational practices are widelyavailable, as are comparative rankings of companies basedon performance in key environmental, social and governance(ESG) areas that tend to elude mainstream financial analysis.The participation of investors with more than $30 trillion inassets in investor groups focused on sustainable investment—such as Ceres’ Investor Network on Climate Risk (INCR), theUN supported Principles for Responsible Investment (PRI),the Forum for Sustainable and Responsible Investment (USSIF), and European, Australian and Asian investor groups onclimate change—is testament to the importance of these newtools for managing emerging ESG risks.

NEW ECONOMIC & INVESTMENT REALITIESThe complex, interrelated challenges of meeting energydemand, mitigating the worst impacts of climate change andensuring that future generations have water and other naturalresources to sustain their own economies pose enormousshort and long term risks for investors.

Climate change in particular—11 of the warmest years onrecord have occurred since 2000—is already having profoundeconomic consequences around the world. Extreme weather,which is the predictable consequence of climate change,accounted for more than 90 percent of the natural catastrophesworldwide in 2012 (see Figure 1, p. 6), with the biggest lossesbeing in the United States.

In 2011, the United States experienced 14 extreme weatherdisasters causing more than $50 billion in total damages. In2012, insured losses from Hurricane Sandy, a historic droughtand other climate-influenced extreme weather topped $58 billion.1 The broader economic ripples were even higher,especially in the case of the ravaging drought where foodprice inflation and shipping disruptions lasted well into 2013.

Hurricane Sandy alone caused more than $70 billion ineconomic losses2 including an estimated $15-$20 billion ofinsured losses—the second largest catastrophic event on

BILLION CUBICMETERS OFWATER— 154 BASINS /REGIONS

Figure 2: Global Fresh Water Demand Gap Projected By 2030

4,500

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through 2010; supply in 2005 is 4,081 BCM per year; supply in 2030 under projectedtechnological and infrastructural improvements equals 4,866 BCM per year; net ofenvironmental requirements

Source: Water 2030 Global Water Supply and Demand model; agricultural production based onIFPRI IMPACT-WATER base case. [extracted from Charting Our Water Future; Executive Summary;McKinsey and Company; 2009; p 12]

that scale, after Hurricane Katrina in 2005. Sandy’s impactswere exacerbated by a record-breaking storm surge abettedby rising sea levels caused by warming global temperatures.

These trends have profound implications for low-lying citiessuch as New York, Boston, New Orleans, Miami and manyothers. In the United States alone, nearly five million peoplelive less than four feet above mean high tide. In just threesouth Florida counties, excluding the most populated, Miami-Dade, $30 billion in taxable property lies less than three feetabove mean high tide.

Globally, the economic and investment risks from climatechange and other sustainability challenges are increasing aswell. Even with accelerated investment in water efficiencyand resource management, many countries and continentsare on course to suffer major freshwater deficits in the nexttwo decades. (See Figure 2.) A recent McKinsey studyestimates that by 2030 global water demand will outpacesupply by 40 percent. This shortfall will hit all corners of theworld, including the southwest United States, Australia,Africa and East and Southeast Asia.

Uncertain water supplies—whether a lack of water, or toomuch at once—has obvious reverberations across supplychains and can cause severe business interruptions that poseinvestment risk. More than 160 companies in the global textileindustry were affected by Thailand’s 2011 floods, stoppingabout a quarter of the country’s garment production and alsodisrupting auto parts and computer hardware supply chains.Insurance company Munich Re received claims worth morethan $350 million from the 2010-2011 Australian floods,contributing to a 38 percent quarterly profit decline.

Government responses to these challenges create additionalrisks and opportunities for investors. While U.S. lawmakershave failed to enact carbon regulations, much of the world—including California, the world’s ninth largest economy—has moved forward on this front. Carbon regulations to reducethe emissions that cause climate change affect one-third ofthe world’s population today, with economic implications forbusinesses operating in those jurisdictions. Sector-specific

carbon regulations are also gaining traction, including morestringent fuel-economy standards for US-made vehicles andwidely anticipated greenhouse gas regulations for powergeneration facilities. As domestic and global pressures buildto ward off worst-case climate warming scenarios, all companiesand investors should expect to be operating in a carbon-constrained global economy before long.

STRATEGIC RESPONSES BY FORWARD-LOOKING PORTFOLIO COMPANIESMany of the world’s leading corporations are alreadyintegrating sustainability considerations into their businessmodels. Rather than be at the mercy of sustainabilitypressures that will continue to reshape the global economy,companies are mitigating social and environmental risks andseizing opportunities to invest in solutions, enhance theirbrands and help assure sustainable earnings.


The value of incorporating sustainability into businessstrategies and investment decisions is not hearsay oranecdotal, but strongly supported by an increasing bodyof academic research and industry evidence. Recentexamples include:

Ñ A meta-analysis by Deutsche Bank Climate Advisorsin 2012 found that 89% of the more than 160academic studies, research papers and meta-studiesshowed that companies with high ESG performanceratings exhibit market-based outperformancecompared to industry peers, and 100% of theacademic studies agree that companies with highratings for Corporate Social Responsibility (CSR) andESG factors have a lower cost of capital in terms ofboth debt (loans and bonds) and equity.4

Ñ In an 18-year study (1993-2011) conducted byRobert Eccles and George Serafeim of HarvardBusiness School, 90 companies with strongsustainability policies and practices outperformed a similar sampling of 90 companies having lowsustainability standards. “The annual above-marketaverage return for the high-sustainability sample was4.8% higher than for their counterparts and with lowervolatility. The high-sustainability companies alsoperformed much better as measured by return onequity and return on assets5,” the report concluded.

Ñ Companies on the California Public Employees’Retirement System’s Governance Focus List, selected

for in-depth engagement because of CalPERS’concerns about weak sustainability performance,produced cumulative returns averaging 39% belowtheir benchmarks in the three years prior to CalPERSengaging with the companies and 17% above theirbenchmark returns for the five years after theengagement was undertaken.6

Ñ A portfolio of 151 SRI funds between 2002 and 2009,a period of high market volatility, outperformed theMSCI World Index.7

Ñ In a study of more than 450 companies between 2001and 2010, Sustainable Asset Management found thata portfolio of sustainability leaders outperformed anoverall sample by 1.74% annually, while a portfolio of weak sustainability performers underperformed theoverall sample by 1.87% annually.8

Ñ In a 2011 white paper, RCM Capital Managementfound that over a five-year period (2006-2010) aportfolio comprising the top quintile of global best-in-class ESG companies outperformed the benchmarkMSCI World Equal Weighted Index by 1.7%, whilethe bottom worst-in-class portfolio underperformedthe benchmark by 1.0%.9

A more in-depth discussion of supporting evidence thatESG focused strategies can produce superior results,and do not underperform, for both companies andinvestors, is provided in Appendix A.

The Business & Investment Case for Sustainable Investment

Building on these trends, Ceres in 2010 created The 21stCentury Corporation: The Ceres Roadmap for Sustainability(“the Ceres Corporate Roadmap”), a virtual owner’s manualfor the sustainable corporation. Now being used by hundredsof major companies and by investors in corporate engagements,The Ceres Corporate Roadmap contains 20 specificexpectations in key areas of governance, disclosure andengagement, as well as performance indicators such asreduced greenhouse gas emissions, improved water efficiency,and improvements in human and worker rights in supplychains. Companies that meet these expectations will be bestprepared to compete in the 21st century global economy—an economy rapidly being shaped by climate change, resourcescarcity, population pressures and related challenges. TheCeres Investor Blueprint provides guidance to help investorsaddress these same challenges.

INVESTOR RESPONSES TO THECHALLENGES OF SUSTAINABILITYInvestors are increasingly aware that sustainability challengesare investment challenges. Ahead of the 2012 internationalclimate summit on Doha, Qatar, a coalition of the world’slargest investors managing $22.5 trillion in assets called ongovernments to adopt carbon-reducing policies that willaccelerate the necessary trillions in clean energy investmentthat will help slow climate change.

In recent years there has been rapid growth in the number of financial indices that address sustainability, including the S&P/IFCI Carbon Efficient Index, HSBC Climate Index,Prudential Green Commodities Index, the NASDAQ GlobalSustainability 50 Index, and full suites of sustainable andenvironmental indexes by FTSE and MSCI. Some major stockexchanges, including those in London, Rio de Janeiro andJohannesburg are requiring public disclosure of sustainability-related information (such as greenhouse gas emissions) byall listed companies. In response to a petition from Ceres andleading investors, the U.S. Securities and Exchange Commissionin 2010 issued climate change disclosure guidance thatrequires disclosure of material climate-related risks bypublicly-held companies.

Despite these encouraging steps, most institutional investors donot yet fully understand how environmental and social forcesshaping the 21st century economy will impact their portfolios.And even those investors with an awareness of these trendsmay not be familiar with available analytic tools or even havemade the commitment to become “sustainable investors.”

This Blueprint is intended to guide asset owners, assetmanagers and consultants through a step-by-step processthat will lead to a more comprehensive understanding ofmaterial risks and opportunities that will help maximizesustainable risk-adjusted investment returns.

INTEGRATING SUSTAINABILITY ANALYSISINTO INVESTMENT DECISIONSThere is a strong and growing body of objective evidence thatcompanies that integrate sustainability principles into theiroperations and strategies perform better and, over time,produce superior returns with decreased volatility and risk to shareholders, than companies that do not.3

But sustainable investing isn’t simply about identifying andinvesting in companies with proven sustainabilityperformance; it is also about:

analyzing ESG risks in every asset class and mitigatingthese risks across the entire portfolio;

understanding the economic impact of increasinglycommon severe weather events that are causing hundredsof billions in economic losses and tens of billions ininsured losses every year;

knowing the practices that safeguard worker health andsafety, protect human rights and support localcommunities across the supply chain

financing the clean energy technologies of the future and understanding the risks in water infrastructure bondsin a world that can no longer take ample supplies of freshwater for granted;

preparing for the impact of new regulatory frameworksthat will inevitably catalyze a shift away from fossil fuels torenewable energy sources;

understanding the risk to infrastructure, real estate10 andsupply chains that sit on land just a few feet above sealevel and are vulnerable to stronger storm surges fromrising seas and more powerful storms.

These are just some of the “sustainability” risks andopportunities that often elude traditional financial analysisand overall investor interest.

Sustainability challenges are also opening up large newopportunities for investors. The International Energy Agencyhas estimated the global clean energy investment opportunitiesin renewable power, energy efficiency and cleaner transportationat $5 trillion within the next decade.11 Climate changeadaptation will require enormous infrastructure investmentsrelated to power generation and distribution, transportation,agriculture and water efficiency. Mercer Consulting estimatesthe investment opportunities to be as high as $5 trillion overthe next 15 to 20 years.12


THE 21ST CENTURY INVESTOR: CERES BLUEPRINT FOR SUSTAINABLE INVESTINGFiduciary Duty & ESG Factors 10

FIDUCIARY DUTY & ESG FACTORS

Fiduciaries who manage institutional assets owe a duty ofutmost good faith, loyalty and prudence to the beneficiarieswhose money they are managing. Integrating material ESGfactors into their investment decision-making is fullyconsistent with the fiduciary duty of institutional investors.

The overriding objective of institutional trustees and managersis to generate sufficient, consistent risk-adjusted returns thatenable the fund to pay benefits and meet its liabilities overmultiple generations. This goal is embedded in fiduciary dutyand is often cited as an obstacle to incorporating ESG factorsinto the investment process. The argument that ESG-inclusiveinvesting is inconsistent with fiduciary duty is based on thepremise that including ESG factors in investment decision-making would compromise returns to achieve extraneoussocial or environmental objectives. This perspective misses themark on both the nature and goals of “sustainable investing.”

Institutional investors are bound to meet their obligations totheir fund’s or client’s beneficiaries over the life of the fund.Fund trustees and managers must therefore manage theirinvestments to satisfy both long and short-term liabilities,using strategies designed to meet target return rates thatprovide sustainable benefits over multiple generations.

In the United States, the fiduciary duties of institutional assetowners and asset managers are generally defined by statecommon law and statutes for public, religious, endowmentand foundation funds; and by federal statute (ERISA) andregulations for labor (Taft-Hartley) and corporate plans.Although there are some differences, the essential elementsof fiduciary duty are generally quite similar.

While the exact formulation varies among jurisdictions and bytype of investor, the two basic elements of fiduciary duty areduty of care (or prudence) the duty of loyalty (includingimpartiality among participants and beneficiaries).13 Generallyspeaking, fiduciaries must act:

Solely in the interest of participants and beneficiaries

For the exclusive purpose of providing benefits

Impartially, taking into consideration the differing interestsof various classes of participants and beneficiaries

With the care, skill and prudence exercised by similarfiduciaries, including with respect to diversification ofinvestments and monitoring of performance

Incurring only reasonable and appropriate costs

In accordance with the governing law, documents andpurpose of the trust fund14

Under the Employee Retirement Income Security Act (ERISA),the key duties of a fiduciary administering a coveredretirement plan, as outlined by the U.S. Department of Labor,similarly include:

Acting solely in the interest of plan participants and theirbeneficiaries, with the exclusive purpose of providingbenefits to them

Carrying out their duties prudently

Following the plan documents (unless inconsistent with ERISA)

Diversifying investments

Paying only reasonable expenses15

So how is sustainable investing relevant to the discharge of fiduciary duty?

Modern Portfolio Theory (MPT), an approach to portfolioconstruction first developed in the 1950s, has played adominant role in prevailing concepts of fiduciary duty—inparticular the duty of care and its principles of prudence anddiversification—over the past several decades. Briefly, MPTis a mathematical formulation of the concept of diversificationof assets in a portfolio, in which higher risk demands higherreturns. According to MPT, portfolio risk is reduced byinvesting in multiple non-correlated asset classes, therebymaximizing risk-adjusted returns.16

MPT is based on a number of economic assumptions,including that markets are fully efficient and investors areentirely rational—i.e., that all market players have access toall relevant information and act in their economic self-interestbased on that information.

Some commentators have criticized MPT as having variousshortcomings and counterproductive effects as applied.17

However, MPT is not inconsistent with sustainable investingstrategies and the incorporation of ESG factors into investmentdecision-making.

The interpretation of fiduciary duty has evolved significantlyover time and must continue to evolve to adjust to changingsocial and economic realities. For example, rigid rules

“To ignore the risks around climate and sustainability in your portfolio could be and will be characterized as a dereliction of your fiduciary duties.”

Kevin Parker, former Global Head, Deutsche Asset Management

specifying prohibited and permitted investments gave way to MPT and diversification across multiple asset classes.18

It is again time to re-examine current concepts of “prudent”institutional investing in light of basic fiduciary duty principlesand new factors affecting investment risk and opportunity.19

Today, new investment risks and opportunities based onemerging trends like climate change and resource scarcityrequire consideration by prudent fiduciaries. This approach,which we have termed sustainable investing, adopts a longer-term focus, is less tied to short-term benchmarks as the solemeasure of success, and incorporates ESG factors intoinvestment analysis and strategy. This is fully compatible withMPT and provides a clear path for today’s fiduciaries tocomply with their duties of loyalty and prudence.

The courts and the Department of Labor have permittedconsideration of social and environmental issues in investmentdecisions, provided that the trustees reasonably believed theywere acting in the interests of beneficiaries and would notcompromise the fund’s risk-adjusted returns.20 A thorough2005 legal analysis by the international law firm Freshfields

surveyed the law of fiduciary duty in a number of leadingjurisdictions including the U.S., and concluded, “ESGconsiderations may be taken into account as long as they aremotivated by proper purposes and do not adversely affect thefinancial performance of the entire portfolio.” The Freshfieldsreport noted that the duty of prudence may even requireinvestors to consider relevant ESG factors in making investmentdecisions, and concluded that consideration of climate changein investment analysis is “clearly permissible and is arguablyrequired in all jurisdictions.”21

Environmental and social variables can no longer be treatedas extraneous “non-financial” matters. These drivers ofinvestment risk and opportunity are becoming increasinglyimportant in developing strategies to manage risk and seekadequate risk-adjusted returns. Given the increasedavailability of ESG data and evidence of its materiality tocompany and investment performance, we believe thatdisregarding such information would be inconsistent with theresponsibilities of 21st Century fiduciaries.

THE 21ST CENTURY INVESTOR: CERES BLUEPRINT FOR SUSTAINABLE INVESTINGFiduciary Duty & ESG Factors 11

Environmental and social variables can no longer be treated as extraneous “non-financial” matters.

THE 21ST CENTURY INVESTOR: CERES BLUEPRINT FOR SUSTAINABLE INVESTINGCeres Blueprint for Sustainable Investing 12

21ST CENTURY INVESTOR: CERES BLUEPRINTFOR SUSTAINABLE INVESTING

INVESTMENT GOVERNANCE�

Step 1: Develop Investment BeliefsThe Board of Trustees, or highest levelof fiduciary authority, will establishcore investment principles that includea commitment to sustainableinvestment.

Step 2: Implement Trustee OversightThe Board of Trustees, or highest levelof fiduciary authority, will establishoversight of sustainable investmentinitiatives and accountability forimplementation.

INVESTMENT PRACTICES�

Step 3: Assess MaterialityThe trustees, in collaboration withinvestment and governance staff,consultants, managers, and sector & issue experts will identify thesustainability issues and risk factorsthat are material to the fund.

Step 4: Review Asset AllocationThe trustees, in collaboration with theCIO, investment staff, consultants,managers and sector & issue expertswill evaluate asset allocation modelsfor material sustainability risks.

Step 5: Integrate ESG intoInvestment StrategyTrustees, investment staff, consultantsand managers will select sustainabilitystrategies best suited to the fund’s risk-adjusted return objectives.

Step 6: Incorporate ESG intoManager SelectionTrustees, investment and governancestaff and consultants will requiresustainable investment and engagementexpertise in manager and consultantprocurement.

Step 7: Evaluate ManagerPerformanceTrustees, investment and governancestaff and consultants will monitormanager performance againstsustainable investment expectations.

Step 10: Integrate SustainabilityCriteria Across All Assets Classesand StrategiesTrustees, investment and governancestaff and consultants will assess ESGrisks and opportunities in every assetclass and incorporate sustainabilitycriteria into all investment strategies.

ASSET STEWARDSHIP �

Step 8: Align Active Ownershipand Proxy Voting WithSustainable Investment GoalsTrustees, investment and governancestaff, and investment managers willestablish engagement strategies andproxy voting guidelines consistent withsustainable investment goals.

Step 9: Support Policies andMarket Initiatives that Promote a Sustainable Global EconomyAsset owners & investment managerswill support market & policy initiativesthat advance sustainable investmentinitiatives and promote a sustainableglobal economy.

THE 21ST CENTURY INVESTOR: CERES BLUEPRINT FOR SUSTAINABLE INVESTINGTen Action Steps Toward Sustainable Investment Practices 13

CERES INVESTOR BLUEPRINT: 10 ACTION STEPS TOWARD

SUSTAINABLE INVESTMENT PRACTICES

These 10 action steps are aimed at institutional investor governing boards, investment consultants, internal investment and governance staff, and external asset managers. The dots show who is primarily responsible

for each step, and most involve collaboration among these groups.

10

9

8

7

6 5

4

3

2

1

Trustees

Consultants

Investment &Governance Staff

Investment Managers

ManagerSelection

Monitoring

Active

Ownership

Classe

sAs

set

Investment

Strategy

Asset

Alloca

tion

Materiality

Oversight

Beliefs

Initiatives

Market

Based on more than a decade of experience working with institutional investors, and extensiveconsultation with a broad cross-section of asset owners and managers, this Blueprint recommends10 action steps for institutional investors seeking to become sustainable investors. While thesesteps are presented in what we believe is a logical sequence, they can be undertaken in any order.

“Every investor needs to work through these 10 steps. By asking these questions, each investor will figure out what issues are material to their particular investment objectives and

how to ensure that they are mitigating investment risks and seizing opportunities that might otherwise go unnoticed.”

Nancy Kopp, Treasurer, State of Maryland


� ESTABLISH CORE FUND VALUES

Beliefs have consequences for investment decisions madeby consultants, staff and asset managers. When trusteesarticulate the belief that sustainable investing leads to betterfinancial outcomes because all risks and opportunities areconsidered, “then arguably the role of the fiduciary is clearer.Assessment of beliefs helps to identify distinct views onsustainable investing issues such as climate change andresource scarcity. The strength of the beliefs held willdetermine how the investment strategy can be adapted totake account of long-term factors.”22

If trustees do not articulate principles to guide their approachto investing and risk management—and why those principlesmatter—they effectively defer key decisions to others(investment managers, consultants and staff) who willmanage according to their own policies, practices andprejudgments.23 When trustees clearly communicate a set of investment beliefs, every person and entity associated with the fund has a framework for understanding what thetrustees expect.24

Investment Beliefs Require Self-Examination Establishing investment beliefs encourages trustees to askimportant questions, debate priorities and seek advice fromindustry experts and peers in similar organizations. Theprocess gives trustees a better understanding of the fund, its beneficiaries, its goals, key challenges for meeting short,medium and long-term obligations, relevant time horizons forinvestments, and the risk factors that could impact returnsover the fund’s life. Consequently, the process of reviewing orformulating investment beliefs is a good moment to evaluatethe role of ESG analysis in identifying material investmentrisks and to commit to integrating ESG considerations intoevery aspect of the investment process.

A recent survey of 685 asset owners, asset managers andconsultants by Pensions & Investments found that 57% haveformalized Investment Beliefs that provide guidance on suchissues as return objectives, risk management, diversification,market efficiency, costs, governance, the goals of longer terminvestment, reforms that support the integrity of economiesand markets, engagement with portfolio companies and thecontribution of environmental, social and governance factorsto sustainable investment performance.25

� COMMITMENT TO UNDERSTANDING ESG ISSUES AS THEY AFFECT THE FUND IS A CRITICAL INVESTMENT BELIEF

Towers Watson, in their 2012 report on sustainableinvestment, We Need a Bigger Boat, advises trustees toconsider sustainability beliefs in the context of risk,opportunity and “the longer-term risks and costs associatedwith sustainability issues such as resource scarcity andclimate change.”26

There is no template for investment beliefs; they are uniqueto every fund and will differ depending on such factors asinvestment objectives and liabilities. Trustees can obtainuseful input and guidance from their investment consultants,peers and outside experts but must make and “own” the keyjudgments on what to include concerning the contribution ofESG factors to the fund’s expectations for sustainable risk-adjusted returns.

Because many trustees do not have an investmentbackground, and those that do are not necessarily familiarwith ESG risks, trustee education on these issues is crucial.Such training can be done in-house, preferably in collaborationwith experts in relevant aspects of sustainability risks or in off-site sessions conducted by established programs for trusteetraining, such as those affiliated with Harvard and StanfordUniversities. Ceres, the Initiative for Responsible Investing at Harvard, ICGN or PRI are useful resources for identifyingor developing trustee training programs.

Step 1: Establish a Commitment to Sustainable Investment Through a Statement of Investment Beliefs1

Trustees assure consistent decision-making by investment staff, consultants and managers byestablishing clear core values—values that should include full consideration of material issues thatmay affect sustainable investment return, including environmental, social and governance factors.


Ñ the california State teachers’ retirement System(calStrS) Board of trustees links fiduciary duty tocritical factors that affect global economic growth andthe long term sustainable returns CalSTRS requires.The trustees also support specific policies the staff hasdeveloped to support sustainable investment returns:

As a significant investor with a very long-terminvestment horizon and expected life, the successof CalSTRS is linked to global economic growthand prosperity. Actions and activities that detractfrom the likelihood and potential of global growthare not in the long-term interests of the Fund.Therefore, considerations of environmental,social, and governance issues (ESG), as outlinedby the CalSTRS 21 Risk Factors, are consistentwith the Board fiduciary duties.27

Ñ ontario municipal Employees’ retirement System(omErS) explicitly incorporates ESG factors into itsinvestment analysis for reasons of long-term financialperformance:

2.1 Socially Responsible InvestingOAC [OMERS Administration Corporation]believes that well-managed companies are those

that demonstrate high ethical and environmentalstandards and respect for their employees,human rights, and the communities in which theydo business, and that these actions contribute tolong-term financial performance. As part of itsdue diligence in researching investments andmonitoring performance, OAC incorporatesenvironmental, social and governance factors intoits decision-making processes.28

Asset managers should also develop investmentbeliefs, including attitudes toward ESG factors.

Ñ f&c Investment has an unequivocal statementabout the value of incorporating ESG issues:

F&C Investment strongly believes that the prudentmanagement of (ESG) issues is fundamental tocreating value for investors. Companies that aresuccessful in avoiding ESG risks, and also atidentifying and capitalizing on the opportunities,will outperform over the longer term.29

A larger sampling of investor belief statements thatrecognize the contribution of ESG factors to investmentreturn is provided in Appendix B.

ExAmplES of InvEStmEnt BElIEfS thAt IncorporAtE ESG


� OWN THE INVESTMENT PROCESS

Decisions affecting the fund are continually being made atmany different levels of the organization. Chief investmentofficers, investment committees and portfolio managersroutinely make decisions that affect asset allocation, portfoliocomposition and, in many cases, the selection of consultantsand external managers.

The active involvement of trustees in ESG integration sends a strong message to investment and governance staff—andto their asset managers and consultants—that investmentrisks and opportunities are being comprehensively examinedin ways that “investing as usual” may not account for. It alsoalerts investment consultants and managers that the fund willhold its providers accountable for integrating ESG factors intotheir investment processes, practices and advice.

� ASSIGN OVERSIGHT

The responsibility for overseeing an investment process thatincorporates ESG analysis needs to be formalized by appointinga point person (or committee) who is already a member of theboard or reports directly to the board. Ideally such individualshave an interest or expertise in sustainable investment andshould seek appropriate training about key sustainability risks,especially if someone with limited knowledge of these issueswill conduct oversight. Where a fund has a sole trustee (suchas the Treasurer of North Carolina or the Comptroller of NewYork State) with other competing responsibilities, a practicalsolution to ongoing oversight of sustainable investmentpractices is to delegate a senior staff member whounderstands the mandate and has relevant expertise.

� UNDERSTAND RISK

Trustees need sufficient involvement in the fund so theyunderstand where the fund may be vulnerable to strategies,companies, sectors, and industries poorly prepared for futurecompetitive pressures and trends. They should understandESG factors that impact all asset classes and investmentstructures. Among the factors that all investors should belooking at: the physical and regulatory impacts of climatechange that will affect investment strategies for energy, water,real estate, utilities, agriculture, tourism, forest products andother industries; depletion of water resources that areessential to agriculture, power generation, most industrialprocesses and human survival; and human rights violationsand unsafe or exploitive labor practices that can affect brandvalue and the legal and ethical license to operate.

� MONITOR IMPLEMENTATION OF SUSTAINABLE INVESTMENT INITIATIVES

Trustees should require investment managers to submitwritten reports on the implementation and results ofsustainable investment initiatives on a regular schedule. The trustees should also require similar formal reporting from investment consultants and internal staff concernedwith investment, manager selection and governance. Thetrustees should review and discuss these reports, askquestions of their service providers and staff, evaluate theprogress and success of these initiatives, and periodicallyconsider whether adjustments in strategy and tactics (andpotentially service providers) are needed.

Step 2: Establish Board Level Oversight of Sustainability Policies and Practices2

Trustees need to actively support and oversee key aspects of the investment process to assure that sustainable investment practices are being implemented.


Investors need to identify issues and risk factors that, for them, are significant enough to influence investmentdecisions. This process of identifying material risk factorsmust be undertaken in dialogue among asset owner Boardsof Trustees, investment consultants, investment staff and theasset managers who will implement investment strategies.

The U.S. Supreme Court has ruled that a material fact is onewhose existence, were it known, “would have been viewed by the reasonable investor as having significantly altered the‘total mix’ of information made available.”30 As interpreted bythe U.S. Securities and Exchange Commission, “a matter is‘material’ if there is a substantial likelihood that a reasonableperson would consider it important.”31 ESG analysis can oftenreveal such material facts that would have gone unnoticedusing traditional financial analysis.

The Supreme Court has also established principles thatacknowledge the place of uncertainty and contingencies, whichskeptics often cite in challenging the materiality of ESG risks:

1. Contingent or speculative events are not immaterialsimply because they are contingent or speculative;

2. The materiality of contingent or speculative eventsdepends on the significance the reasonable investorwould place on the information;

3. The significance of contingent or speculative events toinvestors depends on both the likelihood of occurrenceand the magnitude of potential impact.32

Like other investment risks, those associated with ESG factorscan be unpredictable concerning timing and magnitude. Thatdoes not make them any less material. Some investment risksand opportunities may be more significant to particularinvestors and should be carefully analyzed by the investmentstaff, consultants and managers. For example, while energyconsumption of a real estate portfolio would be a materialconcern for all investors (because it will impact the operatingcosts and long term value of the real property), it could be ofparticular concern to a construction industry pension fundbecause of the impact of this issue on members’ jobs andpension contributions as well as investment performance.

� WHAT GUIDELINES HAS THE INVESTMENTCOMMUNITY ESTABLISHED FOR MATERIALITY?

Whether it relates to conventional financial performancemeasures or ESG factors, “materiality” is a subjective standard.The first effort to codify sustainability indicators, commonlycalled key performance indicators (KPIs) was undertaken in1997 by the Global Reporting Initiative (GRI). GRI guidelinesplace the responsibility on companies to identify their ownmaterial issues and recommends that companies use multi-stakeholder engagement, including investors, to determinekey issues. While GRI has identified hundreds of KPIs thathelp companies disclose their sustainability performance,most companies do not consistently follow the GRI guidelines,including disclosure on how companies identify material ESG factors that affect their business. Consequently, manysustainability reports do not provide investors with reliable,actionable information about material ESG risks. The recentlyreleased fourth generation of GRI Guidelines (G4) continuesto place a strong emphasis on corporate reporting of materialESG issues and performance.

In response to the lack of objective standards for determiningmateriality, and because company reporting and conventionalfinancial analysis often does not include material ESG riskfactors, a group of investment industry experts knowledgeableabout sustainability issues convened in 2011 to form theSustainability Accounting Standards Board (SASB). SASB’sobjective is to establish “industry-specific accountingstandards for material sustainability issues for use by U.S.publicly listed corporations and their investors”33 and to haveits standards become as authoritative as the financialaccounting and reporting standards of FASB. The SASBworking groups, which include companies, advocacy groupsand other stakeholders, in addition to investors, aresystematically evaluating material key performance indicatorsfor each industry, a process they hope to complete in 2014.

Also underway is another initiative, Project Delphi, by morethan three-dozen global asset managers, asset owners,consultants and ESG service and data providers to identify

Step 3: Identify Sustainability Issues Material to the Fund3

Understanding and addressing material sustainability risks is integral to fiduciary duty.


the material ESG “Super Factors” most likely to influencecorporate financial performance, affect investment decisionsand impact long-term value. Their report, slated for release in

2013, will focus on identifying risks and the opportunitiesassociated with these ESG Super Factors.

Universe of PotentialSustainability

Issues

Sustainability Issues

Most Relevant to the Sector

Financial Impacts / RiskIssues that may have a financial impact or may pose a risk to the sector in the short-, medium-, or long-term (e.g., product safety).

Legal / Regulatory / Policy DriversSectoral issues that are being shaped by emerging or evolving governmentpolicy and regulation (e.g., carbon emissions regulation).

Industry Norm / Competitive IssueSustainability issues that companies in the sector tend to report on and recognizeas important drivers in their line of business (e.g., safety in the airline industry).

Stakeholder Concerns / Social TrendsIssues that are of high importance to stakeholders, including communities, non-governmental organizations and the general public, and/or reflect social andconsumer trends (e.g., consumer push against genetically modified ingredients).

Opportunity for InnovationAreas where the potential exists to explore innovative solutions that benefit the environment, customers and other stakeholders, demonstrate sector leadership and create competitive advantage.

MATERIALITY TEST

ExAmplES of mAtErIAl SuStAInABIlIty ISSuES for InvEStmEnt & lonG tErm vAluE crEAtIon

A 2010 report by Harvard’s Initiative for ResponsibleInvestment provided an intellectual foundation for SASBthrough guidance on and tests for materiality.34 The authorsidentified a set of representative sustainability issues thatinvestors may find material, including:

Ñ Climate change and the efficient use of energyÑ Releases of toxic chemicals into the environmentÑ Sustainable management of forests, fisheries, and other

natural resourcesÑ Safety and decent working conditionsÑ Equal access to technologies and financial services for

all members of societyÑ Availability of waterÑ Equal employment opportunitiesÑ The need for sustainable products and services

The authors also recognized that the materiality of ESGissues varies by sector and industry. Instead of settling on asingle definition of materiality, they developed a frameworkfor assessing materiality that can be used at the sector,industry or company level, including issues such asregulation of carbon emissions that will affect some sectors

more adversely than others and innovative responses to riskand problem solving “that demonstrate sector leadershipand create competitive advantage.”35

Investors can also learn from stakeholder groups that routinelymonitor company policies and practices, and from thecompanies themselves, especially those that are thinkingstrategically, taking action and communicating about nearterm and longer term critical success factors for value creation.Companies should be encouraged to report to investors onhow their sustainability initiatives affect their financialperformance, and investors should consider how a company’sdisregard for social and environmental risks reflects flawedgovernance or shortsighted management that couldundermine long-term competitiveness and value creation.

The more investors discuss and debate the issues and riskfactors they believe may be material to their portfolio or fund,the more probing questions they ask of their consultants,managers and portfolio companies—and the more theirgovernance staff may become aware of a need for shareholderengagement around ESG issues (see Step 8).


Trustees should review current asset allocation strategies todetermine whether they are prepared for risks arising fromclimate change, supply chain interruption or increased costsfrom human rights issues, increased demand for energy,political risks, affordable access to water and other resources,foreseeable limits on greenhouse gas emissions and othermaterial sustainability risks. These new risks are typically notan explicit part of fund analysis and asset allocation strategiesand are not systematically managed. At best, many of theserisks tend to be discussed anecdotally or understood as partof inflation or GDP projections.

� CLIMATE RISK POSES UNIQUE & UNPRECEDENTED CHALLENGES TO ASSET ALLOCATION

Because climate change risk is ubiquitous, commonly usedstrategies for diversifying risk, such as Strategic Asset Allocation(SAA), may leave entire funds still exposed under certainscenarios. While these asset allocation strategies are generallyeffective in mitigating risks across traditional and alternativeassets, including risks associated with many ESG factors, theywill provide limited diversification to carbon risk. For example,when carbon emissions become taxed or regulated, all assetclasses that have investment exposure to carbon producers(oil/gas/coal producers) will be affected. That risk extends toinvestments in heavy users of fossil fuels (utilities, transportation),which, as costs increase, may experience reduced profitmargins that will impact investment returns. These risks lackprecedent, and asset allocation models that rely on historicquantitative analysis do not adequately account for them.

� UNDERSTAND THE RISKS ASSOCIATED WITH A DIFFERENT REGULATORY ENVIRONMENT

The prevailing investment model that has led most investorsto diversify across asset classes did not work particularly wellduring the financial market breakdown of 2008, and it willnot work well when widespread regulatory controls that tax orput limits on carbon emissions (or physical risks) adverselyimpact investments across many of those same asset classes.

An alternative approach is to diversify across sources of risk.Climate Change Scenarios—Implications for Strategic AssetAllocation, a 2011 report by the consulting firm Mercer,estimates that institutional portfolios could be exposed tosystemic risks from climate related policies that could affectinvestment returns by as much as 10% over the next 20years. Mercer suggests that to “manage climate change risks, institutional investors need to think about diversificationacross sources of risk rather than across traditional assetclasses.”36 According to one of Mercer’s scenarios, a typicalportfolio seeking a 7% return could manage climate changerisk by shifting about 40% of their portfolio into climate-sensitive assets such as infrastructure, real estate, privateequity, and timberland.

While there is no single solution for mitigating portfolio riskfrom regulatory, legislative and other responses to climatechange, investors should begin examining climate risks by:

including climate risk assessments in routine reviews ofportfolio and fund strategies;

increasing allocations to assets that will benefit fromgrowing demand for low carbon, efficient, clean energysolutions, effectively creating a climate hedge;

boosting engagement with portfolio companies to improvetheir policies and practices on climate risks.

The Mercer report includes in-depth analysis of existingclimate-related risks by asset class and a menu of suggestionsfor new allocation strategies to help mitigate those risks.

Climate-related risks, both carbon-reducing regulations andphysical impacts, were not part of investment dialogueswhen many institutional investment policies and assetallocations were being formulated. Can investors with multi-decade liabilities afford to ignore them now? Assessment ofcarbon risk exposure across portfolios is a prudent initial stepin understanding and considering appropriate responses,including investments in both climate mitigation (e.g., lowcarbon energy sources, energy efficiency) and climateadaptation (i.e., resilient infrastructure projects).

Step 4: Evaluate Asset Allocation for Material Sustainability Risks4

Decisions about asset allocation directly affect the incurrence and management of material sustainability risks.

� UNDERSTAND HOW ASSETS ARE EXPOSEDUNDER A RANGE OF ENVIRONMENTAL & SOCIAL SCENARIOS

Entirely different climate-related investment risks are thoseassociated with physical impacts such as stronger storms,rising sea levels, wildfires, and droughts that can affect broadgeographic areas, regional economies and specific sectors.37

Likewise political instability, national or international workerprotections (or lack thereof) can affect a range of industriesin geographic regions. There are cross sector risks frominternational and regional regulatory changes. For example, if policy makers act to limit global warming to 2 degreesCelsius, more than half of all oil, coal and natural gasreserves—now classified as valuable assets on balancesheets—will be unburnable unless new technologies forcarbon capture are developed.38

Trustees should ask their consultants to “stress test”traditional allocation models by running sustainabilityscenarios on these issues. A consultant can model factorssuch as a drought, a particular sea level rise prediction, theimpact of civil unrest in a region, resource scarcity or a newregulatory framework for climate change and assess theimpact on the portfolio. These scenario overlays may revealrisks that can then be mitigated.


If policy makers act to limit global warming to 2 degrees Celsius, more than half of all oil, coal and natural gas reserves—now classified as valuable assets on balance sheets—will be unburnable unless new technologies for carbon capture are developed.


Implementing a sustainable strategy can be a one- or two-step process that follows the larger asset allocation decision.

Trustees and investment staff make choices about investmentstrategies in public equities—the largest allocation in mostfunds—that are as basic as active versus passive and asspecific as index weighting or investment theme.

In the two-step process, the specific investment strategy will be determined first and the integration of ESG second.Investors new to ESG integration may find this approachcloser to their comfort zone, because of familiarity withcertain investment strategies not necessarily associated withincorporating ESG factors. Ideally these are done together inone unified process, but either approach is workable. Anychosen strategy can be configured for ESG integration.

Among equity strategies there are two primary approaches—investors with active strategies can use ESG analysis in the stockselection process. Passive investors can license an ESG index orcan modify an existing index to incorporate ESG components.

� ESG INTEGRATION FOR ACTIVELY MANAGEDEQUITIES STRATEGIES

Many active managers, such as Boston Common AssetManagement, Calvert Investments, ClearBridge Investments,Generation Investment Management, Impax AssetManagement, Parnassus Investments, Pax WorldInvestments, Portfolio 21 Investments, RobecoSAM andTrillium Asset Management, among many others, offerdedicated investment products that incorporate ESG analysiswith the goal of generating superior investment returns. Inmany cases client requests for further customization of ESGcriteria are possible, but the core investment process isinformed by a proprietary approach to analyzing ESG risksand opportunities. Other active managers who do not yetroutinely examine ESG factors could be engaged to developclient specific investment strategies that target sustainableholdings or strategies that build ESG analysis into thefundamentals of portfolio construction.

� ESG INTEGRATION FOR PASSIVELY MANAGEDEQUITIES STRATEGIES

For those investors who choose a passive strategy, virtuallyevery major index provider has an ESG or sustainabilitythemed offering that is already licensed by an investmentmanager—or is available for licensing. Many of the passivestrategies that integrate ESG are benchmarked against abroad-based investment universe. One example is a best-in-class approach that focuses investment exposure withinindustries (or regions) to companies demonstrating strongersustainability practices. This approach is commonly used tohelp maintain sector and/or geographic neutrality versus thefund’s performance benchmark.

Track records now exist for ESG benchmark indexes for mostsector, region and market cap strategies, as well as for manystyle and thematic strategies. The returns of the ESG indexesversus the standard ones show no inherent performancepenalty for incorporating ESG analysis, and in come casesthe ESG indexes outperform their benchmark. (See AppendixA for examples.)

New ESG indexes for passive strategies are being developedspecifically for large institutional investors who by choice ormandate own a cross section of the entire market and haveless maneuverability to exclude specific companies based onESG factors. One approach weights companies in the indexaccording to their ESG “score;” another weights companiesaccording to how those scores are improving over time.39 Suchstrategies that tilt portfolio exposure by increasing investmentconcentrations in companies with higher ESG scores can bestructured to retain ownership of the whole market, a priorityfor so-called universal investors.

If a particular index strategy only exists in a non-ESG form,including so-called smart-beta strategies based on factorssuch as momentum, volatility and fundamental analysis, itcan be customized to incorporate whatever ESG or thematiccomponents the investor would like to have.

Step 5: Select an Investment Strategy and Integrate Sustainability Criteria5

• Asset Owners should choose investment strategies that will serve the fund’s objectives and foster sustainable investments.

• The integration of ESG criteria does not restrict investment options.

� ESG INTEGRATION FOR INVESTORS INPUBLICLY LISTED REAL ESTATE INVESTMENTTRUSTS (REITS)

Investors in REITs can use ESG analytic and benchmarkingtools such as the Global Real Estate Sustainability Benchmark(GRESB) to assess the sustainability performance of real estateportfolios and whether sustainability best practices are likely to enhance and protect shareholder value. GRESB uses sevenaspects of sustainability divided into two sustainability“dimensions”: 1) Management and Policy and 2)Implementation and Measurement. These two dimensionshelp to identify and map the property holdings of eachparticipating REIT (or private fund) in the approximately$500 billion U.S. REIT market. Analysis of this type will helpinvestors better understand how their REIT holdings (andprivate funds) have embedded sustainability into their realestate portfolios and how their sustainability metrics compareto other REITs, regions and sectors.

� ESG INTEGRATION FOR INVESTORS INEMERGING PUBLIC EQUITIES MARKETS

Investors in emerging markets should confer with theirconsultants, managers, ESG analysts and index providersconcerning the availability of information on ESG issues.Because company and investment information is often lesstransparent than in developed markets, the importance ofidentifying and evaluating ESG risks is even greater. To thatend Northern Trust has launched an emerging markets indexfund that requires the portfolio’s companies to adhere to theUN Global Compact, excludes manufacturers of controversialweapons and establishes standards for corporate governance.

Another helpful resource concerning the unique ESGchallenges in emerging markets is The Emerging MarketsDisclosure Project,40 which addresses issues that includecultural differences in engaging with corporations, differentmodels of ownership structure, different legal structures andapproaches to proxy voting, and different leverage points forengaging and changing companies. Emerging markets alsovary greatly in their uptake of ESG metrics, with severalhaving stricter mandatory disclosure than North America(e.g. South Africa, Brazil) while others lag far behind.

� TAKE ACTION TO MITIGATE UNWANTED SUSTAINABILITY RISKS

A new investment strategy may be warranted following aportfolio review of ESG risks. Such analysis often identifiesspecific areas of concern, commonly by sector or morenarrowly by industry and company. With this knowledge, the portfolio can be reconfigured in a number of ways.

If the type of existing investment strategy is producing thedesired returns, determine with your consultants andinvestment manager how that general strategy can beadapted to incorporate ESG risks and opportunities—or whether its good performance is unsustainable because of ESG risks that can’t be easily mitigated. If the currentstrategy has been underperforming, trustees and investmentstaff should have their consultant analyze and recommendoptions to improve performance and integrate ESG factors.

Other investors may prefer to focus on strategies that moreexplicitly incorporate sustainability criteria—for example, onesthat minimize fossil fuel exposure or focus on companiesproviding solutions to water management, resource depletionand climate change.

A caveat that should be but is not always obvious is that eventhough the academic literature shows sustainably managedcompanies tend to outperform their peers, the net performanceof the portfolio will be highly dependent on the specific strategyadopted, the time frame, the fees charged, the skill of themanager and general economic trends.



A growing number of investors are building ESG criteria intotheir procurement of money managers, including CalPERS,CalSTRS, NYCERS, the State of Connecticut, and the UAWRetiree Medical Benefits Trust. Investors building a sustainableinvestment strategy need to understand how their managersare incorporating ESG criteria into their investment practices.

A good place to start is requests for proposals (RFPs). Someinvestors have standard templates for specific strategies indifferent asset classes, while others write new ones for eachmanager search. In either case the RFP can be amended ordrafted to enquire about a manager’s attitudes, expertise andpractice for evaluating ESG.

Each investor needs to determine what the RFP shouldemphasize. General considerations that will help frame theselection process should include:

whether the provider’s investment policies reflectconsideration of ESG risks and opportunities overintermediate and longer term time horizons;

the provider’s experience, expertise and tools for evaluatingESG risks and opportunities;

how the provider’s actual investment decisions demonstratethe integration of ESG risks and opportunities.

If the asset owner’s expectations are made clear, investmentmanagers and consultants responding to RFPs willunderstand that “investing as usual” is no longer acceptable.

Risk management practices, which are often very detailed inRFP responses, can provide trustees with good insight into howa prospective manager considers ESG issues in combinationwith traditional risk management metrics—and how themanager’s investment approach may perform under differentmarket conditions or the introduction of new regulations.

� SEEK ANSWERS THAT WILL REVEAL HOWMANAGERS INCORPORATE ESG FACTORS

Key concerns and questions investors should consider fortheir RFP include:

Attitudes, Expertise & Implementation Concerning ESG FactorsÑ What ESG products or services do you offer and how

would you suggest applying them in investment strategies,including the one in this RFP?

Ñ How do you think shareholder value can be enhanced orpro

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