We offer this paper, written in collaboration with Sarah Cleveland Consulting, to fill a need we have observed among investors and advisors to have a clearer understanding of how environmental consideration are applied in the investment process. We also seek to resolve some confusion about the labels applied to this style of investing—Environmental, Sustainable, Responsible, and ESG (Environmental, Social and Corporate Governance) are all commonly used, but often the strategies they are applied to look quite different.

Although it may seem that Sustainable Investing and Environmental Investing could be one in the same, the term “sustainable” has now been applied to so many strategies, including those that have nothing to do with environmental considerations, that it is now virtually meaningless.

There are many reasons investors may pursue environmental investing.  They may seek to improve the resilience of our society, to learn about environmental risks in the investment process, or to find new opportunities in emerging technologies. As interest has grown, we have observed many investment managers rush to throw their hat in the ring and offer a solution. However, across the industry, methods of environmental research and integration into the investment strategy vary widely. It can be difficult to glean much from the label of a strategy; investors need to ask real questions in order to discern the rigor and quality of the investment process behind the label.

We offer this paper, written in collaboration with Sarah Cleveland Consulting, to fill a need we have observed among investors and advisors to have a clearer understanding of how environmental consideration are applied in the investment process. We also seek to resolve some confusion about the labels applied to this style of investing—Environmental, Sustainable, Responsible, and ESG are all commonly used, but often the strategies they are applied to look quite different.

Although it may seem that Sustainable Investing and Environmental Investing could be one in the same, the term “sustainable” has now been applied to so many strategies, including those that have nothing to do with environmental considerations, that it is now virtually meaningless.

There are many reasons investors may pursue environmental investing: to improve the resilience of our society, to avoid investment risk, or to seek new opportunities. As interest has grown, we have observed many investment managers rush to throw their hat in the ring and offer a solution. However, across the industry, methods of environmental research and integration into the investment strategy vary widely. It can be difficult to glean much from the label of a strategy; investors need to ask real questions in order to discern the rigor and quality of the investment process behind the label.

Amanda is Portfolio 21's Communications Manager.  She has more than 10 years of research, communications, and interactive media experience in the financial industry.

This paper is intended to provide information to investment professionals and individual investors interested in the emerging "fossil free investing" movement.  This campaign is seeking to encourage institutional investors to divest from fossil fuel companies, due to their climate change impact and corporate environmental practices.

Record Date:  December 10, 2012

Ex-Date, Reinvestment date, Payable Date:  December 11, 2012

Ordinary Income Rate:

PORTX:   $0.33036781

PORIX:    $0.42547284

Short-term Capital Gains Rate:  None

Long-Term Capital Gains Rate:  None

Please contact us if you have questions about these distributions.

McKibben recently hit the road in a biodiesel bus for a 21-city speaking tour to raise awareness around why divestment is a powerful tool for education.  The most prominent example of this was, of course, the campaign to end apartheid in South Africa.  Beginning in the late 1970s and continuing through the early 1990s, this campaign, which was a primary focus of the nascent Socially Responsible Investing industry, mobilized educational institutions, governments, and faith-based investors to divest from companies with South African business interests.  According to an analysis by corporate responsibility consultant Richard Knight, during the 1980s a total of 155 colleges at least partially divested.  They were joined by 90 cities, 22 counties, and 26 states that also took some form of economic action.  Nelson Mandela has stated that he believes the University of California’s $3 billion divestment in the late 1980s was a particularly significant milestone in the eventual dismantling of apartheid.

It is probably not surprising then that McKibben is focusing his efforts at colleges, universities and religious organizations across the country.  Today’s youth will have many decades to manage the impacts of current and future climate change and have the most at stake.  They may be able to speak collectively and persuasively that fossil fuel risks have grown too large to ignore and must be addressed systemically.  Since early November, more than 100 college and university groups have signed on to the campaign to Go Fossil Free.  Some, like Harvard, University of New Hampshire, and Brown, are passing student resolutions and pushing for dialogue with administrators.  Others, such Unity College in Maine and Hampshire College in Massachusetts have already started the process of creating new investment policies.

We applaud the work of these young activists and wish them great success.  Clearly, we are of like mind that the risks inherent in these industries are just too high.  We have supported 350.org since its launch and Portfolio 21 Investments’ policy is to not invest in fossil fuel production or any extractive industry.  We recently shared more about our policy, and the reasoning behind it, with journalist Marc Gunther following his recent article on this topic for Guardian Sustainable Business (“Where can investors who worry about climate change put their pension?”, November 30, 2012).  Marc included our response, along with comments from several other fund managers, in a follow up post on his blog.

Amanda is Portfolio 21 Investments' Communications Manager.  She has more than 10 years of research, communications, and interactive media experience in the financial industry.

Among the Global 500 group companies, representing the largest market capitalization, climate change is a growing concern and focus of their business planning—more than two-thirds identify climate change risks to their business operations, and more than one-third see these risks posing real and present dangers.  The impacts of recent extreme weather events have likely made an impression.  This acknowledgement of the current impacts of climate change has increased by 10% in the last two years among CDP respondents.

The CDP’s challenge at this year’s Forum indicates that although there is a growing corporate awareness and momentum toward emissions reductions, this will be only be part of the solution.   CDP Chairman Paul Dickinson framed the challenge:  “Most of the things that get done in the world get done by the world’s largest companies.  Governments need to step up and match the operational domain of the corporations.  That means international treaties.”  And further:  “The developed world has no moral authority to say that they can’t consume in the way that we do…if we don’t get leadership in your country, from the United States.”  We are seeing corporations demonstrate willingness, but there is a great degree of uncertainty about the future of energy—what will it cost and where will it come from?  Setting a price on carbon would likely help incentivize businesses to reduce pollution, and perhaps even compete with one another about who could do it most efficiently and in the shortest time period.  I hope that’s a race that we will one day see unfold.

Amanda is Portfolio 21 Investments' Communications Manager.  She has more than 10 years of research, communications, and interactive media experience in the financial industry.

As the global economy continues to grow at a pace more slow and uneven than that hoped for by many investors, the mood of the world’s stock and bond markets remains nervous and cautious. Most investors and the media have become focused on the dramatic stories of the global economy, which tend to involve countries with too much debt. Markets have been driven by perceptions of what central bankers and government policymakers say they will do to “stimulate” global economic growth. Portfolio 21 is mindful of the global economy, but we concentrate on the fundamental and environmental performance of individual companies. And we know that many company’s management teams are focused on moving their businesses forward and are not waiting for the world’s central bankers’ latest policy pronouncements.

Today we are able to find companies that are adjusting to the conditions of slow and uneven growth, finding ways to improve their businesses, and move their environmental practices toward more competitive positions. Consider the Swedish ball bearing producer, SKF. In response to a slowdown in global manufacturing, the company is adjusting throughput to account for slower demand from Asia and Europe. Yet, SKF is pushing its “BeyondZero” initiative even harder as it aims to reduce the environmental impact of company operations and assist customers in improving their environmental performance. Many stocks that interest us have become cheaper than we might have expected, which is exciting in the cases where we have not yet bought, but quite a disappointment in terms of the ones we already own. We have taken advantage of the general decline in the price of economically sensitive stocks to buy more of what we believe to be the very best quality companies.

Over the past twelve months ending June 30, 2012, the period covered by this report, global investors have been struggling through the implications of the seemingly endless unfolding of the debt crisis and slower-than-hoped-for economic growth in China and the United States. Yes, we had some hopeful days of good news, but on balance the negative revelations have outweighed the positives. In terms of investment performance, Portfolio 21 has struggled a bit and we are frankly disappointed in the results, as the fund lagged the global equity markets. We greatly appreciate your patience and loyalty during this period.

As of June 30, 2012, the fund’s assets were $358.7 million. Performance is presented below:

Performance as of 6/30/12

On the important matter of environmental performance, although there is no specifically identified immediate economic reward for excellent environmental practices, none of our holdings were divested for environmental, social, or governance (ESG) reasons. In fact, our holdings continue to set the high bar for other companies worldwide.

Direct engagement with companies is fundamental to Portfolio 21’s commitment in finding companies with superior environmental initiatives. Over the course of the year, our Research Analysts monitor news feeds and company publications, and correspond with company managements. While we track companies’ achievements we also seek clarification when companies fall short.

For instance, in February 2012 the New York Times published an article entitled “In China, Human Costs Built into an iPad.” The article revealed unethical practices were discovered by Apple during audits, yet suppliers were not always forced to make changes. While supply chains are complex, Portfolio 21 expects Apple to ensure corrective actions when violations take place. We were very concerned about the article’s description of Apple appearing to prioritize profit over worker safety. We contacted the company to express these concerns and within a week Apple responded that the Fair Labor Association (FLA) would be conducting special voluntary audits of Apple’s final assembly suppliers, and that the FLA would make their findings and recommendations publicly available.

Although we acknowledge this was a significant error in Apple’s supply chain management, the company responded responsibly and was not divested from the fund. All of our holdings are reviewed on an annual basis to confirm that they continue to meet our investment criteria. Over the last year, we reviewed 92 companies. We found no egregious actions worthy of divestment, but our Research Analysts sought additional communication with eight companies. Topics of engagement included clarification surrounding key performance calculations, revenues earned from military contracts, and new acquisitions.

While the investment returns of the past year are not something that we are pleased with, many of the companies we are invested in have in fact produced impressive financial results. This good corporate performance, combined with the noted decline in stock prices, has given us the opportunity to increase our holdings in companies that we believe are the world’s best in terms of environmental management and future potential financial results.

Portfolio 21’s Investment Team focuses on finding companies that have demonstrated excellence both from a financial perspective as well as from an environmental perspective. Our Research Analysts engage directly with companies in our worldwide research effort, and our work is detailed and specific to each company we examine. That is how we seek to produce good long-term investment results, by concentrating on individual company fundamentals, environmental practices, and stock valuations. Unilever is a good example of a recent fund addition is this regard. The company has realized a return-on-equity over the last twelve months that was significantly higher than its global sector peers and more than double that of the MSCI World Equity Index. Unilever demonstrates an environmental awareness not realized by many large companies. In 2009, Unilever launched its Sustainable Living Plan. The plan contains over 50 targets that will assist the company in halving its environmental impacts by 2020. Unilever has also created an Agriculture Code, to which 100% of its suppliers/farmers must comply by 2020. Standards outlined include agrochemicals, soils, water, biodiversity, energy, and waste. Unilever’s plan also sets goals for the company’s packaging use, energy use, logistics, and waste. 2020 targets include: reduce packaging weight by one-third; reduce carbon dioxide emissions from its logistics network to 2010 levels, and reduce carbon dioxide emissions from energy used at factories to 2008 levels or below. Furthermore, the company pays a nice dividend to shareholders and its five-year average price-toearnings ratio is below sector peers and the MSCI World Equity Index.

We believe that our high standards in these areas give us an advantage; conversely, we are clear in the fact that we have no advantage when it comes to trying to outguess the world’s central bankers or in trying to predict the very next turn in the global economy. We think we have a pretty good idea of what’s going on with the long-term fundamentals and environmental strategies of the companies we are interested in as investments, but when it comes to the shortterm global economy, we are observers developing a view along with the rest of the pack.

Our view is that the global economy is in an extended period of adjustment and the problems associated with the debt load and generous retirement and social service promises accumulated over the prior decades have no solutions. The best the world’s policy makers and central bankers can do is to buy time so that the rest of us can get use to living with these problems and we can all make required adjustments. People, governments, and companies are all adjusting differently, and we are working hard to own the companies best able to adjust. Sadly and ironically, we could probably make the same type of comment about climate change. The decline in the prices of economically sensitive stocks and commodities, accompanied by the rise in demand for so called “safe haven” assets, demonstrates that investors are gearing up for continued economic struggles ahead.

At Portfolio 21, we have tended to have a greater percentage of our portfolio invested in economically sensitive companies than that found in the broad market. Many companies that produce products making a positive difference in energy use, or limiting environmental degradation, are in fact economically sensitive. While that exposure hurt our results in the past year, we are maintaining our general portfolio position as we have confidence in the specific companies and management teams. The change we have made in the portfolio has been to use the price declines of economically sensitive stocks as an opportunity to buy more of what we believe to be the most well positioned companies, while pruning weaker holdings.

We cannot help but to see analogies between the ongoing debt crisis and the state of the global environment. Both problems are massive and come as a result of decades of habitual borrowing against the future. These habits were formed during a long period of economic growth fueled, quite literally, by oil and debt. As long as things were growing fast enough, society seemed willing to ignore the ultimate impacts of the debt load and the myriad environmental crises being created alongside all the growth.

One has to wonder, if we had not taken on all the debt and pushed the pace of industrial development and consumerism, maybe we could have done things in a manner that would not have been quite so harmful to the environment. Will that be the silver lining to today’s debt-laden storm clouds? We’d love to say yes, we think that the world will slow down responsibly and begin to mend the many issues that the debt and oil driven growth binge has created. However, we do not think it makes any sense at all to pin our future on hopes for societal change. We need to make sure that we are invested in the companies that have already recognized these issues and made required changes: the farsighted global leaders, focused on environmental issues as well as financial quality.

Management Discussion of Fund Performance

The last twelve months saw investors flocking to the relative growth and perceived safety of U.S. stocks in the midst of a global slowdown. The fund was underweight U.S. stocks, and overweight European Industrial stocks, which produced a drag on performance. We continue with this general positioning as we find many excellent companies with attractive stock prices outside of the U.S.

Outside of the U.S. market, the globe was awash in big negative numbers with the eurozone leading the way. As expected, the fund’s overweight position in Spain hurt performance. Investors fled from everything Spanish, even stocks like Telefonica, which gets less than 30% of its revenue from its home country. Our feeling is that European companies are being painted with too broad of a brush. As a result, not only have weak companies been sold off, but many large European companies with global reach and strong financials have experienced stock price declines to the point that we believe they will be a source of good returns for the fund in the future.

On the sector side, our belief that conventional energy stocks are in secular decline helped, as the Energy sector underperformed and we had virtually no exposure. Our overweighting of Technology also helped, as companies continued to invest in productivity tools as opposed to new hires.

The biggest performance drag sector-wise was our exposure to large European Industrials. While they suffered from the locations of their headquarters, longerterm these companies are focused on what the world will need: doing more with less. Building efficiency, power efficiency, and transportation efficiency are all themes we see playing out well for the fund as carbon constraints increase.

Individually, the big European Industrials like Siemens, ABB, SKF and Schneider Electric were all down by 30 to 50% for the 12 month period. A couple of U.S. stocks, Johnson Controls and NetApp, failed to meet earnings estimates and were penalized 30-40% as the market assigned them “show me” status.

Novo Nordisk was again a top performer as it continued to stay ahead of the competition in insulin analogues. Samsung and Apple were also winners, fighting to fulfill the seemingly endless desire for high-end smart phones. eBay extended its comeback, thanks in no small part to PayPal, and Ecolab’s acquisition of Nalco continued to please investors.

We have cut the number of names in the fund over the last 12 months. The further concentration is due to increased confidence in the financial and ecological profile of our core holdings. Indeed, we were quite happy with the fundamental performance of our companies over the last year and are quite optimistic that better stock returns will follow. The following table highlights some of the past, present, and future metrics that illustrate the fund’s fundamental and valuation positives.

This is not a forecast of the Fund’s future performance.  Earnings growth for a Fund holding does not guarantee a corresponding increase in the market value of the holding or the Fund.

Again, thank you for your patience and loyalty. Since Portfolio 21 began in 1999, we remain true to our investment philosophy and long-term approach. We believe Portfolio 21’s investment process identifies companies that have a higher probability of adaptation in the context of ecological limits, making them better investments over the long term. As always, we welcome your comments and questions. You can reach us at welcome@portfolio21.com.

Sincerely,

The Portfolio 21 Investment Management Team

John Streur, President	Jim Madden, Chief Investment Officer	Tony Tursich, Senior Portfolio Manager
Beth Williamson, Senior Research Analyst	Emily Lethenstrom, Senior Research Analyst

Portfolio 21 invests in foreign securities, which are subject to the risks of currency fluctuations, political and economic instability and differences in accounting standards. The Fund invests in smaller companies that involve additional risks such as limited liquidity and greater volatility.

The Fund’s environmental policy could cause it to make or avoid investments that could result in the portfolio underperforming similar funds that do not have an environmental policy.

Fund holdings and sector allocations are subject to change and are not recommendations to buy or sell any security.  See complete fund holdings information.

Current and future portfolio holdings are subject to risk.

The MSCIWorld Equity Index is a free float-adjusted market capitalization index that is designed to measure global developed market equity performance. The New York Mercantile Exchange, or NYMEX, is a commodity exchange where natural gas, electricity and other futures and options are traded. NYMEXWTI Crude Oil is a grade of crude oil used as a benchmark in oil pricing. NYMEX Natural Gas futures contract is widely used as a benchmark for natural gas prices. The London Metal Exchange, or LME, is the world’s largest futures and options exchange for metals. LME Copper is a standardized exchange-traded contract, which is used as a benchmark in pricing copper. The Intercontinental Exchange, or ICE, is the principle futures exchange for cotton. ICE Cotton is a futures contract on cotton, which is used as a benchmark for cotton pricing. The MSCIWorld Materials Index is a component of the MSCIWorld Index and represents the material securities defined by MSCI. The MSCIWorld Industrials Index is a free float-adjusted market capitalization weighted index that is designed to measure the industrials sector performance of 23 developed markets around the world. The U.S. Dollar Index measures the value of the dollar against a basket of six major currencies. The Gold Spot price is quoted as U.S. Dollar per Troy Ounce. The Japanese yen is the official currency of Japan. The conventional market quotation is the number of yen per U.S. dollar. It is an independent, free- floating currency. The Barclays Capital U.S. 7-10 Year Treasury Bond Index measures the performance of U.S. Treasury securities that have a remaining maturity of at least seven years and less than 10 years. The Barclays Capital U.S. 20+ Year Treasury Bond Index measures the performance of U.S. Treasury securities that have a remaining maturity of at least 20 years. The S&P 500 Consumer Staples Index is an unmanaged index considered representative of the consumer staples market.

Investment performance reflects fee waivers in effect. In the absence of such waivers, total return would be reduced. Must be preceded or accompanied by a current prospectus. Please refer to the prospectus for important information about the Fund including investment objectives, risks, charges, and expenses.

The Price to Earnings (P/E) Ratio reflects the multiple of earnings at which a stock sells.

Earnings per share is calculated by taking the total earnings divided by the number of shares outstanding.

Return on Equity is the amount, expressed as a percentage, earned on a company’s common stock investment for a given period.

EBITDA is earnings before interest, taxes, depreciation and amortization.

The PEG ratio is the forward P/E ratio divided by the projected EPS growth rate.

The Fund is distributed by Quasar Distributors, LLC.

The first important number he details is 2 degrees Celsius, which is the amount that scientists and most governments have agreed is the maximum increase in global temperature, without very serious consequences.  The second number is 565 gigatons, which is the amount of carbon dioxide that we can emit by midway through this century in order to keep us within the 2 degree Celsius range.  This all makes the third number even more daunting; 2,795 gigatons is the amount of carbon contained in the proven reserves of the world’s fossil fuel companies.  Meaning, the world’s inventory of fossil fuels is five times the amount that scientists think would actually be safe to burn.  And every day fossil fuel companies spend millions of dollars to find and extract more coal, oil, and natural gas.

This equation very clearly illustrates an unsustainable system with dire consequences for the economy.  Some kind of mechanism must evolve to increase the price of fossil fuels and decrease the cost of renewable energy sources, and quickly.  But if that optimistic climate-saving scenario does indeed play out, energy companies will be left holding assets that they can no longer sell, which will cause the industry losses in the trillions of dollars.  The consequences for investors of this “carbon bubble” are being researched by UK-based Carbon Tracker Initiative, which published a seminal report earlier this year titled, “Unburnable Carbon.”

McKibben’s article is sobering, but its prominent place in Rolling Stone is encouraging, and it is already getting a lot of attention.  Considering the extreme global weather this year, this could be a very good moment for the message.  A recent opinion poll reported that in July 70% of Americans stated that they believed that the climate is changing, which is a 5% increase vs. the same poll in March.  This is a rapid, and likely seasonal, increase in acknowledgment of the problem, but it remains to be seen when opinion might translate into significant national will.  There is still much progress to be made toward articulating the future that we want to see, and how we will transition to the energy sources that we need in order to get there.

Amanda is Portfolio 21 Investments' Communications Manager.  She has more than 10 years of research, communications, and interactive media experience in the financial industry.

Human impacts can damage the health of ecosystem function, which, over time, can degrade their abilities to provide necessary services.  This is particularly evident in urban areas—their environments are dominated by human technology and their infrastructure must operate on a large scale in order to offer transportation, food, housing, and recreation to a dense population.  When confronted with environmental challenges, such as clean drinking water, wastewater treatment, or air filtration, some municipalities are identifying that their highest value investment is to take a Green Infrastructure approach to invest in their natural capital.  Supporting the natural processes of ecosystems turns out to be less capital intensive than trying to build and maintain systems to provide the same services.

A prominent example is from New York City in the 1990s, when the city’s drinking water quality had fallen below standards required by the Environmental Protection Agency.  Water quality in the city had historically been very high, but its source in the rural Catskill-Delaware watershed had undergone several decades of increasingly intensive agriculture, and was rapidly transitioning to higher population suburban developments.  The city estimated the costs to build and operate a water filtration plant at $6-8 billion, with an annual cost of $300-400 million.  But rather than pursue this route, it opted to spend approximately $1 billion to restore the watershed so that it was once again able to purify water through its diverse ecosystem services.

Some examples from our home region of the Pacific Northwest include retrofitting Portland, Oregon neighborhood streets with bioswales and tree planting projects that capture 80-95% of stormwater runoff and filter its pollutants onsite.  This practice has reduced sewer overflows and the need to upsize existing infrastructure pipes, which avoids considerable expense.  In Seattle, Washington, replacing streets with permeable pavement and other green infrastructure has cut paving costs almost in half.

Many more pilot projects, and studies to quantify their impacts, are currently underway around the world.  The majority of projects are not made more expensive by their environmental investments, in fact, they are of equal or lesser expense.  It is encouraging to see this trend in cities embracing the vision of an ecosystem services approach and linking it to long term economic value.

Amanda is Portfolio 21 Investments' Communications Manager.  She has more than 10 years of research, communications, and interactive media experience in the financial industry.

After nearly 17 years, Leslie Christian has transitioned to explore some new projects. She will be continuing her work as Chair of Upstream 21 Corporation and following her deep commitment to investing in regional economies. She will also be continuing her work on rethinking modern portfolio theory and asset allocation.

When I reflect back on Leslie’s contribution, my first thoughts are of enormous gratitude and the greatest respect for what she brought to Portfolio 21 Investments.  In 1998, Leslie and I came up with the concept to launch an investment strategy using The Natural Step principles as a foundation for our investment selection process.  At the time, sustainability was a relatively new and undefined term. While many SRI investment strategies had environmental screens, these screens were primarily used to screen out companies with poor environmental performance. We developed a comprehensive positive screening approach to selecting environmental leaders, which brings us to where we are today.

All of us at Portfolio 21 Investments are thankful for Leslie’s contribution to our success over the years and we wish her the very best in her future work.

The other big news is that John Streur has joined the Board of Directors of Portfolio 21 Investments as non-executive Chairman. John brings 25 years of investment industry and mutual fund management experience to the role, most recently as President and Trustee of The Managers Funds and CEO of Managers Investment Group, LLC. We first met John about four years ago while he was doing research on environmental investing. We were honored that he had identified us as one of the leaders in the field. When we met earlier this year it became clear that John's unique combination of depth of experience with global investment processes, along with his commitment to environmental investment principles, would make him a strong addition to our Board. We are very fortunate to welcome John to Portfolio 21 Investments.

Carsten Henningsen, Founder & CEO

References to other mutual funds should not be considered an offer of those securities.