4 steps to address climate risk in your SMSF portfolio

ESG, ethical or responsible investing may appear to be interchangeable names for the same thing. While there is some crossover, there are differences between them. It’s important to understand what they are so you can identify the investment style that best suits you.

• ESG stands for environmental, social and governance. In this approach, investors consider how an investment manages its environmental risks and meets its social obligations, for instance by paying staff fairly and ensuring the supply chain is free of slavery. The G stands for governance and this refers to the way business is conducted, for example making sure executives don’t pay bribes.

• Responsible investing. The fund manager or investor considers both the investment’s financial return and its ability to bring about positive change and/or reduce environmental destruction.

• Ethical investing. In this style of investing, the fund manager or investor seeks to align their values, principles or ethics with their investment decisions. These funds typically avoid investing in companies in the fossil fuels, tobacco, gambling, pornography or armament sectors.

Steps to applying a framework to your SMSF

Here are some steps to follow if you wish to apply an ESG (or responsible or ethical) overlay to your investment decisions.

1. Identify your ethical and responsible investing values

For instance, you may wish to avoid investing in assets that are exposed to animal cruelty. Or you may want to avoid allocating capital to businesses or assets whose activities harm the environment.

Once you have identified your priorities, you can apply that lens to new and existing assets in the fund to determine whether they are aligned to your values. But be aware these are complex issues and the right approach to investing is not always cut and dry. Investing in water is a good example, given it’s currently a controversial area.

“We recommend some investments in the water market. We often have quite detailed discussions with clients about whether it’s really a beneficial market to invest in,” says Fiona Thomas, financial adviser and general manager with investment advice firm Ethinvest.

“On balance, our view is much like putting a price on carbon, putting a price on water recognises its value,” she adds.

2. Do research into assets that align with your values

This begins with filtering out companies or managed funds that do not meet the SMSF members’ values or investment criteria. 

Some managed funds use negative screens to exclude certain sectors such as gaming and alcohol. Others use positive screening to include companies and sectors that align with the fund’s objectives, for instance clean energy businesses.

Assess each asset’s relative performance and, if applicable, any ESG rating that has been applied to the investment or fund. For instance, Lonsec has developed a sustainability score to the investments it rates to assess how funds track against the United Nation’s 17 Sustainable Investment Goals, which cover things like reducing hunger and equal access to education.

“Understanding ratings and how they work can help trustees to decide which assets to include or exclude in the fund. Think through whether you’re happy to include products with any ESG rating or only those with the highest possible rating,” advises Amanda Cassar, an adviser of and director with financial advice firm Wealth Planning Partners.

Another consideration is whether the investment manager is a signatory to the UN’s Principles of Responsible Investment. Investors that sign up to these principles agree to consider sustainability when making investment decisions.

3. Conduct due diligence on the fund or company’s assets

Explore other companies in which the asset may have an interest, businesses that provide them with services and to which businesses they may be related.

For instance, electric vehicles rely on lithium batteries to run. The lithium is mined using chemicals, which can contaminate the soil around the mine. Conversely, electric vehicles help reduce reliance on fossil fuels. Weigh up considerations like this before deciding how to invest.

“I had one client adamantly tell me they don’t want any investments in their portfolio that are involved in coal mines. Yet on investigation, they held BHP Billiton, which owns BMA Australia, which owns and operates two open-cut coal mines,” says Cassar.

4. Devise an appropriate investment strategy

When choosing your investments, factor in the asset’s performance, fees, liquidity and benchmark asset allocation. Balance these variables with the SMSF members’ risk profiles, goals, objectives, retirement expectations and personal circumstances.

Emerging financial risks

ESG risk is a huge topic to explore. An increasingly important issue is how much physical damage could be caused to the asset’s property or business by storms, floods and fires that occur as a result of climate change.

Regulatory risk is also an emerging problem for trustees to consider.

“Australia could potentially be locked out of European markets for some of our exports because we don’t have a price on carbon or well-defined ways of managing climate risks. Unless this changes, some local companies may not be able to sell their goods in Europe in the future, which affects their bottom line,” says Thomas.

But remember, it’s not all about risk; some companies’ opportunities will rise as climate risks increase. Examples include companies that will benefit from the transition to clean energy.

The bottom line

Investing along ESG, responsible or ethical lines is still in its infancy in Australia, but rapidly gaining momentum. Even if you have not taken ESG into account in the past, it makes sense to explore how your investments may be affected by climate change risks, given the expectation they are rising and are likely to impact asset values in the future.