Ed note: The Sustainability Report is pleased to present this comment piece from Jason Ross, head of superannuation research at Rainmaker Information
Jason Ross, head of superannuation research, Rainmaker Information
Back in the 90s a hot topic was the hole in the ozone layer. As the hole was above Australia, we suffered due to the actions of other nations.
The ongoing effects is that Australians are more likely to get sunburn from UVB than those living in Europe, North America or most of Asia. According to the Australian government we have one of the highest rates of skin cancer in the world. At least two in three Australians will be diagnosed with skin cancer by the age of 70. A major cause of skin cancer is UVB. As the ozone layer protects the earth from UVB the increase in skin cancer in Australia has been indirectly linked to the hole in the ozone layer.
In hindsight, scientists realised the dormant and lingering effects of Chlorofluorocarbons (CFC) in degrading the ozone layer had long lead times and now acknowledge they should have acted sooner.
In the 90s, environmental social and governance (ESG) didn’t exist so investors didn’t have to worry so much about the effect of CFCs on investments. They just had to worry about losses due to having to update machinery to remove CFCs.
The good news is that the acceleration of the hole in the ozone layer stopped and is very slowly improving. Governments coordinated their actions. The cost to health and the environment outweighed the cost of having to replace machinery that relied on CFCs.
It has similarly taken a long time for climate scientists to convince and influence portfolio managers of the long-term risks of increases in severe weather due to changing climactic conditions. Regulators and investment and legal experts acknowledge that climate change will impact financial risk management and long term investment decisions. This will influence where funds are flowing to and thus asset prices. Larry Fink, the CEO of the largest international money-management firm BlackRock wrote in his annual letter in January 2020 that he believes that “we are on the edge of a fundamental reshaping of finance” due to climate change. As a result of these changes, Fink will be “exiting investments that present a high sustainability-related risk, such as thermal coal producers; launching new investment products that screen fossil fuels” as well as increasing transparency.
Furthermore there is an increase in consumer demand for ESG funds. Super money is flowing out of default funds and into ESG options. Taking care of other people’s money comes with great responsibility, and over the course of the last year the Australian regulator has stepped up its focus on climate and weather-related risks as part of its expectation of trustees to review long-term risk to investment assets.
From a risk perspective, the regulator expects trustees and the portfolio managers working for them to be asking questions such as: what will happen to investments if sea levels rise by a metre or more, what will happen if there are more catastrophic weather events, what will happen if there are more claims for the insurance policies? The list of risk questions goes on.
What is sometimes missed is that all these difficult risk questions don’t need to be answered as part of just ESG filters within portfolios themselves. Rather, trustees need to mitigate climate and weather-related risk at a board level as part of the tasks the risk committee is required to complete.
Climate change and weather-related risks as well as mitigating those risks need to be included as part of Prudential Standard SPS220 -Risk Management. Furthermore, in a paper titled “Climate change: Awareness to action”, APRA wrote about “the financial nature of climate change risks to its regulated entities. APRA has advised that these risks are material, foreseeable and actionable now”.
Super funds are realising that climate change is a long-term risk management issue. They need to be included in a super funds risk committee reports. The added complexity is that super fund members rely on the returns they will receive from their investments in Australian stocks and other securities.
This leads to the question of the speed of the required change. Australia is a resource rich nation that exports coal, fossil fuels and meat. Mineral fuels including oil make up 34.6% of total exports. Ores, slag and ash (including iron ore) make up 23.5% of exports. And meats (farm animals emit greenhouse gases) make up 4% of exports. It has been argued that ways that impede these industries may cause a slowdown in the economy and even a recession. This could lead to an increase in unemployment.
Furthermore, mining and the production of meat are important contributors to society. Steel is produced in a furnace by heating iron ore and coal. Steel is required for the construction of everything from bridges to hospitals and schools.
As a result I would be surprised if any super fund trustee would think that mining in Australia could slow down overnight. Mining for fossil fuels in Australia will realistically not stop in our lifetime. However, the type of mining conducted, whether coal or natural gas, and the way it is conducted will continue to be reviewed. The requirement for extensive environmental engineering and remediation as part of mining will increase over time.
In January the Bank of International Settlements (BIS) released a major report that warned of economic shock should coal plant valuations deteriorate too quickly. It warned that rising severe weather events will cause an issue for insurance companies. It also warned that drastic and sudden measures by policy makers may de-value coal plants so quickly that this could cause a flow on effects, ie, these assets were subject to huge regulatory risks.
BlackRock’s recent decision to remove fossil fuel exposures from some of its active investment holdings and to restrict investments to companies that draw less than 25% of their revenues from fossil fuel products, and launch more ESG focused ETFs is an example of portfolio managers attempting to address associated financial risks. BlackRock anticipates funds to flow out of companies involved in thermal coal.
At the same time it’s worth noting that in 2015, one of the most profitable private equity investments involved the purchase of the Vale Point power station in NSW for $1 million, which is now earning over $2.5m per annum. However, one wonders if a super funds would build or purchase coal power plants in the current environment, post the BlackRock and BIS announcements.
Superannuation funds have demonstrated that they can lead the way in sustainable investing especially as investing this way has been found to not only maintain if not boost returns but also reduce investment risks and volatility. Research by Rainmaker has revealed that in 2019 the benchmark returns of balanced ESG funds have exceeded the benchmark of other non-ESG balanced funds over a one, three and five year period.
Government policy and the coordination of long-term climate change risk management is perhaps lagging that of super funds and international pension funds. This comes at a time when the recent Australian bushfires have enraged the public.
Sound investment returns and managing ESG risk are not mutually exclusive. Both can be achieved at the same time. But it does require super funds to enhance the way they design their portfolios and execute their strategies.
Fund managers and trustees will not want to look back in hindsight on 2020 and wish they had started acting sooner.
- AXA IM develops carbon footpath strategy based on forward climate action - February 28, 2020
- Australian Ethical to cut administration fees, enhance customer experience - February 28, 2020
- J.P. Morgan Asset Management developing ESG scoring framework - February 28, 2020
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