New Zealand Super’s low-carbon reference portfolio has outperformed the original reference portfolio, adding NZ$800 million to the fund and providing evidence of ESG alpha.
The low-carbon reference portfolio, that until now has had targets of reducing emissions intensity by 20 per cent and its exposure to potential emissions from fossil fuel reserves by 40 per cent, has added about 60 basis points per annum to performance since it was brought in.
New Zealand Super incorporated the low carbon approach into its reference portfolio in 2016, making it a benchmark rather than an active decision, essentially creating a greater hurdle for adding value.
“The 60 bps difference between the low carbon benchmark and the old reference portfolio is consistent with our thesis that the market not pricing climate risk properly,” Matt Whineray, the fund’s chief executive, said in an interview. “So not only has this approach reduced what we considered to be an insufficiently rewarded risk, it has also added return.”
Whineray does clarify that the relatively short time period is a caveat in looking at performance, but he points out that if it was a negative return the performance would be highlighted and the time frame overlooked.
“If it had been the other way and it was a negative 60 bps everyone would have ignored the time frame. It is comforting that this is consistent with our thesis.”
In 2017 the fund first made significant moves to make the portfolio resilient to climate risks, with 40 per cent of the fund at that time – the global passive equity portfolio – moving to low-carbon.
The transition involved moving NZ$950 million away from companies with high exposure to carbon emissions and reserves into lower-risk companies.
In equities the fund also use derivatives for exclusion. The portfolio completion team, under Mark Fennell, created a short swap consistent with the carbon benchmark.
“That’s been important too. I can tell from performance reporting we are outperforming the benchmark,” he said.
This year the fund overall underperformed the reference portfolio, due mostly to the underperformance of some of the strategies such as value and global macro, but it added value through those carbon exclusions.
The fund uses a carbon measurement methodology created in consultation with MSCI, and each year ranks all stocks by reserves, ownership and emissions intensity, filtering them according to the target criteria.
Having met the 2020 targets, new ambitious limits have been set and the fund now aims to reduce the emissions intensity of the portfolio by 40 per cent and fossil fuel reserves by 80 per cent by 2025.
As the targets get bigger the diversification of the portfolio gets lower but Whineray is not too concerned with that, citing a tracking error difference of about 50 basis points.
“They are not massively different portfolios because carbon exposures are quite concentrated in certain industries as you’d expect and the weightings of those sectors has been declining,” he said.
The fund’s climate strategy is built on the theory that climate risk is mispriced, but the board holds the executive team to account on the possibility that at some point the market will price it in.
“The market is getting better, but one of the reasons we said this is difficult for markets is because there are a bunch of different risks – transition, physical, consumer behaviour, liability – and a bunch of different paths to get to, is it two, three or four degrees?” Whineary said. “As governments put in new measures, corporates get better at disclosures [and] the market gets a bit better. But there is still uncertainty about how to get to wherever we are going. We are still comfortable that the mispricing exists.”
The fund has made a number of moves to make it resilient to climate risk and to make the most of opportunities in the mispricing.
The climate strategy is made up of four parts:
- Reduce exposure to fossil fuel reserves and carbon emissions
- Incorporate climate change into analysis and decision making
- Manage climate risks by being an active owner through voting and engagement
- Actively seek new investment opportunities for example in renewable energy.
The reduction strategy has been reflected mostly in the passive listed equities portfolio but also in factor mandates and other active mandates. Unlisted assets will be the next focus.
The investment teams have been working to include climate risk in the valuation frameworks so there is a more structured way of thinking of how to price the risk across investments. And the fund has been actively engaging across a number of different programs including Climate Action 100+.
Whineray says the fund has invested in renewable energy projects but is actively looking for more opportunities.
“The board has given us a nudge to say we’d like to see more of that and it’s something we need to pick up.”
The fund’s climate report was produced in line with the TFCD framework and coincides with the New Zealand government’s recent announcement that financial sector, publicly listed companies and Crown financial institutions, like New Zealand Super, will be required to report on climate risks based on the TCFD framework.
New Zealand Super has been recognised this year in the PRI’s Leaders Group 2020, which showcases leadership of 36 of its 3,500 signatories. The fund was recognised for its climate reporting.