Richard Newell

Portfolio risk analysis is improving, but there is much to be done for investors to achieve a holistic assessment of how governance and sustainability affect portfolios. Sustainable investing advocates are urging asset owners to take a more holistic approach to ESG integration in their portfolios, in the light of a re-pricing of assets that is taking place against a background of international conflict, inflation and how central banks are responding to these events. Historically, ESG risk analysis has disproportionately focused on listed equities, but the Ukraine crisis has highlighted the impact on emerging market debt, sovereign debt and high yield. The ability of asset owners to address systemic risks across the ESG spectrum will positively impact their investment portfolios. For ESG risk analysis to succeed, “investors need to be asking questions about risk and what they mean for long term-returns on a more consistent basis”, according to Sydney-based asset consultant Alexis Cheang. Fixed income impact In fixed income, the heightened geopolitical risk in Europe and Asia has fuelled the volatility in emerging market sovereign debt, while developed-market sovereign bonds are maintaining stable capital inflows despite rising domestic inflationary pressures. The evolving sustainable bond and sustainability linked loan markets present their own challenges, of assessing whether the use of proceeds intention matches an investor’s vision of sustainability. “One of the things we’ve seen in the past is a lack of clarity about the use of proceeds,” said Joey Alcock, chair of the responsible investment group at Frontier Advisors in Melbourne. “Asset owners would naturally be sceptical of an issuance intended to improve or repair fossil fuel facility. Yes, you’re making it more efficient but you’re also extending its life.” Nonetheless, industry players are predicting that Australia’s developing green finance sector will be an increasingly essential component of corporate funding. The move towards green financing has, up to now, been driven by equity investors in Australia. They are increasingly agitating, through voting and engagements, for better governance around environmental and social risk. That’s now translating into the debt market. Globally, investment managers are trying to improve their credit risk analysis in this area. The pricing model that Federated Hermes has developed to capture the influence of ESG factors on credit spreads, for example, shows a convincing relationship between ESG risk and credit spreads. Environmental risks have become a main focus for investors as attention on climate change impact, water security, deforestation and biodiversity protection has increased. Energy transition challenges The energy transition presents some massive challenges – not least of which is the ability to compensate local communities in emerging markets like Indonesia, for example, whose livelihoods are bound up with coal and other high emitting industries. Technological breakthroughs might decrease the price of renewable energy, leading in turn to a steep drop in the demand for fossil fuels and a radical change in the energy mix. This is bound to have a material impact on effective ESG and ultimately investment returns. Entities that process fossil fuels may need to write down assets or ultimately default. Banks, insurers and pension funds that have outstanding loans or stocks in the fossil fuel industries will see the value of their investments decrease in the long term. The so-called ‘just transition’, managed poorly, will unsettle local communities and exacerbate the divisions in society at large. Options besides standard data Investors still complain about a lack of reliable and consistent data. Clients of the leading credit rating agencies such as Fitch, Standard & Poor’s and Moody’s are demanding extra detail on the sustainability factors that affect individual credit-rating decisions. While no universal standard risk measure exists, the rise of benchmarks such as the EU’s sustainable product disclosure framework and the International Sustainability Standards Board’s efforts to develop a global baseline of corporate sustainability disclosures, enable investors to remove some of the uncertainty. One of the problems highlighted by shareholder action on sustainability is the lack of vision shown by companies at management and board level. Frameworks such as the Global Reporting Initiative and the Task Force on Climate-related Financial Disclosures are meant to encourage management to move away from a compliance-driven mindset and toward proactive risk reduction strategies. They place responsibility on senior management to identify sustainability risks and to take responsibility for ESG integration and risk mitigation, ensuring they hire people with the appropriate skills, knowledge and expertise to manage those risks.

If it is unquestionably right that asset allocators should be committing to low-carbon transition finance, it follows that every encouragement should be given to speed the flow of capital. BNY Mellon recently published a report showing that the world might need something in the region of US$100 trillion to achieve the goal of net zero by 2050. Asia, with its high fossil fuel-derived energy dependence, needs about half of that figure. Delivering the funding will require a swift and comprehensive transformation of the financial system’s structures and processes, according to Hanneke Smits, CEO of BNY Mellon Investment Management.“I also think there is a great opportunity here from an investment perspective to leapfrog some of the carbon-intensive technology that we have seen in developed markets, in much the same way mobile phones leapfrogged the laying down of landlines in rural India,” said Smits.The hard work is deciding the strategies that will materially decarbonise a business. Joseph Bae, co-chief executive of global private equity and infrastructure firm KKR, believes investors must not shy away from allocating to companies that need to align themselves to net zero, including energy and utility companies.For actual reductions in carbon emissions to occur, “it requires more than simply reducing the carbon exposure of an individual portfolio," Chris Trevillyan, director of investment strategy at Australian asset consultant Frontier Advisers. “Therefore, investors will need to invest in high emitters, but with a clear plan and direct actions to reduce the emissions in those businesses.” Clean portfolios don’t solve the problemMany investors are focused merely on reducing their reported carbon emissions or ‘portfolio carbon.’ “By myopically focussing on portfolio purity and picking and choosing investments that make them look green, without having to advocate for real-world carbon reduction, they aren’t effecting the kind of change needed to tackle the climate crisis,” said Hendrik du Toit, founder & chief executive of asset manager Ninety One.“All they are doing is creating discrete so-called clean portfolios. They are leaving the problem of heavy emitters to others, perhaps even to bad owners.”By way of example, in a typical global equity portfolio, a reduction of 50% exposure in the BRICS (Brazil, China, India and Russia) plus Indonesia will lead to a 3% reduction in reported portfolio carbon intensity. The weight of those countries in the index is just 8%, another reason divestment may be more attractive than engagement.“This gives institutional investors an incentive to divest and avoid these markets. Our experience in emerging markets tells us a very different approach is required,” said Du Toit.Much progress is being made in Asian sustainable investing, but as Joseph Bae points out, there is a two-speed market. Asia’s electricity production must be a key area of capital focus“The situation in the smaller markets, in terms of access to capital, is very different from China and India. There needs to be a recognition that where private capital can add value is in some of those gaps."One of US-based investment firm KKR's largest investments is in the Philippines power company First Gen. "They produce almost 20% of all the electricity in the Philippines, and it’s almost all renewable. Geothermal, hydro, wind and solar," said Bae.Geothermal power plant on Mount Apo. Steam and pipework at the Geothermal Power Station. Mindanao, Philippines. But the Philippines is not a market where a lot of international capital flows. “There are real gaps in terms of availability of funding. So that has to be a big part of the solution.The financial community needs to scale up the creation of financial instruments that help capital allocators channel capital to companies and projects that move the global economy closer to carbon neutrality - and that enable poorer nations the opportunity to participate in the net-zero transition.Electricity production must be a key area of capital focus. Many emerging markets, such as India and Indonesia, still rely heavily on coal for electricity production, with fossil fuel accounting for 25-40% of total carbon emissions. Transport accounts for a further 9-18%. Since electric vehicles need a clean energy grid to deliver the benefit, cutting emissions from electricity production can tackle 40-50% of total emissions in many emerging markets.According to Du Toit, four major funding streams need to be developed to clean up electricity generation in the developing world:Available capital must be scaled up for renewable energy roll-out. That requires a concerted effort across public and private markets and incentives to be considered across the capital structure.Sizeable investment needs to be directed towards expanding transmission infrastructure. Distributing power over long distances is a crucial consideration in Asia Pacific. It will require governments to work closely with finance and power generators.Incentives for state utilities to accelerate the closure of high-emitting plants. There can be no transition without a clear plan to phase out the highest emitters. This phase will be particularly difficult in parts of Asia.Funding for a fair transition for employees and communities at risk from removing the reliance on fossil fuels. This process will need to be handled very sensitively to ensure that local communities are given the resources to survive the removal of their lifeblood. A successful investment outcome relies on this just transition.Engaging governments to collaborate with institutional investors will be crucial if targets are to be achieved. “The investment community cannot do it on its own. We have to collaborate with government and policymakers to ensure that the right incentives and frameworks are in place,” said Smits.“For governments, policymakers and capital allocators, this is the longer path to take. It is also the right path,” added Du Toit.Bae is excited by the opportunity to invest in the ‘brown to green’ transition. But he believes Asia needs to be a leading force for the world to really make progress on decarbonisation.“With China and India among the biggest emitters globally, this is going to be an enormous challenge for Asia, but also an investment opportunity. I’m optimistic that regulators, governments, and the private sector will find a way to work together.”

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Richard Newell

Overcoming the challenge of incomplete data

There are still many known unknowns in sustainability investing

Progress on carbon reporting standardisation

Investors, capital and technology must work closer together

The greening of the job market

Governance and corruption – an enduring problem

Fighting the ESG pushback

Solving the pollution conundrum

How are investors supporting the energy transition?

How to build a broad momentum around decarbonisation efforts

To counter the ESG backlash investors must practice real engagement

How investors can contribute to real change in decarbonisation in Asia