How Pension Funds Can Rake in Green by Investing Green

In early February, California State Treasurer Phil Angelides unveiled an initiative called "GreenWave," designed to help the state's public pension funds -- initially CalPERS and CalSTRS -- become more environmentally responsible. He effectively challenged California's pension funds to stand up and be counted on one of today's most important issues and, in so doing, he highlighted the historical silence of these sleeping financial giants.

Unfortunately, his proposals are almost certain to elicit either silence or outright opposition from some rather well-entrenched apostles of the status quo. That would be deeply regrettable, and directly injurious to the financial interests of Californians.

Collectively, California's public retirees constitute what is arguably the single greatest concentration of financial power in the world. By the end of 2003, California pension funds in the top 200 U.S. pension funds had over $330 billion in assets. With that much money comes influence -- and responsibility.

So far, however, the impact of California's financial strength on the issues that Californians care about has been, to put it mildly, somewhat muted. They are not, in short, utilizing their potential impact nor, we would argue, fulfilling their full fiduciary responsibilities.

In fact, the most visible -- if not the only -- policy issue on which California's financial strength has been heard over the last 10 years is on the issue of corporate governance. CalPERS, for example, has long been a global leader in this area, and has successfully weighed in on everything from individual company malfeasance to the recent systematic abuses at investment banks and mutual funds.

So there is a history of pension fund activism and leadership coming from California. But -- important as corporate governance is -- it has been inconsistent and insufficient. There can, there should and there most likely will be much more to come.

This is why we applaud Angelides' attempt to move into what we see as the next battleground for California pension fund activism: "sustainability investing" -- ensuring that the companies in which the funds invest not only perform well financially, but also environmentally and socially. There are good reasons -- both political and financial -- why this should be so.

Politically, sustainability is an issue that Californians truly care about. They always have, from the days of John Muir and Yosemite, all the way through to the wind farms at Altamont and the nation's first (and strictest) auto emissions regulations.

In parts if not all of the state, the Green Party is a growing, sometimes transformational, political force. And from a purely financial perspective, a focus on sustainability has already demonstrated the potential to reduce risk and enhance portfolio returns. In short, California pensioners stand to make MORE money by paying attention to sustainability. And who can argue against more money?

Yet despite both academic studies and practical experience illustrating the benefits of sustainability investing, virtually none of the California funds and their advisors and money managers has so far taken substantial steps in this direction. We think that there are at least four reasons for this:

* The deep-seated (but erroneous) belief that addressing social and environmental issues almost inevitably requires sacrificing risk-adjusted financial returns. (Quite the reverse has actually been proven true, in recent studies by such icons of traditional money management as State Street Global Advisors, Barclays Global Investorsand Morgan Stanley.)

* The equally erroneous view that, since returns are "inevitably" compromised, fiduciary responsibility demands that social and environmental factors be set to one side when investment decisions are being made.

* The silent conspiracy of passive resistance by the vast majority of money managers and pension fund consultants. These two key sets of actors are virtually unanimous in their indifference or even hostility to "socially responsible investment" (SRI). (Unfortunately, few if any of SRI's critics in either group have taken the trouble to actually review any of the growing body of sophisticated financial research supporting the SRI case.)

* The extraordinary deference of most pension fund trustees, who tend to be intimidated by their professional advisors, and who all too often forget that the advisors and money managers work for them and not the other way around.

As a result, California lags at least five years behind Europe in capturing the benefits of sustainability investing. Indeed, pension funds in most European countries are now legally obligated to report on what they are doing to address environmental and social risks in their investment strategies. California pensioners should be so lucky.

In this dismal landscape, there are, however, some rays of hope. California could, if it had the political will, adopt its customary leadership position in this regard. For example, in early 2002, the Contra Costa County pension fund decided to conduct an experiment to see how issues of sustainability might affect the financial performance of their investments.

To do this they first allocated approximately $150 million to an "eco-enhanced" index fund. The fund tracks the Standard and Poor's 500 index fairly closely, but overweights the top "sustainability" performers and underweights the laggards. After its first year, the fund had outperformed its benchmark by 150 basis points (1.5 percent), an excellent result for a conservative, risk-controlled "enhanced index" strategy.

At the same time, the county also commissioned an innovative live simulation study to test what would happen if a similar environmental and social "tilt" were applied to their other money managers as well. Interestingly, despite considerable variations in investment style, geographic focus and portfolio company size, the environmentally and socially enhanced portfolios would have outperformed in virtually all cases. In this particular case, the county's pensioners would have had an extra $9 million in their retirement savings plans had this been done.

Then there is Angelides' GreenWave initiative, which is designed to "bolster financial returns, create jobs and clean up the environment." California and the country need more such initiatives that are born of the realization, in the treasurer's own words, that "the way in which we deploy capital can shape not only the contours of our economy, but also the future of our communities, our society and our environment for decades to come."

That is precisely the sort of visionary leadership that California's pensioners need and deserve. Now if only they would start demanding more of it.