Does pension funds' fiduciary duty prohibit the integration of environmental responsibility criteria in investment processes? A realistic prudent investment test Andreas G. F. Hoepner ab ; Michael Rezec a & Sebastian Siegel c a School of Management, University of St Andrews, The Gateway, North Haugh, St Andrews, KY16 9SS, UK; b Principles for Responsible Investment, PRI Secretariat, c/o UN Global Compact, DC2-612, United Nations, New York, NY 10017, USA; c School of Business and Economics, Abo Akademi University, Tuomiokirkontori 3, FI Turku, Finland

Summary (1) For the question, if (angloamerican) pension funds‘ fiduciary duties allow ESG integration, answering the following question remains crucial: –Can pension funds integrate ESG criteria in a prudent investment process without compromising their financial attractiveness? To the best of our knowledge, this paper conducts the first, empirically realistic, global analysis of this question for corporate environmental responsibility criteria Financial Sample: Annually updated FTSE All World Developed (24 countries, about 1,800 firms per annum) from Jan 2005 to October 2010

Summary (2) ESG Sample: Annual (5 step) EIRiS ratings for (i) Environmental Policy, (ii) Environmental Management, (iii) Environmental Impact, (iv) Environmental Reporting and (v) Overall Environment [Average of criteria (i)-(iv)] Econometric Method: Carhart (1997) model with control factors for our universe of 24 sample countries from Style Research Result: We cannot reject our nullhypothesis that pension funds integration of ESG criteria in a prudent investment process does not compromise their financial attractiveness in a single case Implication: At least with regard to EIRiS corporate environmental responsibility scores, pension funds unlikely compromise on their financial attractiveness by integrating environmental criteria in their prudent investment process

Background: Pension funds & ESG criteria Pension funds represent the major source of long term capital in many developed capital markets. Institutional investors, primarily pension funds, drive global financial markets. It has been suggested that pension funds should be logical investors in ESG funds and that an increasing proportion of pension funds are incorporating ESG criteria. Some regulatory changes e.g. July 3, 2000 an amendment was made to the Pensions Act of 1995 requiring trustees of occupational pension schemes to disclose their policy on Socially Responsible Investment in their Statement of Investment Principles (SIP). The legal framework for pension funds impose strict requirements on pension fund trustees to invest in a prudent fashion while taking the interest of the plan members into account by which is generally meant achieving some reasonable return.

The conclusion from seminal Freshfields (2005) report “The short conclusion is that ESG considerations may be taken into account as long as they are motivated by proper purposes and do not adversely affect the financial performance of the entire portfolio.”

What does this mean in practice? Employee Retirement Income Security Act of 1974 (ERISA). ERISA § 404 A fiduciary shall discharge his duties: “(B) with the care, skill, prudence, and diligence under the circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims; (C) by diversifying the investments of the plan so as to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so” 2008 US Department of Labor Bulletin “ERISA’s plain text does not permit fiduciaries to make investment decisions on the basis of any factor other than the economic interest of the plan.”

What does this mean in practice? (1) The traditional implementation of the duties of pension fund trustees have been that the trustees duty is to invest according to the risk parameters specified in the investment policy, maximize investment returns, minimize risk and make no other decisions than those in good faith for the exclusive benefit plan participants and beneficiaries

What does this mean in practice? (2)

What does this mean in practice? (3)

Research Question Research Question: Can pension funds integrate ESG criteria in a prudent investment process without compromising their financial attractiveness? Respective Nullhypothesis: Pension funds integration of ESG criteria in a prudent investment process does not compromise their financial attractiveness.

Empirically realistic data sample Financial Sample: –Annually updated FTSE All World Developed from Jan 2005 to October 2010 –24 developed countries, about 1,800 firms per annum –Realistic universe for a pension fund (avoiding riskier emerging markets in its direct investment) ESG Sample: –EIRiS, the (independent, ESG focused) ethical consciousness of FTSE4GOOD, as realistic data provider of pension funds –Annually updated 5 step ratings from end of December 2004 to end of December 2009 i.Environmental Policy ii.Environmental Management iii.Environmental Impact iv.Environmental Reporting v.Overall Environment [Average of criteria (i)-(iv)]

Econometric approach Portfolio Construction: –We build 25 value weighted long only portfolios for each of the 5 rating steps or each of the 5 criteria based on continously compounded stock returns (inclusive of dividents) –Empirically very realistic, as (especially large) pension funds cannot make consistent use of equal weighting or short selling in their direct investment due to their size and rather risk averse purpose –Annual update of stock universe and ESG rating as in case of Fama and French‘s (1993) SMB and HML factors Econometric Model: –Carhart (1997) model on developed country basis –Control factors for our universe of 24 sample countries from Style Research –Model seems strong, as all 25 Adjusted Rsquared > 90%

Results Please see attached tablesattached tables

Conclusion We cannot reject our nullhypothesis that pension funds integration of ESG criteria in a prudent investment process does not compromise their financial attractiveness in a single case. Implication: At least with regard to EIRiS corporate environmental responsibility scores, pension funds unlikely compromise on their financial attractiveness by integrating environmental criteria in their prudent investment process.

Thank you very much for your attention. We would be very thankful for (especially critical) comments and questions!