As the superannuation sector continues to grapple with charting, and staying, on the path to net-zero targets, global index provider Scientific Beta suggests funds face a tricky task ahead in trying to accommodate numerous well-intended objectives.
Last year, its research highlighted how ‘green dilution’ remained strong when putting a large emphasis on other environmental, social, and governance (ESG) considerations alongside targeting low-carbon emissions in equity portfolios.
The average dilution stood at some 92 per cent, according to Erik Christiansen, head of investment solutions for Scientific Beta.
“With ESG, many investors tend to have a lot of different objectives at the same time. Very often, they come up with a long list of issues they want to [tackle],” he told Super Review sister brand InvestorDaily.
“The problem is, the more targets or objectives you try to pursue at the same time, the less you are going to achieve on any one of them. With just, say, climate change on your mind, you’re probably going to be able to do something more meaningful with climate change, but the more objectives you include, you will dilute that objective. You can’t do everything well at the same time – that’s the idea of green dilution.”
Scientific Beta’s research indicated that, in adding combinations of ESG scores to carbon intensity as a weight determinant in developed equity portfolios, only 8 per cent of the carbon reduction objective survived the inclusion of ESG scores in portfolio weighting schemes.
This would no doubt be on the minds of Australia’s super funds that have made public commitments to meet net-zero targets over the next two decades, including $74 billion fund HESTA; Australia’s largest super fund, $315 billion AustralianSuper; and $160 billion fund, Aware Super.
“The two objectives are, simply put, unrelated. By adding too many ESG factors, investors lose the focus on the carbon reduction objective. So if you are seeking to reduce the carbon intensity of your portfolio, you need to prioritise the decarbonisation objective,” Christiansen said.
He observed that the lack of correlation between carbon intensity and ESG scores holds true even if companies’ carbon intensity, or their carbon emissions per unit of revenue or market capitalisation, is compared to their environmental rating.
“ESG ratings have little to no relation to carbon intensity, even when considering only environmental factors underpinning ESG ratings,” said Christiansen.
“Even just using environmental scores, rather than a range of ESG factors, leads to a substantial deterioration in carbon performance. You get a worse outcome by mixing social or governance ratings with carbon intensity objectives, which typically results in creating portfolios [that] are less green than the comparable market capitalisation-weighted index.
“In other words, including social and governance scores more than completely reversed the carbon reduction objective.”
The investment executive proposed that dilution can be avoided through a separation approach, whereby ESG scores are used only for screening whether companies are included in a portfolio, then using carbon metrics to determine the portfolio weights.
However, in Australia, YFYS performance testing for super funds imposes tracking error targets that tether them to high-emitting Australian companies, inadvertently restricting fund investment behaviour to continue to fund high-carbon emitters regardless of their ESG performance.
Unlike the low-carbon benchmarks readily available in Europe, the absence of a YFYS-compliant low-carbon benchmark in Australia leaves super funds with few viable options, Scientific Beta has previously stated.
“Tracking error constraints on super funds make it difficult to act [and] limits how much they can do in terms of financing climate solutions,” Christiansen agreed.
“If they decide to focus on or be overweight companies that provide climate solutions, that could lead to tracking error.”
It painted a very different picture to regulators in Europe, he observed, where “the political and regulatory environment actually pushes pension funds to do more.”
“In the European context, regulators agree climate risk is something that needs to be taken into account and acted upon. Instead of funds having to defend themselves, [there] they probably have to defend themselves for not acting on it,” Christiansen said.
However, it was perhaps one step better than the US, where the issue has been “very polarising”, he noted, amid growing tensions between Republican and Democratic states on the issue.
Last year, research by the Responsible Investment Association Australasia (RIAA) pinpointed outperformance for super funds with leading responsible investment practices, finding that the MySuper products, of those deemed by the RIAA to be “responsible super fund leaders”, delivered a better average net return than “non-leaders” over three, five and eight-year time frames.
A total of 10 responsible super fund leaders were named by RIAA in its latest Responsible Investment Super Study 2023, namely, Australian Ethical Super, AustralianSuper, Aware Super, CareSuper, Cbus Super, HESTA, Future Super, Rest, TelstraSuper, and UniSuper.
According to the research, these leaders had an average net return of 7.65 per cent over three years, 6.09 per cent over five years, and 6.75 per cent over eight years versus non-leaders with a return of 7.54 per cent over three years, 5.67 per cent over five years, and 6.30 per cent over eight years.
Addressing the concern of whether meeting ESG targets could be beneficial or at odds with performance returns, Christiansen argued there was no case of alpha from ESG per se.
“We’re not claiming it’s a new source of alpha or that markets are inefficient at pricing this. At the same time, many empirical studies show there’s no detriment to returns either,” he explained.
“It’s neither positive nor negative, but it puts some constraints and some tracking errors and it limits what you can do – but it does not mean underperformance from ESG.”
