Wrestling with a climate conundrum

Sydney Morning Herald
19 February 2011, Page: 16

It's maddening. We have brilliant renewable energy resources, brilliant innovators and a vast pool of superannuation savings looking for opportunities beyond our overvalued, over analysed, ticket clipped top 50 listed companies.

We also have growing recognition that climate change poses a unique risk to traditional investment management strategies particularly here in Australia, where up to 40% of a typical share portfolio might be concentrated in sectors such as resources, which are heavily exposed to a rising price on carbon.

Why can't we join the dots, for example, between a report like Zero Carbon Australia's Stationary Energy Plan, which last year called for investment of $370 billion over a decade to switch this country to 100% renewable energy by 2020, and a report out this week by the actuarial consultants Mercer, called Climate Change Scenarios Implications for Strategic Asset Allocation, urging super fund trustees to divert up to 40% of their investments to so called climate sensitive assets, those suited to a low carbon economy, for the potential upside and because it could reduce portfolio risk.

Why can't we? Why can't we? Why can't we? Many reasons can be advanced, of course and some of them are sound.

A lot of it comes back to traditional approaches to investment portfolio construction, often guided by actuaries such as Mercer. This is why its global report developed over the past 18 months by 14 institutional investors (including VicSuper and AustralianSuper) with $US2 trillion in assets, with advice from the research team who worked on the landmark Stern Review in 2007 is so significant.

Super fund trustees do not worry as much about absolute returns the percentage movement up or down in your super fund balance in any given year as they do about risk. Principally, the risk of being unable to meet their liabilities as members redeem their funds. For super funds investing about $1.2 trillion of our retirement savings on behalf of millions of us, that is a long term proposition as many of us hope to quit work and live off our savings, income guaranteed, perhaps for decades.

The favourite way to manage risk is diversify your assets, although the US investment legend Warren Buffett once said diversification was simply "protection against ignorance,.. it makes very little sense for those who know what they're doing". As super funds grow beyond a certain size they come to own every class of asset domestic and international shares, property, bonds and cash plus a small but growing suite of alternative assets like infrastructure, hedge funds and private equity.

Notwithstanding the reputation that prominent stock pickers such as Buffett acquire, Mercer cites research showing decisions about which asset class to invest in so called strategic asset allocation account for 90% of the variation in portfolio returns. That is intuitive: it is very hard to make money on shares in a bear market, for example. Better to put your money in cash, fixed interest or property.

After diversifying by asset class, the super fund diversifies by manager, each of which has an investment process or "style". The chosen managers create their own diversified portfolio actively buying and selling this or that share, bond, property trust or building, or piece of infrastructure. Or they slash their management fee and passively track a so called index, or basket of representative assets. Layer upon layer of diversification buries risk after risk so if something goes bad, it is a tiny part of the portfolio.

The upshot: being harsh, it is unthinkable for a super fund trustee to invest a large chunk of a portfolio in, say, a series of new solar thermal power stations to be built at an uncertain cost using an unproven technology and valued,.. how? But in climate change we face a crisis unlike any we have faced before. Mercer writes that while some climate sensitive assets may be traditionally deemed as more risky on a standalone basis, selected investments could reduce portfolio risk.

Modelling the impacts of climate change on the different asset classes in a typical portfolio over the next 20 years is difficult, but Mercer tries. It runs four scenarios: from climate breakdown (business as usual, we do nothing, likely 3° of warming by 2050) to Stern action (emissions halve by 2030, carbon price $110/tonne, likely 1.8° of warming). Most asset classes fall in value if we do nothing. Most rise if we take tough action. Under two more probable, middling scenarios a delayed response, or a regionally divergent response the impact is patchier. An underlying theme is evident: delay now, pay more later.

If we are to climate proof our super funds, Helga Birgden of Mercer thinks our traditional approach to portfolio construction "isn't going to stack up a lot of decisions are made on historical quantitative analysis whereas a lot of climate change risk requires qualitative, forward looking input". Julian Poulter of the Climate Institute, who has developed a methodology to help super funds assess climate risk, cites Deutsche Bank estimates that just 06 2% of our super funds assets are lowcarbon.

To lift that to 40%, Poulter says, we are talking $486 billion of investment. "Even over a long time this should start to give market people an idea of the portfolio reconstruction required as a result of climate change. [Super fund] trustees could be in breach of their fiduciary duties if they do not proactively hedge this risk, in the same way they do inflation or interest rates".

paddy.manning@fairfaxmedia.com.au