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The financial risks of fossil fuel investments

The recent decision by the Australian National University (ANU) to sell its investments in fossil fuel industries, including seven Australian resource companies, created an immediate storm of both support and criticism. While the Prime Minister, Tony Abbott, used a visit to a coal mine to offer his reassurance for the industry, academics from other universities signed open letters calling on their universities to follow ANU’s lead.

As the rest of the world’s governments move towards clean and cheaper renewable energy, here in Australia we believe we are safe from the changes global warming is causing in our investment landscape. The recent removal of the ‘carbon tax’ by the Federal Government and approval of some large coal projects confirms our stance. Australia is not moving with the changes in the market, domestically or internationally. Some investments will fair significantly worse than others with consequences for our investment and superannuation systems.

Climate change is no longer only about the environment or ethical investment preferences, it is now of economic concern. The dangers of fossil fuel investment are increasingly associated with investment returns rather than the need to mitigate global warming. This phenomenon has been referred to as the ‘next GFC’, the ‘carbon bubble’, ‘global energy deflation’ or ‘stranded assets’. The way government policy is unfolding globally, the lack of preparation domestically could see greater economic fallout in Australia than other countries.

Potential for stranded assets

A stranded asset is when an asset becomes significantly devalued or obsolete. Australian investors are particularly at risk of holding stranded assets because our government policy is not pricing in a tax on carbon. We are therefore lagging in our transition to renewable energy. The movement of investment into the renewable energy sector worldwide and the subsequent decrease in cost, legislative changes and changing social values are affecting our investment landscape. For example, in Germany, the top two utility companies have experienced a loss in value of over 50% in the last four years. This trend is also evident in other parts of Europe and the United States.

The Australian share market and the S&P/ASX200 are highly correlated and dependent upon fossil fuels, mining exploration, and the extraction and sale of materials. With the majority of the indices comprising Materials, Energy and Financials (financials meaning, financial institutions which lend to stranded asset projects and companies), Australian market capitalisation is dominated by companies with strong links to fossil fuel extraction (see carbontracker.org for more on this subject).

In Australia we export 87% of extracted black coal and use the remaining 13% for domestic consumption. Australia’s two biggest coal export markets China and India are setting aggressive new clean energy targets and investing heavily in renewables. China’s wind power alone is expected to provide for more than 20% of the nation’s energy needs by 2020, while India plans to double capacity for renewable energy by 2017. As this trend continues, demand for coal and other fossil fuels will continue to fall, placing further pressure on Australia’s investment market.

According to Towers Watson’s Global Pension Asset Study 2014, Australia has the fourth largest superannuation market in the world. The estimate by the Asset Owners Disclosure Project (a global organisation established to protect superannuation savings from the risks imposed by climate change) is that currently 55% of the world’s investments are in fossil fuel or climate-exposed investments. The Project points out that climate change impacts are especially difficult to quantify due to the long-term risks and uncertain timing of likely impacts.

Mitigating loss is the responsibility of research analysts, institutional fund managers, superannuation trustees, financial advisers, stock exchanges and stock brokers. If these threats do crystallise, the organisations and individuals that move first to mitigate losses will have first mover advantage and be able to shape the changes in the market. Generally, the first major movers will also fair better as the remaining investors will be left holding the devalued assets.

Lack of options available

As the world changes, we must look to new investments and new markets to safeguard our assets. Presently, the market does not offer many safe choices. The options available in the ESG (Environmental, Social & Corporate Governance) or ethical investment market do not provide consistency or certainty in their assessment of fossil fuel investments. This is true in the fixed interest, cash and equities sectors. Advisers are also confined to their Approved Product Lists (APL) which are formulated by the opinions of an adviser’s dealer group.

Fossil fuel free managed fund options include Hunter Hall, which became fossil fuel free as of 1 July 2014 and Australian Ethical, which is moving towards this target, with their funds approximately 90% fossil fuel free according to superswitch.org.au. Alternatively, investors can use the likes of CAER Research to assist in building a direct equity portfolio.

The three finalists for the Money Management Fund Manager of the Year, Responsible Investments Category – OnePath Sustainable Investments Australian Share Trust, Perpetual Ethical SRI Fund and Alphinity Socially Responsible Share Fund – all have different ESG screening. According to Lonsec, they all exclude industries such as Armaments, Tobacco, Gaming and Alcohol. Alphinity additionally excludes Animal Testing and Old Growth Logging. Perpetual additionally excludes Coal Seam Gas and Uranium. None of the three funds specifically mention climate change or fossil fuels in their screening process. Lonsec reports that Perpetual does not have a tolerance for big mining whereas Alphinity and OnePath do. According to Superswitch.org.au Perpetual has a known fossil fuel free component of 26%. However, funds do not have to report on their investment holdings and often only report on their top ten holdings. This is stated to be due to the high cost of disclosure, damaging a funds competitive advantage and ‘trade secrets’. Determining how financially robust a fund is can be difficult. Even if it is ethical, the fund may not safeguard an investor’s money from the potential carbon bubble.

UniSuper has recently excluded fossil fuel investments from its ‘socially responsible’ investment option. However, most industry super funds are similar to mainstream ethical funds on the market. Simply maintaining a client’s investment in an ethical option in an industry super fund is not wholly safeguarding investments from climate-related losses.

There is not yet any risk premium attached to climate-exposed ASX-listed companies. Direct equity investments to watch for include the four big banks who are lending large amounts of money to new mega mine projects – projects which may become stranded assets. If the projects and companies are unable to sell the fossil fuels or are forced to sell at a significantly reduced price it may impact their ability to meet their financial commitments. Mining supply companies, the mining companies themselves or companies with significant investments in the mining companies will also be at risk as their services and materials will no longer be in demand.

Demand for fossil fuel free investments will increase

As clean energy becomes cheaper and more attractive to the consumer through economies of scale and electricity storage technology, the investment markets will change as they do with any new trend, innovation or discovery. Pre-empting the changes and mitigating losses will be a priority for advisers, institutions and investors. Current options for managed fund or APL restricted advisers are not promising nor always transparent. However demand for and performance of ethical and fossil fuel free investment is increasing and the market is changing to meet the demand. As a result, we are set to see some major developments in the investment landscape both domestically and internationally.

 

Hope Evans is an Associate at Whytes Wealth Creation Specialists and has worked in financial planning for six years. She holds a Masters in Environmental Management (Sustainable Development) from Bond University and specialises in ethical and climate-related investments. Her views are personal and may not represent the opinions of Whytes. This article is for general information purposes only and does not constitute personal financial advice.

Disclosure: Hope Evans holds units in the Perpetual Ethical SRI Fund.


 

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