It has been four years since we first published ‘A Guide to ESG in Australasia’ and a lot has happened since then, not in the least part the occurrence of a global pandemic. Post COVID-19, many countries have introduced climate change-related regulations and are actively encouraging the transition to a low carbon economy. In this update, we delve into how regulation is starting to impact allocations and the problems with existing climate risk models
In this guide, we aim to give a brief overview of some of the key trends and developments in ESG in Australia and New Zealand. Some of these issues have been long known, perhaps under different names, while others are relatively new developments. It is by no means exhaustive, but should provide a good basis for those unfamiliar with local issues.
When I first started writing about environment, social and governance (ESG) issues, one of the first people I spoke with was Amanda McCluskey, who was Head of Responsible Investment for Colonial First State at the time. McCluskey narrated how excited she was when she first learned Australian companies had started to incorporate ESG disclosures in their annual reports.
But her excitement quickly turned to disappointment when it became clear most companies were approaching it as a tick-the-box exercise and simply had their law firm draw up a paragraph to include in the report. The legalese was so dense that you could pick out which law firm represented which company.
We have come a long way since those early years of ESG.
Today, failing to observe proper ESG practices can unseat the very top of the corporate ranks, as the Rio Tinto Juukan Gorge debacle and the various malpractices at some of the top banks in Australia have shown.
In part this is due to asset owners, especially superannuation funds, and responsible investment organisations, such as the Australian Council of Superannuation Investors, becoming more vocal in their opposition to missteps and now frequently voting against management on ESG-related issues.
Yet, most of the action in this space is focused on engagement and shareholder voting, but at the point of writing no pension fund had yet drafted a resolution itself, a fact much lamented over by Mike Wyrsch, Chief Investment Officer of Vision Super.
Vision Super and several overseas investors have co-filed a resolution against BHP over its membership of trade associations whose lobbying efforts are not in line with the goals of the Paris Agreement on global warming.
NSW Local Government Super did something similar and co-filed a resolution against Rio Tinto, while LUCRF has co-filed resolutions on modern slavery against Coles and Woolworths.
But true active ownership in this area still has some way to go.
Australia’s Economy – Mining and Resources
Australia’s economy is heavily based on resources and the mining industry is a powerful lobbyist. Data from Marketforces shows that in the 2019 financial year, the top 10 fuel donors, including trade associations such the Minerals Council of Australia, and fossil fuel companies, such as Woodside Petroleum and miner Adani, donated $1.6 million to the various political parties.
It might, therefore, not come as a surprise that the Australian government has been slow to develop a climate policy, despite being one of the more than 170 parties to sign the Paris Agreement on climate change in April 2016.
But in October 2021 the federal government released Australia’s Long Term Emissions Reduction Plan to deliver net zero emissions by 2050, which has morphed into the current Net Zero Plan.
Under the plan, Australia aims to reduce emissions by 43 per cent by 2030 compared to 2005 levels. It also aims to generate 82 per cent of the total energy supply through renewables by 2030.
Still, Australia also has said it will ramp up its extraction and use of gas until 2050 and beyond, despite the International Energy Agency call for ‘huge declines in the use of coal, oil and gas’ to reach climate targets. Current Prime Minister Anthony Albanese’s government says the move is needed to ensure a stable energy supply while transitioning to net zero.
Climate Change
It wasn’t that long ago that when you asked someone in the investment industry what their policy towards climate change was, they would shrug their shoulders and say: “Well, I turn all my lights off when I leave the house.”
But today asset owners are very aware of the risk climate change can pose to their portfolios. Whether it is the risk of holding stranded assets, disruptions to supply chains or plants located in disaster-prone regions, fund managers and investors alike no longer dismiss the impact climate change can have on their portfolios.
The impact is real and increasingly legal precedents are set that hold organisations accountable for damages if they haven’t developed a policy to mitigate the risks of climate change. A famous case took place in the United States, where a series of lawsuits were filed by Illinois Farmers Insurance Company against a number of municipalities in Illinois, including the City of Chicago, in 2014.
The class action centred on the alleged neglect of the municipalities in failing to upgrade their infrastructure to deal with flooding while they knew climate change had caused rainfall to increase in the area.
It was the first time the claimant did not need to prove that either the municipalities had caused climate change or that climate change caused flooding.
The City of Chicago had earlier published a report, titled “Chicago Climate Action Plan”, in which it had made a connection between climate change and rainfall on its own account.
Yet, quantifying climate change risk into an actual basis-point impact on individual investments is still a challenging exercise. Although every day more data becomes available on how climate change is affecting the world and the economies in it, often the information is not specific enough to act on.
Take for example the risk of flooding. It is true some industrial plants are more likely to experience flooding than others, but often it is unknown how well an individual plant can withstand this disruption. How flood proof is it? How long would any supply chain disruption be? Does it affect the whole plant or just a part of it? Every answer seems to raise only further questions.
New Zealand Super has given it a good crack and developed a framework for incorporating climate risk into its valuation model. And although the exercise was helpful and highlighted many areas of risk not previously specified, the fund did not make any changes to its investment valuations due to a lack of granularity.
So instead of incorporating climate change risk directly into portfolio construction and risk management, many institutional investors focus on more tangible trends that are related to climate change, such as the energy transition away from fossil fuels and towards renewable forms of energy generation.
The Energy Transition
The energy transition away from fossil fuels and towards renewable energy is an ESG issue, but project related to this transition will not always score well on these metrics. For example, a portfolio of key companies that will benefit from the energy transition is not necessarily going to be carbon light in nature.
Take Vestas for example. As a producer of hardware for wind energy, it will certainly benefit from a move to renewable energy, but the manufacturing of windmills is carbon intensive. Similar arguments can be made for the producers of electric cars, et cetera.
Yet, whether the intention is to use the energy transition as an alpha opportunity and make money or whether it is to align investments with the objective of reducing carbon emissions, the reality is these two objectives are not mutually exclusive. Investors can do both at the same time and it is likely we will see more action on this front.
Many voices have been raised that governments should try to rebuild their economies post COVID-19 through a green revolution, stimulating investments in carbon-light infrastructure and technologies. And indeed, we have seen a lot of new regulations come out post COVID-19.
According to data from the Principles of Responsible Investments, 2020 saw a 74 per cent increase on 2019 in rules on ESG data disclosure, and an increase of over 100 per cent in ESG integration.
The coronavirus pandemic of 2020 is turning out to become a clear catalyst for many ESG-related regulations and policies to be implemented across the world.
A key piece of post-pandemic legislation was the US Inflation Reduction Act 2022, which contains more than A$520 billion worth of programs and funding to accelerate the transition to net zero in the US. Expectations are that this won’t affect just the US, but also many other economies around the world.
In Europe, the Green Deal Industrial Plan aims to create a more supportive environment for the European Union’s manufacturing capacity for the net-zero technologies and products, thereby protecting the sector from competitors, mainly in the US and China.
But there is also pushback on the rapidly increasing body of ESG regulations. In the US, critics of ESG-focused investment policies have lambasted the idea of restricting investing in carbon-intensive businesses.
One particularly high-profile case saw the State of Texas implementing a blacklist with names of asset managers that had divested from coal-generated power plants.
The US state, which is the largest producer of oil and gas in the country, passed a bill in 2021 that prohibits state institutions from investing with financial organisations that are perceived to ‘boycott’ energy companies.
Yet, despite the push back in Texas, the broader investment industry is moving the other way and according to a study by CREATE-Research, the ever expanding body of ESG-related legislation and public policies are starting to drive the asset allocation decisions of institutional investors.
The investors surveyed in the study expected all asset classes to be affected by the new measures over the next five years, but they expected bonds to benefit most from the reallocation of capital, especially use-of-proceed, green and transition bonds.
“Many pension plans are reaching the stage when replacing a part of their sovereign bond portfolio with these three types of bonds is a logical step,” the authors of the report said.
Carbon intensity is also increasingly used as a measure of default risk in bonds, the authors argued, and this could see further changes to their allocation decisions.
“The distance-to-default, a market-based measure of corporate default risk, is believed to be negatively associated with a company’s carbon intensity. Those with a large carbon footprint are now perceived by the market as being more likely to default, all other things being equal,” they said.
Governance – Best Practice
Governance is probably the most well-established part of the ESG trio as it has arguably been part of security analysis well before the term ESG was coined. Having a management team in place that acts in a responsible and sustainable fashion and strives for best practice is key to the long-term survival of corporates.
Yet, in recent years asset owners have increased the focus on their internal governance, placing more emphasis on board education and adding or expanding the number of independent non-executive directors.
Tim Mitchell, the former General Manager of New Zealand Super and now Global Head of Governance Consulting with Willis Towers Watson, has reflected on the fund’s efforts to gradually expose board members to new investment ideas and the importance of never assuming they were fully up to speed with developments within the organisation.
After all, there were six board meetings a year, plus a strategy meeting, and so Mitchell and his team would organise educational sessions outside of the formal meetings to convey new ideas to the board.
In Australia, there has been much debate about the composition of pension fund boards. Many industry funds adhere to the concept of equal representation, where half of the directors come from the employer’s side and half from employees or the unions that represent them.
Increasingly, there has been a call for the inclusion of more independent directors on these boards. For listed companies, the Australian Securities Exchange recommends the majority of a listed entity’s board comprise independent directors.
Prior to the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, then-Minister for Revenue and Financial Services, Kelly O’Dwyer, had filed a bill that would have required pension funds to have one-third of their boards made up of independent directors.
But in 2017, the government had to withdraw the bill due to a lack of support from crossbenchers.
The Final Report of the Royal Commission, published in February 2019, was the final nail in the coffin of mandatory board compositions.
In the report, Commissioner Kenneth Hayne argued there was no need to prescribe the composition of a board for pension funds as it would distract attention from the basic requirement of ensuring the board is “constituted, at all times, by directors who, together, will form a skilled and efficient board”.
Although pension funds have in recent years appointed more independent directors, it seems the discussion about required ratios has died a slow death.
The ‘S’ in ESG – Modern Slavery
Social issues can include a broad variety of areas for asset owners, ranging from inclusion and diversity policies to investments in social housing. But one of the key issues that has resulted in new regulations for investors is modern slavery.
It is estimated there are currently 40 million victims of modern slavery around the world, while proceeds from forced labour are estimated to generate over US$150 billion annually.
It is further estimated around 25 million people are enslaved in the Asia-Pacific region alone. This is not just a matter for countries where the rule of law is poor or that do not have a democratic system; in Australia, 15,000 people are considered to be enslaved.
Slavery can take many forms, including slavery-like conditions, such as debt bondage, servitude, forced marriage and forced labour. It also includes human trafficking.
For asset owners, the main focus is where these practices take place in the supply chain of the companies they invest in, because apart from the moral aspects, there are financial implications in relation to earnings volatility, brand, business disruption, productivity and increased regulatory focus on labour rights.
In Australia, the Commonwealth Modern Slavery Act 2018 is relatively new legislation that requires businesses with over $100 million of revenue to report their exposure to and management of modern slavery risks in their operations and supply chains.
Reporting started in 2020 and a modern slavery statement must be submitted within six months after the end of the reporting entity’s financial year. This means a company or manager with a financial year to 30 June, must submit their first report on 31 December 2020.
Unlike other jurisdictions, the reporting criteria in Australia are mandatory. The government has the power to publicly name and shame entities that fail to comply and has the authority to take remedial action.
Apart from addressing the ‘S’ in ESG, ending modern slavery by 2025 is also one of the targets under the United Nations’ Sustainable Development Goal 8: Decent Work and Economic Growth.
In September 2019, The Financial Sector Commission on Modern Slavery and Human Trafficking issued a set of guidelines for the financial sector to help end modern slavery and human trafficking.
The blueprint focuses on survivors, because they often find traffickers have hijacked their financial identity or banking products for money laundering or other criminal purposes, damaging their creditworthiness and increasing their risk of re-victimisation.
Some asset consultants have started to include questions about modern slavery in their review process of asset managers. The emphasis here is on collecting data so they can track improvements in or the worsening of existing practices.
As this process is still in its early stages, most asset consultants and investors are unlikely to come down heavily on managers, but if there is no improvement over time, it will start to impact on their ESG rating and, ultimately, their overall rating.
The Future of ESG
So where will ESG take us in the future? It is likely we will see increasing action on climate change as more and more countries commit to reaching carbon neutrality by 2050. Even China, one of the world’s largest polluters, has committed to becoming carbon neutral, albeit 10 years later by 2060.
This is likely to mean more investment in renewable and low-carbon technologies and a gradual abandoning of fossil fuel companies. So it is likely the energy transition will remain a theme in the coming decades.
Another area of recent interest is how the UN’s sustainable development goals (SDG) can be integrated into portfolios. Dutch pension funds APG and PGGM have taken the lead on translating the SDGs into an investment context and have brought AustralianSuper along to develop the platform and share information.
The interesting part here is the asset owners involved in this project will share information on how they are progressing with the integration and hope that by learning from each other they can speed up the process. The funds are already exploring how the sustainable development investment platform, as they call this framework, can be leveraged for unlisted assets in order to implement the SDGs across the entire portfolio.
It is also likely that we will need to reassess some of the models used by the investment industry to assess climate change risk. According to rebel economist Steve Keen, the widely-used economic models that assess the impact of global warming on future gross domestic product growth are deeply problematic and vastly underestimate the economic damage climate change will cause.
A key issue with such integrated assessment models is that many of these models simply look at climate change as a gradual increase in temperature and don’t take climate tipping points into account – points at which the rise in temperature causes ecological processes to move to a different state or even collapse.
Climate scientists largely agree that integrated assessment models are deeply flawed. Looking at historic average temperatures downplays the impact of extreme weather events and it is at the extremes that most of the impact will be felt.
Agriculture, for example, could become very unreliable if entire crops are lost due to flood, wildfires or severe storms. Agriculture will become impossible in parts of the world due to heat stress.
But investors are starting to catch on. For example, Chris Ailman, the former Chief Investment Officer of United States public pension fund CalSTRS, addressed the issue during an interview with Bloomberg, when he acknowledged the fund’s investment strategy had to adapt.
“Extreme weather is now a commonplace event. And I think we have to factor that into our investments as a risk, increased insurance costs,” Ailman said.
Ultimately, climate scientists and investors will need to work together in developing more granular climate models that would look at variables such as temperature, rainfall, humidity and pressure on a daily basis, preferably even more often.
This newfound awareness of the severity of climate change could see an increase in activity around impact investing. Having a well-developed ESG policy is nice, but ultimately people want to see results and so more funds are looking for ways to measure progress.
But whether this will follow the strict guidelines of impact investing remains to be seen. Impact investing is good at measuring positive impacts, but it is often hard to scale up and, therefore, takes on the form of a venture capital type of program, rather than the large-scale investments pension funds are looking for.
Perhaps we will see more funds go the PGGM way, which simply decided to abandon the narrow framework of impact investing and embrace a broader approach, which it calls “investing in solutions”. This allows it to access a wide variety of assets, as long as the case can be made for some demonstrable positive effect.
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