Bill Hartnett, the former Head of Responsible Investment for Local Government Super, is looking to return to Australia as climate risks are becoming an increasingly important issue for investors and the recent election result has created the right circumstances to address these risks.
Although today many institutional investors have committed to net-zero investment portfolios by 2050, back in 2014 it was considered a fairly niche approach to decarbonise portfolios; it was even frowned upon.
Local Government Super (LGS), now called Active Super, was an early mover in restricting its exposure to carbon-intensive companies and applied a high carbon-sensitive screen to filter out companies that derived more than 33 per cent of their revenues from carbon-intensive activities.
This screen was put in place in addition to existing negative screens on tobacco, gambling and weapons.
Spearheading the approach was Bill Hartnett, who was then the Head of Responsible Investment for LGS.
“It wasn’t industry convention to have negative screens across the entire fund,” Hartnett tells [i3] Insights from London, where he currently advises clients on environmental, social, governance (ESG) and sustainable investment issues.
“People thought that you introduced a portfolio risk that should not have been there, so it was very much against the convention of what you should be doing.
“But we wanted to capture companies that we saw were most materially impacted by climate change risks and where we thought there were difficulties in engaging [with them], because that was still the strategy to go with first and foremost.”
It wasn’t industry convention to have negative screens across the entire fund. But we wanted to capture companies that we saw were most materially impacted by climate change risks and where we thought there were difficulties in engaging [with them]
Despite the negative screens, the impact on the fund’s risk profile was relatively limited, he says, something its initial research into the impact of screening on portfolio diversification quickly made clear.
“When we developed the climate change restrictions back in 2014, this was based on our portfolio risk analysis where we were trying to understand what the implications would be if you excluded about 50 companies globally,” he says.
“What would be the tracking error and what would be the portfolio risk implications? We came to the understanding that the portfolio risk would not be significantly increased from excluding those companies.
“In the end, it came down to the question of how diversified do you need a portfolio to be. You can get all the benefits of diversification without being purely passive and hugging the benchmark.”
The carbon screen resulted in LGS excluding certain coal companies, tar sand companies and coal-fired generators. One of these generators was AGL. Hartnett has followed the recent AGL demerger attempt and subsequent shareholder activism led by Atlassian co-founder Mike Cannon-Brookes with interest.
“It is very sad to see an iconic company like AGL lose a lot of value. It is the second-oldest listed company in Australia and it has had its hands tied behind its back in terms of what it could do about decarbonisation due to a government policy that just wasn’t addressing climate change,” he says.
“There was always this focus on cheap and reliable [energy], but not on emissions.”
But it wasn’t just government policy that saw AGL fall behind on climate change; there appeared to be a strong disregard to assess climate risks among the leadership of the company too, he says.
“When AGL outlaid $2 billion in 2012 and 2014 to acquire the ageing Bayswater, Liddell and Loy Yang A coal-fired generators, the Board justified this on the grounds that the assets were quite cheap and earnings accretive to AGL and a means to develop a new revenue stream in generation. Yet they seemed to just ignore the potential carbon risks, even though AGL had overnight become by far the largest carbon-emitting company in Australia,” he says.
“We had noted that some members of the Board at the time were at best very sceptical on climate change science. They were buying 35-year-old assets that were going to become less reliable and that were incredibly high carbon emitters, but this wasn’t reflected in the due diligence.
“And then Australia has endured policy stalemate in the climate change and energy fields over the last decade. When subsequent AGL executives, such as former CEO Andrew Vesey, did try to address AGL’s huge carbon risk issues by proposing to close Liddell, he was abruptly forced to resign by the AGL Board. As an investor it was difficult to determine whether the Board was acting in the best interest of its shareholders or as a proactive agent to prolong the energy/climate policy malaise in Australia. It has really left the company in a bit of a bind.
“I am always a strong advocate that constructive, risk-focused engagement with companies is the primary means for investors to address ESG risks. However, you also have to determine at the outset whether the Boards are mutually receptive and aligned. In the AGL case, the Board did not seem responsive. So, in those circumstances escalation tactics, including divestment, is a way forward.”
Stewardship and Investing
A key point in the debate around sustainability and responsible investing is the question of whether pension funds should be making ethical or moral calls that are not purely financially motivated.
In Australia, there have been attempts to legislate the purpose of superannuation as a purely financial objective. The Financial Services Inquiry led by former CBA chief David Murray recommended that the objective of superannuation should be defined as to “provide income in retirement to substitute or supplement the age pension”.
The then Liberal government initially agreed and introduced the Superannuation (Objective) Bill 2016. But after passing the House of Representatives and a first reading in the Senate, the Bill died a quiet death.
And with housing affordability at a record low in Australia, it seems some politicians want to keep open the option of first home buyers accessing at least part of their super balance in order to help pay for their dwelling.
Yet, in Europe investing is no longer seen purely from a financial perspective as governments realise large pots of money come with great power and the ability to influence society more broadly.
Hartnett says investing and stewardship have become inextricably linked and this philosophy has found its way into industry guidelines.
“What you’re really seeing is a big cultural transition, underpinned by legislation such as the SFDR and EU Taxonomy, happening over here in the UK and EU. Also the revamped UK Stewardship Code 2020 represented a significant extension in the definition of investors’ stewardship responsibilities.
“It is not just simply about discussing material ESG or corporate governance risks with companies to generate strong long-term returns. The 2020 code defines stewardship as the responsible allocation, management and oversight of capital, which also provide positive outcomes for the economy, the environment and for society,” he says.
There is a cultural debate here around the purpose of a company. Is it just to make profits for shareholders along the lines of a Milton Friedman ideology from the 1980s or is it a broader purpose as interpreted by the stakeholder capitalism model? We're definitely seeing a shift towards the latter now
“There is a cultural debate here around the purpose of a company. Is it just to make profits for shareholders along the lines of a Milton Friedman ideology from the 1980s or is it a broader purpose as interpreted by the stakeholder capitalism model? We’re definitely seeing a shift towards the latter now.”
The way a company engages in lobbying can tell investors a lot about the attitude of these businesses towards stewardship, he says. Although the budgets spent on lobbying are often immaterial, lobbying can have a large impact on societal issues, including climate change.
“I did a lot of work on stewardship in Australia and then continued that work in the UK around climate change lobbying and really looking at the real-term day-to-day interactions between governments, companies and the media as part of developing climate stewardship strategies,” Hartnett says.
“How do companies conduct their climate lobbying? Is it directly or indirectly through industry associations? Is this lobbying and advocacy consistent with their public statements on their climate change ambitions? Lobbying expenditure is unlikely to be material from a P&L or balance sheet perspective. However, it is very material from gaining conviction on the company’s overall strategy. Is it real or is it greenwash? As investors we are engaging companies to assist the orderly transition to low-carbon net-zero economies.
“An example of that was in 2019 when BHP came out in supporting of using surplus Kyoto carry-over credits to meet Australia’s Paris Agreement commitments. BHP has does some good work over a long time on climate change. However, no company or country in the world was actually suggesting that you should use Kyoto carry-over credits to satisfy your Paris targets.
“Yet the Australian government then came out shortly after BHP and said it was a good idea. They then took that position to the COP 25 in Madrid and it totally derailed and stalled the process around decarbonisation. We have seen such slow policy development around climate change for so many years now. So there’s a lot of materiality in companies’ lobbying and advocacy positions on climate from my perspective. Governance over lobbying must be robust.”
HSBC and Scenario Testing
More recently, Stuart Kirk, Global Head of Responsible Investing at HSBC Asset Management, caused an uproar when he delivered a tongue-in-cheek speech about what he saw as a lack of evidence that climate change has a material impact on investment portfolios.
Hartnett argues that “Kirk missed the point by focusing purely on narrow financial outcomes”. For example, Kirk said who cares if Miami is six metres underwater because stock markets will keep growing. Hartnett points out the HSBC executive’s recent transition in the past year from a traditional investment role to the responsible investment space, a trend often seen in global fund managers building up their ESG capabilities.
“I think it was [the American psychologist Abraham] Maslow who said: ‘If the only tool you have is a hammer, it is tempting to treat everything as if it were a nail,’” he says.
“If you keep on seeing problems in the same way that you’ve always been seeing them, then you’re going to use the same approaches to get your answers. With climate change that is not the approach to take. We need to quickly develop multiple tools and diverse perspectives to address climate change because it is the classic example of market failure. Governments and consumers are intently looking at institutional investors to lead the way here. It will be a great opportunity for some fund managers and a greater challenge for others.”
There is a problem with the overemphasis on long-term climate scenario analysis at the moment. I think it is more useful to set net zero by 2050 ambitions, but then focus on the here and now, such as setting and reaching shorter-term targets, looking at net-zero-consistent CAPEX, carbon-based executive remuneration targets, lobbying practices, net-zero benchmarks and just transition
But Hartnett does agree on one point Kirk made and that is the overreliance on long-term predictions to inform current portfolio decisions.
“I agree there is a problem with the overemphasis on long-term climate scenario analysis at the moment. I think it is more useful to set net zero by 2050 ambitions, but then focus on the here and now, such as setting and reaching shorter-term targets, looking at net-zero-consistent CAPEX, carbon-based executive remuneration targets, lobbying practices, net-zero benchmarks and just transition,” he says.
“Portfolio scenario analysis will always have an important role for institutional investors. However, relying on scenario analysis out to 2050 means you are going to make a lot of assumptions when many things are still in a state of flux. There is also a lot of complexity around climate change data. When you look at a key metric, the implied temperature rises for example, you’re really looking at assumptions, built on assumptions, built on assumptions.
“And then when you have something like the devastating war in Ukraine happening, it totally throws scenario analysis out and brings to the fore the geopolitical risks with climate change. So I believe that we really need to be looking at more immediate and practical things that we can do as investors to help the transition to net zero and we need to be doing a lot more.
“You can’t just rely on traditional investment tools and you can certainly not compare climate change to Y2K as [Kirk] did. I think that is just a total fallacy because climate change is underpinned by very basic science: the more greenhouse gases you put in the environment, the more difficult it will be to adapt.”
Arguably, the recent election in Australia was won on climate change policy. The rise of the independents, who won more seats than ever before, was spearheaded by individuals with largely liberal agendas, but clear climate change policies, as well as an emphasis on gender diversity.
Hartnett thinks this development could prove to be a turning point in Australia’s policy towards climate change and create opportunities for investment in the energy transition.
“It is one of the reasons why I’m planning to come back to Australia. I think it is very positive and there is a tremendous opportunity to address climate change,” he says.
“Climate change had become a big ideological war [in Australia]. Several Prime Ministers have been toppled on it over the last 10 to 15 years. But if you get good policy coming in and leverage that through institutional investors, then there is a tremendous amount of money and superannuation that can be deployed towards positive solutions.
“And yes, there will be some companies and some fund managers that are going to make this transition better than others. There are always winners and losers in transitions,” Hartnett says.
For a guide to ESG in Australasia please see here.
[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.