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Massachusetts State Senator Benjamin Downing has a personal interest in the health of his state’s pension funds. After his father died 12 years ago, payments from the public system supported Downing’s siblings and mother.

But since 2013, when the senator drafted legislation that would force Massachusetts’ pension funds to stop investing in oil, gas and coal companies, he’s had to answer to charges that his proposed law would threaten beneficiaries’ future payouts. Among the critics is Michael Trotsky, executive director and CIO of Massachusetts’ Pension Reserves Investment Management Board, which oversees a combined $60 billion in assets for the teachers’ and state employees’ retirement systems.

Weighing in on the first version of Downing’s fossil fuel divestment bill, Trotsky told the state legislative committee that pension fund fiduciaries “should be guided exclusively by considerations related solely to risk and return.” He went on to warn that “adding considerations onto the calculus that are extraneous to risk and return can only impact the portfolio’s performance negatively.”

Although the 2013 bill never made it out of committee to a full Senate vote, Downing refiled it this January. “I understand the desire of the pension fund managers to have as much latitude and flexibility as possible to make their decisions,” he says. “But I do think there are public policy goals that are ultimately more important.”

Across the U.S. and elsewhere, a similar drama is playing out as public pension funds consider the virtues and potential pitfalls of fossil fuel divestment. Treasurers, legislators and fund managers must ask themselves whether divestment hurts performance — and if so, how that squares with their fiduciary duty. Given the consensus that climate change is a threat, do public retirement schemes have any business profiting from traditional energy producers? Is divestment or investor engagement the best way to influence companies’ behavior? Faced with the possibility that the world will leave much of its fossil fuel reserves untouched, should pension funds get out while they still can?

Massachusetts is one of three U.S. states wrestling with these questions. Vermont’s legislature will debate a fossil fuel divestment bill this year, also for the second time. In California a stipulation to require divestment by the country’s two largest public pension funds — the $296 billion California Public Employees’ Retirement System and the $186 billion California State Teachers’ Retirement System — is part of a climate legislation package released in early February and endorsed by Governor Jerry Brown.

Public pension funds can’t ignore the divestment issue. Almost 20 U.S. university endowments have agreed to ban fossil fuel investments, among them Stanford University; Goddard and Green Mountain colleges, both in Vermont; and Hampshire College in Massachusetts. More than two dozen American cities have committed to divestment, including Cambridge, Massachusetts; Portland, Oregon; San Francisco; and Seattle. Scores of religious institutions and foundations have done the same.

In Europe the divestment movement recently gained momentum. In March, Oslo became the first national capital to divest its coal company holdings, and a group of six Danish pension funds managing €32 billion ($34 billion) in retirement assets for 200,000 of the nation’s academics, engineers and lawyers announced an April member vote on dumping fossil fuels. In February the world’s second-largest pension fund, the $887 billion Norwegian Government Pension Fund Global, revealed that it divested from 32 coal companies last year. In January, €262 billion Nordea Asset Management, the Nordic countries’ biggest pension manager, announced that it would exit about 40 coal producers, though neither it nor GPFG has unveiled plans for complete divestment.

So far, no U.S. states have followed suit. “I’m not in favor of divestment,” says Elizabeth Pearce, state treasurer of Vermont and a vice chair of the $4 billion Vermont Pension Investment Committee (VPIC), which oversees pension funds for the state employees’, municipal employees’ and teachers’ retirement systems. “Our analyses say that divestment would create losses for the system.”

Possible blows to performance are a major sticking point for asset owners facing a mandated sale of their fossil fuel holdings. Fiduciaries like Vermont’s Pearce and Massachusetts’ Trotsky oppose divestment on the grounds that pension funds are obliged to keep their opportunity set as broad as possible. Banning fossil fuel investments narrows that set considerably: A 2014 report from New York–based Sustainable Insight Capital Management (SICM) found that investors who do so can lose access to 11 percent to 19 percent of the S&P 500 Index, depending on whether exclusion definitions are broad enough to bar heavy power consumers such as carmakers.

VPIC’s own research shows that this constraint could have grim financial fallout. A November 2014 report by the Vermont State Treasurer’s Office estimated that avoiding fossil fuel companies would cost VPIC $10 million, or about 4 percent, of annual expected returns. The report also found that one-time transaction costs to meet the legislation’s requirements could reach another $8.5 million.

The Vermont pension system’s investment adviser, NEPC, also found that divestment would sting: In a February 2013 report the Boston-based firm predicted that if VPIC avoided traditional energy companies, its $1.21 billion in total global equity holdings would suffer a 0.5 percentage point hit to annualized returns, based on NEPC’s historical calculations. Meanwhile, VPIC’s $785 million actively managed global equity portfolio would dip by a quarter of a percentage point per year. NEPC estimated that VPIC would lose from $2.6 million to $8.5 million annually in beta (the overall market return), and from $1.6 million to $2.4 million annually in alpha (returns above market benchmarks). The wide ranges reflect guesses about whether fossil fuel divestment would be limited to VPIC’s equity portfolio or affect fixed-income holdings too, and whether it would apply to commingled accounts.

Asset managers with experience running fossil-fuel-free strategies stress the importance of careful risk rebalancing: “If a fund’s managers embark on a [divestment] strategy, they should be very aware of what the investment implications are in terms of risk in one’s overall portfolio,” says Bruce Kahn, a portfolio manager at SICM and former senior investment analyst at Deutsche Asset Management.

Matthew Patsky, CEO and portfolio manager at Trillium Asset Management, a $2.2 billion Boston-based sustainable-investment firm that runs an equity-only fossil-fuel-free strategy, couldn’t agree more. As one of several people asked by the Massachusetts Office of the State Treasurer to review Senator Downing’s legislation, Patsky says his counsel was to avoid the mistake of simply investing in an index that strips out fossil fuels and offers no further risk rebalancing.

He contends that if a core domestic equity portfolio consisted of, say, 13 percent traditional energy, a fund could safely decarbonize it by putting 87 percent into an index that excludes energy and moving the other 13 percent into an actively managed portfolio that helps balance the overall risk. The actively managed portion might include some allocations to companies specializing in renewables, energy efficiency and other clean technology, Patsky explains, but limiting it to such investments would prove too volatile.

“It’s hard to articulate in a piece of legislation that funds will need to extract their investments in the fossil fuel industry and reinvest not just in solutions for climate change, but in a way that balances all the characteristics of the portfolio to make sure they haven’t caused any unintentional increased volatility or risk,” he says. Patsky calls Downing’s legislation “imperfect” but “a clear step in the right direction.”

Trillium’s fossil-fuel-free strategy has returned an annualized 8.5 percent over the past eight years, bating the 7.3 percent gain for its S&P Composite 1500 benchmark during the same period.

Increasingly, the idea of fossil fuel divestment as an overly risky proposition is being turned on its head, leaving some investors wondering if energy companies present a long-term risk to pension fund portfolios. A growing number of reports — like one published in 2013 by London-based nonprofit Carbon Tracker and the Grantham Research Institute on Climate Change and the Environment at the London School of Economics — warn that more than half of the oil, gas and coal reserves claimed by publicly listed companies can’t be burned if the world hopes to avoid the worst effects of climate change.

These so-called stranded assets could mean that current valuations of such companies are grossly overinflated — a possibility that investors and others are keen to quantify. Among them is the Bank of England, which announced late last year that it was launching a formal examination of the risks that stranded assets could pose to the stability of the financial system.

Although Vermont State Treasurer Pearce resists the idea of divestment, she does fear the environmental and financial risks that fossil fuel companies can pose. What she says she fails to understand is how divestment helps on either count. “We can best address climate issues through constructive engagement of companies through shareholder resolutions and other activities that persuade them to take a look at their own business models and how they relate to the carbon bubble,” Pearce asserts.

She points out that the systems she oversees have voted their proxies in support of climate issues since 2004. Since then they’ve ramped up their environmental engagement by signing shareholder resolutions focused on limiting greenhouse gas emissions and a letter from sustainability advocacy group Ceres to 45 oil and gas producers demanding to know those companies’ plans for their high-carbon reserves.

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