FOSSIL FUEL FREE ESG INVESTING: Recent Australian Performance

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1 FOSSIL FUEL FREE ESG INVESTING: Recent Australian Performance Data for this paper provided by Thomson Reuters This report is issued under Creative Commons Licence Attribution CC BY. You are free to distribute and build upon this work as long as Future Super is credited for the original creation. For more information visit Disclaimer: This report is for information purposes only. The report is not an offer to buy, sell or in any way deal in a financial product. We recommend all investors seek out the services of a financial planner when making 1 investment decisions. Past performance is not indicative of future returns.

2 OVERVIEW: the launch of two groundbreaking indices On 1 September 2015, Future Super and Thomson Reuters Australia launched two ground breaking indices to the Australian market: the Thomson Reuters/Future Super Australia Fossil Free Index and the Thomson Reuters/Future Super Sustainability Leaders Fossil Free Index. The Thomson Reuters/Future Super Australia Fossil Free Index is the first index of its kind in Australia, following in the footsteps of fossil fuel free indexes already available in the United States and Europe. The Thomson Reuters/Future Super Sustainability Leaders Fossil Free Index is the first index in Australia which incorporates a strict negative screen on direct and indirect fossil fuels in addition to traditional Environmental, Social and Governance (ESG) scoring. It provides both institutional and retail investors in Australia access to an index of the 50 leading medium to large sustainable companies on the Australian Securities Exchange. Both indices have been developed with input from a range of data sources including: company annual reports; sustainability reports and public statements; Thomson Reuters Corporate Responsibility Ratings; the Thomson Reuters Eikon Service; Research from Corporate Analysis Enhanced Responsibility (CAER) and the EIRIS Global Platform; Project Finance Databases; and NGOs including Market Forces, Know More, the Ethical Consumer Guide, and the Business and Human Rights Resource Centre. 2

3 INTRODUCTION An increasing number of investors are analysing whether or not their portfolios might be affected by climate change and exposure to fossil fuels. In addition, entities considering the morality or otherwise of investing in fossil fuels are looking to understand the impact on portfolios of removing this exposure. Environmental, Social and Governance (ESG) investing has been widely adopted around the world. Traditionally, ESG screens included removing investments in industries like tobacco, alcohol and controversial weaponry. Traditional ethical investors are increasingly looking to add a strict fossil fuel screen as well, while institutional investors and super funds are under increasing pressure from their members to remove or reduce exposure to fossil fuels in their investment portfolios. While many product providers around the world are adding fossil fuel free screens to their portfolios or indexes, few are combining traditional ESG screens with a strict approach to fossil fuels. These two new indices, launched by Future Super and Thomson Reuters, are the first to tread this path. One is the first fossil fuel free index to be offered in Australia, the other is the first to combine a strict fossil fuel screen with traditional ESG criteria. Key findings: Investment analysts are becoming increasingly concerned about the impacts of fossil fuels on investment portfolios. The number of larger ASX listed companies that pass fossil fuel free, ESG and ethical screens is increasing. The Thomson Reuters/Future Super Australia Fossil Free Index outperformed the Thomson Reuters Australia Index from 2011 to 2015 showing that over the period fossil fuels added increased risk without adding a performance gain. The Thomson Reuters/Future Super Australia Sustainability Leaders Fossil Free Index significantly outperformed the Thomson Reuters Australia Index. The risk adjusted returns of both the Fossil Free Index and the Sustainability Leaders Index show that the outperformance against the sharemarket has been achieved at a much lower level of investment risk (see Sharpe Ratio below). WHY GO FOSSIL FREE? A recent report from The Economist Intelligence Unit found that the effects of climate change may result in asset managers losing $5.7 trillion, an amount equal to the total value of all the worlds listed oil and gas companies. For every additional degree of warming, trillions of dollars may be stripped from the value of global asset manager portfolios over the coming decades. The report also found that if global warming can be kept under 2C, the average projected losses would be cut in half. However, keeping global warming under 2C requires fossil fuel assets to become stranded assets. As the report concluded: While leaving climate change unchecked will result in large-scale value destruction, it should be acknowledged that there is also scope for impacts on investor portfolios should major regulatory efforts to combat climate change be implemented. Among these is the impact of the stranding of assets not least the substantial portion of known coal, oil and gas reserves which will probably remain unburned if climate change is to be limited a scenario not currently priced into current valuations of these assets. 3

4 This means that global investors are currently facing a stark choice. Either they will experience impairments to their holdings in fossil-fuel companies should action on climate change take place, or they will face losses to their entire portfolio of manageable assets should little mitigation be forthcoming. Charting a path away from these two options should be a strong motivation for long-term investors to engage with companies in their portfolios and to shift investments towards a profitable, low-carbon future. Inaction may leave investors holding such [fossil fuel] assets at particularly high risk. The global climate change advocacy organisation 350.org explains the particularly high risk outlined by The Economist Intelligence Unit with what they term climate maths in an easy-to-understand way: We can emit 565 more gigatons of carbon dioxide and stay below 2 C of warming anything more than that risks catastrophe for life on earth. The only problem? Burning the fossil fuel that corporations now have in their reserves would result in emitting 2,860 gigatons of carbon dioxide five times the safe amount Gas GtCO Oil Global fossil fuel reserves Already burnt Coal Global carbon budget Remaining 0 Economists are now warning that if there is a global consensus to limit man-made global warming to 2 degrees, up to 80% of all known fossil fuel reserves would need to stay in the ground. This means that if and when the world makes significant progress tackling climate change, whether through domestic action or an international agreement, the value of fossil fuel companies may suddenly and sharply fall. The fossil fuel reserves remaining in the ground and subsequent devaluation is referred to as stranded assets. Fossil fuel companies are overstating the value of reserves on their balance sheets because they will become stranded as the globe reaches recommended limits of carbon emissions. (Cambridge Associates, 2015) The polluting assets of fossil fuel companies, many of which are listed on stock exchanges like the Australian Stock Exchange, may be devalued as a result of the changes that are already occurring in the global economy. Some of these changes are driven by: New government regulations (like the Renewable Energy Target and vehicle emission standards); The rapidly reducing price of clean energy; Changing consumer behaviour (e.g. the trend toward installing solar on rooftops); and Sudden and disrupting changes in technology (e.g. the battery storage revolution) 4

5 Some economists have begun warning that changes in the structure of the global economy, driven by the above scenarios, may lead to a carbon bubble. Such an occurrence may lead to losses for investors as it becomes difficult to recoup the money invested in fossil fuel exposed companies with assets that are no longer usable in their intended way. But it is not just future returns that may be affected by changes in the energy sector. There is also evidence to show that funds may have outperformed over recent years had they shunned the fossil fuel industry. If you look just at the financial data in Australia... over the past five years...the value of coal stocks has gone down by 71 per cent, so you ve lost a lot of money if you ve been in coal. -- Valerie Rockefeller, Chair of the $1.1bn Rockefeller Brothers Fund, ABC Four Corners, Monday 15 June 2015 While the financial risks of fossil fuel investments is becoming increasingly compelling, traditional ethical investors are demonstrating another reason behind their appetite for divesting from fossils. As they put it: if it s wrong to wreck the planet; then it s wrong to profit from that wreckage (Bill McKibben, founder of 350.org). The fossil fuel divestment movement is one of the fastest growing movements in history. These investors are working together to speed up the stranding of fossil fuel assets by removing the social licence of the fossil fuel industry. Large super funds like UniSuper and HESTA have been pressured by their members to remove some of their fossil fuel assets, while more recently the Commonwealth Bank has walked away from its adviser role on Adani s project in the Galilee coal basin after significant public pressure. A PASSIVE MANAGEMENT APPROACH TO ESG THAT INCORPORATES FOSSIL FUELS The Thomson Reuters/Future Super Australia Sustainability Leaders Fossil Free Index is the first product to genuinely integrate strict ESG screens into a passive index product. Ethical and ESG fund managers in Australia have traditionally been active asset managers with a focus on small and mid cap companies. ESG fund managers have been left with little choice but to be active managers as the number of securities which pass traditional ESG screens hasn t been large enough to avoid active management. An index of Sustainability Leaders could not have been created because there wasn t a big enough universe of investible stocks to make a Sustainability Leaders Index possible. At present, 129 out of approximately 280 stocks in the Thomson Reuters Australia Index pass negative screens used in constructing the Sustainability Leaders index. However, in March 2013 this dropped to 82 stocks and by September 2009 dropped as low as 60 stocks. This is accounted for by the changing nature of the largest stocks on the Australian Stock Exchange. While 5 years ago the largest companies on the ASX were dominated by energy and resources companies, many of these companies have fallen out of the top 300 of the ASX over the last 5 years and been replaced by companies in industries such as healthcare, communications and information technology. These industries tend to pass a screening process designed to enhance performance by applying ESG screens. Where product providers have previously attempted to create passive, index style Australian equity products, they have attempted to get around the limitations by only applying a very light ESG screen on tobacco, armaments and gambling. Given the lack of tobacco and armament producers on the ASX, this results in very little change to the broad Australian equities index. 5

6 Traditional ESG screens push fund managers toward certain sectors and themes such as healthcare, technology and regional banks, and typically exclude certain sectors such as resources, materials and energy. ASX data shows that up to July 2015, the sectors which have provided for positive ASX performance since the Global Financial Crisis are Healthcare (+126%), Telecommunications (+32%), Information Technology (+25%), and Consumer Staples (+10%). The sectors which have performed negatively over this time have been Materials (-38%), Consumer Discretionary (-35%), Industrials (-31%), Energy (-28%), Utilities (-13%) and Financials (-8%). This attribution shows that ESG rules which impact the sector allocations of screened portfolios are adding to any alpha that active stock-picking is producing The outperformance of these sectors is a contributor to the back-tested outperformance of the Indexes, outlined below. BACK-TESTED PERFORMANCE OF THE INDEXES Back-testing was done on the Australia Fossil Free Index from October 2010 to June 2015, and showed outperformance against the Thomson Reuters Australia Index, which represents around 280 of the largest stocks on the ASX. 1 October June 2015 Thomson Reuters/Future Super Australia Fossil Free Index Thomson Reuters Australia Index Return (p.a.) 9.65% 7.71% Standard Deviation Annualised Sharpe Ratio Max Drawdown 31.6% 39.5% The Thomson Reuters/Future Super Australia Sustainability Leaders Fossil Free Index was back-tested from April 2013 to June 2015, which showed significant outperformance against the Thomson Reuters Australia Index. 8 April June 2015 Thomson Reuters/Future Super Australia Sustainability Leaders Index Thomson Reuters Australia Index Return (p.a.) 17.87% 8.39% Standard Deviation Annualised Sharpe Ratio Max Drawdown 16.3% 18.6% 6

7 While the outperformance is significant, the Sharpe ratio particularly stands out. The Sharpe ratio is a measure of risk-adjusted performance whether a portfolio s returns are due to smart investment decisions or a result of taking excess risk. While the Fossil Free Index and Sustainability Leaders Index produced outperformance compared to the Thomson Reuters Australia index, investors are typically looking to see that higher returns do not come with unwelcome additional risk. The greater a portfolio s Sharpe ratio, the better its risk-adjusted performance has been. A Sharpe ratio of 1 or more is considered to be good, a ratio of 2 is considered to be very good. The Sharpe ratio for the Sustainability Leaders Index is This places the index in the good to very good category, and significantly higher than the Thomson Reuters Australia index (a similar index to the ASX300) which scored A comparison with the Sharpe ratio of ethical funds that do not have strict fossil fuel screens also shows that the addition of a fossil fuels screen increases the Sharpe ratio and reduces volatility. Strong risk adjusted returns are a hallmark of a genuine approach to responsible investment. The companies that pass ethical screens tend to be in more defensive industries such as healthcare, and ethical screens tend to filter out more risky or speculative investments such as resources. Those companies with a poor environmental record or social and governance issues are the companies more likely to face heavier regulation or fines, or suffer damage to their reputation. Similar research on fossil free portfolios has been conducted by US analysts Parametric Portfolio Associates and The Australia Institute (with 350. org and Aperio). Parametric s research (Feb 2015) concluded: In examining the historical data, we find that divestment can be achieved with minimal impact on portfolio return or volatility over the long-run. The Australia Institute commissioned research in March 2014 that said:...screening out fossil fuel extraction and downstream industries can have negligible impact on risk-adjusted returns. That might seem surprising, given the attention paid to the Australian mining boom and ongoing (but declining) incumbency of fossil fuels in Australia s energy mix. In fact this result simply illustrates a well-established result from a substantial body of theoretical and empirical literature. The impact on risk-adjusted returns from screening out companies or sectors is minimal provided the screen is not excessively restrictive. CONCLUSION As the global transition away from dirty energy sources picks up steam, we are beginning to see the financial case for the immediate screening out of fossil fuels. The back-testing of the two indices that have been created as part of the development of this report demonstrate the increased risks added to a passively managed portfolio from the addition of fossil fuels. We expect that as index tracking investment strategies take off, so too will there be a growth in the ESG screening of these investment strategies. The two indices that Future Super and Thomson Reuters have launched may be of assistance to investors seeking to incorporate ethical screens into their passive investment strategies. 7