Taking Environmental Issues Seriously in the Wake of Australia's Fires

Australia is burning. Since August 2019, an estimated 12 million plus acres have burned, six times what was burned during the wildfires in California in 2018 and nearly six times the acreage burned in the Amazon during the summer of 2019. Scientists estimate that the fires in Australia have already released over 300 million metric tons of CO2 into the atmosphere in the four months since the bushfire started, more than half of Australia’s total greenhouse gas footprint in 2018. And the bushfire season is not over.

Unfortunately, this is not a black swan event. Though bushfires are natural to Australia’s ecosystems, the frequency, duration, and severity of fire weather in recent years have been increasing dramatically. Australian Bureau of Meteorology (BOM) data show that 2019 was Australia’s hottest and driest year on record, mainly driven by greenhouse gas emissions. While the fires can often be attributed to natural occurrence and arson, climate change is one of the major factors. Data show that Australia’s climate has warmed by just over 1°C since 1910 when BOM began keeping records. More importantly, some of the hottest years on record have been concentrated in the last 10 years.

Global Climate Change

This is a global phenomenon with wide-reaching economic and social impacts. The warming climate causes rising sea levels, which directly affects property values and the wellbeing of those that live in low sea-level areas. This results in higher insurance premiums. Higher temperatures and droughts reduce agricultural production and labor productivity, directly impacting the food value chain and indirectly influencing inflation, trade, employment, and ultimately economic growth. Heatwaves strain power grids and increase heat-related diseases and deaths, putting pressure on emergency services and hospitals, which increases government health care expenditures. These are just a few examples of the broader impacts of climate change on everyday life.

Around the world, investments in ESG-focused funds such as sustainable, responsible, and impact investing assets have continued to surge, with asset owners and pension funds leading the way. The number of companies joining and adapting to the UN-supported Principles of Responsible Investing (PRI) policies has continued to grow, especially in the last three years. In Australia, more and more superfunds and investment managers have become signatories of PRI (a total of 150 members, including 37 asset owners, 101 investment managers, and 12 service providers).

Demands for more action by regulators and the public are growing as evidenced by the increasing number of litigations related to climate change. For example, a recent court case against a super fund for not doing enough for climate change cites the urgency for assessing climate change risk. Growing attention on environmental issues such as climate change, water stress, carbon emissions, and toxic waste has led to increased awareness of environmental, social, and governance (ESG) factors in investments, company governance, and corporate behavior.

Incorporating ESG with an Environmental Tilt

Quantifying ESG from an investment perspective is not easy, not least because these factors involve additional operational costs and changes to existing investment processes. However, ESG factors are increasingly considered necessary disclosures for companies.

For investors, a deep understanding of the ESG profiles of investments allows them to decide whether their investment allocations suit their investment principles and philosophies. Investors need to make this assessment from a risk/cost and return basis so that they can weigh asset allocations accordingly. This applies for asset type selection (active asset pickers vs. passive ETFs vs. thematic indices), or individual stock picking (weighing investments in highly profitable but low-ESG-score stocks).

Investors must consider uncertainty over policy changes/adaptations over time, assumptions on the measurement of direct and indirect impact over different time horizons, as well as the impact of policy changes, quality of data, and unquantifiable implicit costs associated with ESG-related issues. These factors can all create large variations in measurement outcomes. Nevertheless, modeling and forecasting ESG-related issues like climate-change-associated impacts help to raise awareness of the severity of the climate crisis in a systematic and quantifiable way. These models also provide a consolidated view on how investment portfolios adapt to policy changes and adjust investment processes, which helps to improve data collection and deliver a longitudinal view to perform trend analysis.

Case Study: ASX 200 vs MSCI Australia ESG Leaders Index

To assess the environmental exposures and performance of key Australian stocks, we compared the ASX 200 (the Australian large cap equity index) to the MSCI Australia ESG Leaders Index—a capitalization-weighted index that provides exposure to companies with high ESG performance relative to their sector peers. We also leveraged MSCI’s ESG ratings to analyze data as of Dec 31, 2019.

While the ASX 200 portfolio scores similarly on the Governance and Social pillar (on a scale of 0-10), its score on the Environmental aspect is significantly lower (5.69) compared to the benchmark (6.72). From a sector perspective, while sector allocation in the portfolio scores on par or lower vs. the benchmark on overall industry adjusted ESG score, overweights in Materials, Consumer Staples, Utilities, and Energy score the lowest on overall industry-adjusted ESG-score basis. This is also consistent with contribution to tracking error by these sectors from a risk perspective.

How does this sector allocation affect returns through the ESG lens? The Contribution to Return vs. ESG Score Comparison chart shows that while the Materials sector ranks poorly on an ESG basis, this sector contributed most to portfolio active return (sector returned +4.96% out of +23.38% portfolio return in 2019, +1.85% out of total -0.41% active return). A closer inspection shows that within the Materials sector, the Metals and Mining industry has been the main contributor (largely coming from overweights in BHP and Rio Tinto). On the other hand, while the Financials sector scored relatively better on an ESG basis, this was the worst performing sector over the past year, driven by the Banks industry.

Looking at MSCI ESG Overall Rating breakdown (an industry-focused ESG value assessment rating), although the portfolio has more than 42% in A-ESG-rated assets, the lowest Environmental score comes from high overweights in BBB-rated assets.

Over the past year, allocation to BBB-ESG rated assets increased by about 4% to over 16% but there have been no material changes to the overall ESG or individual pillar scores.

Assessing Environmental related issues separately, Packing Material and Waste (4.53), Biodiversity and Land Use (2.94), and Toxic Emissions and Waste (2.96) are some of the key issues that lower the portfolio scores against the benchmark.

Looking at the Materials sector in the portfolio alone, although scores across all Environmental issues are underwhelming, Water Stress and Toxic Emissions and Waste are the key drivers of low Environmental scores.

The scores are consistently low in these areas across assets in the sector. The table below shows a snapshot of highly overweight assets in the sector with low Environmental key issues scores. Using this information, managers can screen out and exclude the companies that conflict with their investment principles.

While these scores attempt to quantify the ESG impact of these companies, they do not provide information on how individual companies manage climate-related risk to reduce their environmental footprints. For example, BHP has been actively engaging in greenhouse gas emissions reduction operations, setting specific emission reduction targets. In 2019, the company announced a five-year, $400 million climate investment program to develop technologies to reduce emissions from its operations as well as those generated from the use of its resources.

Incorporating ESG ratings, performance, and risk attribution together, the highest average active overweight in the BBB-ESG rated sector was the biggest return detractor over the past year from a performance attribution perspective, accounting for -1.41% out of the -0.41% total effect. Using Brinson attribution, the negative relative return was mostly attributed to overweight in the Materials sector (0.81%). Note that sector allocation positively attributed 7.49% but the stock selection and interaction effect more than offset the gains and resulted in -0.81% loss. Interestingly, from a risk-based attribution perspective (based on the Barra Australia risk model), the BBB-ESG rated sector was the biggest contributor.

By the same token, the AA-ESG rated sector was the biggest average underweight over the period; both Brinson and risk-based attribution show that low allocation to highly-rated ESG assets detracted from performance. Further drill-down reveals that underweight in the good-performing Health Care sector was the main detractor.

Over the past 10 years, the MSCI Australia ESG Leaders Index has nearly doubled the performance of the ASX 200 index.

A simple performance comparison shows that there is no clear-cut outperformance of high-ESG-rated indices against standard core equity market indices and vice versa. However, it is encouraging to see that funds and indices that focus on sustainable investments are booming and continue to receive substantial inflows. Most ESG-focused funds and indices are relatively new and do not have a long enough performance history to make robust comparisons.

Nevertheless, this does not discount the merit of being ESG aware and proves that considering ESG factors does not limit returns. The crucial point here is more about taking a balanced and informed view so that decisions can be made incorporating all the traditional factors as well as ESG metrics associated with different investment horizons and philosophies on a risk- and return-adjusted basis.

Conclusion

As climate crisis and environmental impacts from our actions continue to escalate, it is not just the policymakers’ task or simply for the purpose of fulfilling ever-growing climate-change-related regulatory reporting requirements, but individually we have a responsibility to ourselves, future generations, and broader society to protect this planet. It is also a part of corporate social responsibility and shareholders’ rights to know how their capital has been used from the environmental point of view even for the purpose of transparency.