Every year the money flowing into “sustainable” investment funds in one form or other breaks records. In the first seven months of 2007, 15.2 per cent of net investments in equity funds in Europe went into environmental funds, against 2.6 per cent during the whole of 2006, according to Watson Wyatt, the investment consultants.

Market estimates suggest about $4,000bn is invested globally in strategies incorporating environmental, social responsible investment (SRI) and governance factors, all with the overarching goal of managing risk and enhancing returns.

Watson Wyatt is convinced that “sustainability, and, in particular, environmental issues, will influence and shape the economic landscape and equity markets over the coming decades”.

Socially responsible investment growing in importance

Two years ago, Dutch group, Robeco, the Rotterdam-based asset manager that is part of Rabobank, bought two-thirds of Sustainable Asset Management (SAM) in Switzerland. At the time, SAM – set up a decade before – had about €2.5bn ($3.88bn) invested in private equity and listed investments focused on sustainability. Now it has closer to €5bn under management and about 10 funds including a Sustainable Water fund, a Smart Energy fund, a Sustainable Climate and a Healthy Living fund

SAM’s approach is two-fold. It identifies trends that might pose industry challenges and then picks a portfolio of small and mid-sized stocks. It also looks at investing in large-cap companies, depending on how its sustainability criteria affects competitiveness and fair value.

SAM is one of five groups shortlisted for the FT’s sustainable investor of the year award. Others include F&C’s global and sustainable investment team.

Calvert Social Investment Foundation, meanwhile, which has more than $125m invested, pioneered the idea of “community investment” – raising money from private investors to lend to local community projects with the purpose of alleviating poverty and helping sustainable development. The idea is to preserve investors’ capital and blend financial and social returns.

E+Co, in the US, provides venture capital as well as development services to small and medium enterprises that supply clean, affordable energy to households, businesses and communities in developing countries in Asia, Africa and South America. It has backed, for example, brick-makers in Bolivia to fuel kilns with natural gas, and wind-powered water pumps in Senegal.

Aavishkaar India Micro Venture Capital Fund provides micro-equity funding (of about $20,000 to $500,000) and support to entrepreneurs and ventures designed to help local communities in rural and semi-urban India. It has invested about $1.3m so far.

“A tipping point has been reached – with the pursuit of sustainability firmly on the political and public agenda, the investment community response is now rapidly evolving,” says Jane Goodland, investment consultant at Watson Wyatt.

Mercer, another consultant, this month announced it was expanding its database on fund managers to evaluate the extent to which they integrate sustainability into their mainstream investment processes. They are doing so because of the increased interest of pension fund trustees and other institutional owners of assets who believe that environmental, social and governance issues can have an impact on long-term investment performance.

Up to now the academic evidence has suggested that incorporating non-financial issues or “extra-financial” issues into investment decisions will result in lower returns for investors. However, returns from some of the oldest sustainable investment funds, such as F&C Asset Management’s Stewardship range, have recently bought this theory into question by performing in line with wider stock market indices over long periods.

Increasingly, stock markets and investors are giving weight to issues such as governance, sustainability and the environment. The move has been helped by government-led initiatives to use taxes, financial penalties and tradeable permits to bring home to companies their impact on the environment through harmful greenhouse gas emissions and waste packaging.

As a result, lawyers are reversing opinions that any institutional fund manager using SRI or sustainability as an investment framework might be compromising returns and therefore breaching their fiduciary duties to clients. Now pension fund managers are becoming comfortable with using a socially responsible long-term investment framework to identify risk and opportunities outside the limits of conventional investment analysis. Watson Wyatt says pension funds increasingly recognise that too much emphasis on the short-term canharm a funds’ long-term investment goals.

“The modern genre of sustainable investment, which is now primarily motivated by value creation and supported by academic research, is encouraging more pension funds to pursue this approach,” says Ms Goodland. “It will become impossible to take a long-term investment view without considering the impact of sustainability issues on investments.”

This new interest has prompted a number of innovative fund launches in the past few months, including climate change funds, a proliferation of “green” fixed income, real estate funds, and clean technology funds and funds trading in carbon credits.

The market in carbon credits began in early 2005 with the start of the EU’s emissions trading scheme. Companies were allocated permits based on how much greenhouse gas – notably carbon dioxide – they might emit. Companies that cut emissions could sell credits to other companies that exceeded their allowances.

The market had some hiccups to begin with – some European countries had issued too many credits – and prices fell. In December one of the first hedge funds set up to trade in carbon emission credits quietly shut down after failing to raise its targeted $125m.

However, prices have stabilised and according to the World Bank, the market in carbon trading was worth about $64bn last year.

In May, four investment groups, Alliance investment trust, the Universities Superannuation Scheme, SNS Real, and Mitsui & Co, invested £56m ($110m) in Climate Change Capital, a carbon trading fund manager with $1.6bn under management. More than $1bn of its funds are in carbon markets, including a portfolio of carbon credits.

Peter Moon, USS’ chief investment officer says: “We believe the low-carbon investment arena is poised for considerable growth in the coming years ... As a long-term responsible investor, USS holds the view that the fund should take steps to reduce the risks associated with a changing climate.”

USS is just one of a growing number of asset managers, as well as hedge fund groups, clamouring to enter this investment area.