There are many accounts about the severity of pollution that rapid industrialisation has brought to China, and one of the most striking is the example of not being able to see from one end of Tiananmen Square to the next owing to smog. This highlights the dangers that unchecked carbon emissions poses, but the government’s reaction is a sign of why investors should take notice.

China has launched its first carbon trading scheme in the Shenzhen industrial zone, with a view to rolling it out at seven other areas by 2014. The aim is to reduce the amount of carbon dioxide emitted by 40-50 per cent by 2020 (from 2005 limits). The scheme sets a cap on the level of carbon dioxide that can be emitted in a region and gives companies credits equal to one tonne of carbon, which they can then buy and sell according to their needs. Notably as a command economy, China could sort out pollution faster than a democratic state, but its focus on rapidly seeking sources of alternative renewable energy shows how the world could change for investors. As these pages were written, President Obama too had announced a climate action plan that will limit emissions by power plants.

The analysis

The impact of government curbs to carbon emissions has been measured in two recent investment analyst reports. In April, Elaine Prior a senior analyst at Citi Research in Sydney, produced a report entitled Unburnable carbon – a catalyst for debate. In it she tackled the notion, popular among climate change experts, that only around one-third of all proven reserves of fossil fuels can be consumed by 2050 if global warming is to be limited to a 2-degree rise in temperature, with action required by 2017.

If this is the case, she said, then asset owners should tilt their portfolios away from companies with the highest carbon footprint, noting that currently 14.1 per cent of the ASX200 relates to fossil fuels.

In July 2012, Nick Robins, an analyst at HSBC in London, produced a report entitled Coal and carbon – stranded assets: assessing the risk that estimated the impact of government regulation to limit carbon emissions could cut the valuations of BHP Billiton, Anglo American and Rio Tinto by around 3 to 7 per cent. For Xstrata, which has a much higher reliance on coal mining, the hit would be between 7 to 15 per cent.

While the losses might be a moot point, perhaps the clearest takeaway is that investors should challenge company assumptions on capital allocation towards longer-term coal expansion projects.

Robins’ report noted that while China was committed to cutting emissions and so was South Korea, elsewhere there was less agreement.

In Australia the coalition has vowed to reverse a cap on carbon emissions and to trade emissions.

The pressure group, the Asset Owners Disclosure Project goes one further than both these reports, calculating that 55 per cent of the ASX has an exposure to carbon emissions from not only the mining companies, but to transportation and heavy industry that support these firms, and to the insurance companies that insure against increased flooding risk.

A cultural shift

In Australia the objection to carbon limits rests on concerns to its impact on the economy and to jobs, but the lesson of China shows that when the pollution gets out of hand the public wants action. If we get more climate change events such as flooding and tornados then opinions will change. The question then is when will high carbon impact companies start to suffer? The regulation in China suggests it starts now, but timing is a key issue.

Investors can tilt investment portfolios away from mining companies, but this strategy poses a risk if fossil fuels are stronger for longer than expected.

Nathan Fabian, chief executive of the Investor Group on Climate Change, whose role is to disseminate the reports such as those by Citi and HSBC , says funds need to make their own call about when emissions will be reduced by regulation.

“They need to scenario plan they need to have a view on when these things will occur, if they are not doing that, they are really neglecting their responsibility to take this evidence seriously.”

Julian Poulter, executive director of the Asset Owners Disclosure Project, believes that superannuation funds also require a cultural shift in thinking. The shift, he admits, will be hard.

Fund managers and chief investment officers are incentivised and employed for short-term gains, but a tilt away from carbon stocks might only pay off over five to seven years. Poulter acidly notes some trustees would rather their funds join others in a market crash than pull away from the crowd.

“Mercer are no doubt the most progressive asset consultant in this area, but even for them to get changes made provides them with some cultural challenges. Imagine Mercer going to its client base and saying ‘you know what, actually we think that indexation doesn’t work for climate change; as asset owners you need a far more active strategy to climate risk as fund managers are just not simply solving the problem’. That represents a major challenge.”

Currently the Asset Owners Disclosure Project is advocating investors apply a hedge across their portfolio tailored for the level of carbon risk to which they are exposed to. They also advocate explaining their policies to members to prepare them for the asset return journey the fund is undertaking.

However, the progress taken by superannuation funds to limit their exposure to carbon is slim. Fabian says that while many are getting their managers to carry out climate risk analysis, only a couple have an explicit allocation to carbon light products. Cost is a problem as most products require additional research, such as alternative indexation, which leads to extra fees, making it difficult for asset consultants to approve them.

Fund reaction

As a neutral observer of trustee boards over the years, Hugh Dougherty, head of manager research at Towers Watson, has seen the logic of climate change pressure groups gradually winning round the sceptics. Five years ago, he says, there tended to be only one person on the board who would be engaged, who would commonly be shouted down by sceptics, while a silent majority observed. Today it is different.

“The advocates are still there but the sceptical critiques have died off and the silent majority want to know more.”

One of the objections to reducing allocations to carbon intensive companies is also losing ground. Fabian says that the technology for carbon capture, where emissions are pumped into old gas reservoirs, are years from reaching the scale and applicability required. “What you are talking about is unforseen technological shift. At this stage it is a big gamble to assume that will be the outcome,” he says.

Tom Lambert, associate consultant and environmental specialist at Frontier Advisors, sees more and more trustees accepting this logic.

“The notion of universal ownership does appear to be gaining more currency. More assertive arguments by representatives of super funds are being made that sustainable environments underpin the ability to provide for members’ retirement incomes. Some trustees are likely to feel apprehensive about how this concept conflicts with the sole purpose test and their fiduciary duty to members. But in the absence of major turmoil in financial markets it is likely to command more attention from both members and trustees.”

Louise Davidson, ESG investment manager at CBUS, argues a lack of action now poses the biggest risk for trustees.

“Even if there are people who are unconvinced about the science behind climate change, it is a pretty big gamble to take and I don’t think many trustees would be prepared to take that.”

A mainstream process

Despite some of the scepticism of climate change pressure groups, mainstream fund managers are starting to take action.

Ian Woods, head of ESG research at AMP Capital compares two companies making the same profit with different approaches to sustainability.

“If a company is relying on underpriced pollution, ill-informed consumers, poorly paid staff in Bangladesh or weak government regulation; if what it is doing is not fundamentally good for society and its government is allowing it now, then eventually it is not going to be able to do that. The company that is sustainable in practice is the one that will be better off in three to five years’ time.”

And risk is a bigger incentive than opportunities. “One of the challenges for any investor is trying to understand the conviction for your earnings forecast. What is the range of potential expectations? If you start risk weighting them, the risk is on the downside.”

Woods adds that such processes sets in motion a more sceptical outlook on whether business models are sustainable from a range of factors such as new technology.

Companies that think ahead are becoming the favourites of investors. Davidson at CBUS says that how well a company manages issues like climate change is a pretty good proxy for how well managed they are generally.

“If a company is able to demonstrate that the work that they are doing in these areas is thorough and contemporary and progressive that is a pretty good reflection of their management style and you can take some comfort from that as an investor.”

Dougherty sees the analysis as a competitive advantage for fund managers, such as AMP, which can afford dedicated experts on sustainability. Though, he adds, many managers might not be bragging about it. “Some managers are doing ESG but they just don’t label it as such. They might even start the conversation by saying they don’t believe in it.”

Yet for the biggest managers a dedication to sustainability is now a basic hygiene factor. AXA Investment Managers, in the last year has brought in a way of scoring equities for ESG risks as a core part of its investment process. ESG in action – CBUS One of the most prominent examples of a fund investing to reflect climate change concerns is CBUS. Over the last four to five years it has invested and built properties with a green star rating of 4.5 or above – an award given by the Green Council Building of Australia, where one star says a building meets minimum standards of energy efficiency and use of sustainable materials and six stars shows “world leadership”.

Davidson of CBUS says this policy has been highly successful in bringing higher rents and better quality tenants. Part of the returns comes from the lower costs of buildings with greater energy and water efficiency and good waste management.

“Over the last five to six years we have had a clear demonstration of the value that building property, CBD property with a certain star rating, brings. There is a growing tenant desire to be in sustainable properties, that reduce costs through greater energy efficiencies, to how well properties are positioned to withstand more extreme weather events.”

ESG in action bonds

If the risks of climate change to companies clear then the impact on governments are more opaque. Local Government Super (LGS) runs its entire allocation to international bonds by using sustainability analysis. Bill Hartnett, sustainability manager of the fund, says the economic pressures caused by flooding, pollution and resource scarcity are one of the best indicators of default risk. The more carbon intensive an economy is, the more likely it is to be at risk of decline, while the more indebted a country is, the greater difficulty it will find in coping with the rebuilding costs brought by storms and floods. The allocation, which at $180 million represents 3-4 per cent of LGS, includes a 15 per allocation to climate bonds issued by development banks.

Hartnett says the portfolio looks very different to the benchmark, but still manages to have a low tracking error.