At the recent climate conference in Paris, agreement was reached on a range of actions needed to avoid dangerous climate change. Whilst this was a positive outcome, it is just a start.
To keep warming within safe limits, a massive amount of capital needs to flow rapidly from the old fossil-fuel-based economy, to a new, clean-energy economy.
The investment community was recognised at the conference as a key player in achieving that goal, and the fiduciary duties of trustees with respect to climate risk were widely discussed. However if we are to achieve the significant structural shifts required, the conversation needs to change.
Most analysis of fiduciary obligations with respect to climate change to date has taken a risk-based approach along the following lines:
- Climate change either will or may be a risk to an investment portfolio;
- Trustees have a fiduciary responsibility to manage investment risks;
- Trustees are therefore obliged to consider climate change when managing their investment portfolio.
This is a critical starting point and should be almost a given by now (although it is far from being so). It will not, however, achieve what’s needed to address climate change, as it inadequately recognises the causative impact that investment markets have on the world and their consequent stewardship responsibilities. In short, it is a necessary but insufficient response.
If we are serious about addressing the existential threat of climate change, we need a tougher conversation. The questions should be, “To what extent can trustees take more affirmative action to direct investments toward clean sectors, and still comply with their fiduciary obligations? Can clean investment be a primary decision in its own right rather than a secondary decision related to risk?”
Trustees’ fiduciary obligations stem largely from Sections 52 and 62 of the Superannuation Industry (Supervision) Act (SIS Act), which require them to act in members’ best interests in providing for their retirement or earlier death. Trustees must formulate an investment strategy having regard to the risk and likely return from investments, diversification, liquidity and cash flows.
The law doesn’t require super funds to be invested in every sector and stock in the market. Nor does it say that trustees will be judged according to what a fund would have earned, had it been invested in sectors or stocks that the trustee chose to avoid.
Confusion arises from Section 52 which is often interpreted as a “best financial outcome” duty as opposed to a “due process” duty. This leads trustees to fear that they will be judged according the relative performance of the “non-divested” portfolio. This is a debated area but there is sufficient opinion that best interest does not refer solely to financial outcomes and does not mean achieving the best possible financial return in all circumstances.
It is a myth that a trustee’s legal obligations cannot be met within a selectively limited investment universe. Adequate diversification can still be achieved and independent stress testing should still be applied to ensure that the portfolio is structured to meet fund objectives.
Australian Prudential Regulation Authority (APRA) Prudential Practice Guide 530 (paragraphs 34, 35 and 36) contemplates precisely this approach. It provides that a trustee may offer an ethical investment option provided there is no conflict with the SIS Act, and that the fund can meet its diversification and liquidity obligations. Whilst SPG 530 demands a robust process for determining whether a decision is in the best interests of members, it recognises that ethical considerations may not be readily quantifiable in financial terms. In 2014 the UK Law Reform Commission reached a similar finding in its analysis of the UK law.
Moreover, there is no valid reason to conclude that such a portfolio has any less chance of performing consistently over the long term than others. The track record of Australian Ethical’s funds and others in the sector over multiple time periods are testament to that.
Trustees have significant scope to act more boldly in structuring their portfolios to be consistent with what’s required to address the challenges of climate change. In many cases it is not the law that constrains action, but inertia and a lack of will. It’s time to start asking the right questions and to stop reasoning and rationalising our way to inaction.
Originally published in the February 2016 edition of Superfunds Magazine.