Tony Dhar (Partner) and Sarah Barker (Special Counsel) report on international developments in mainstream client approaches to climate change that are raising the bar for fund managers on ESG investment risk management.

Fossil fuel exclusions and financial best interests

The issue of 'fossil fuel divestiture' continues to noisily occupy column space in the financial press.  Confined by word limits, the debate on point is often simplistic and polar – presented as a binary choice between maximising financial returns and the environmental ethics of investing in sectors with a significant carbon footprint (primarily through the combustion of fossil fuels). 

Consistent with the binary positioning of the debate, the divestment or exclusion of fossil fuel-related assets by institutional investors has largely been explained by reference to 'moral' or 'ethical' grounds.  Such a decision can be relatively straightforward for philanthropic foundations and private endowments (such as the high-profile Rockefeller Foundation), and faith-based organisations and educational institutions (such as the Uniting Church in Australia, the World Council of Churches, Australian National University, Stanford and Oxford Universities) - where the interests of their stakeholders are more readily ascertainable.  In contrast, open industry, retail and corporate funds and retail investment houses would have difficulty substantiating an 'ethically-based' divestment or exclusion in the absence of a clear mandate in the fund's governing rules or direction from the member corpus, as this may conflict with obligations to prioritise financial interests. 

Increasingly, however, institutional investors are now mandating or directing funds and investment houses to factor ESG into their investment processes. Accountability to institutional investors requires these funds and investment houses to report on their approach to the recognition of the material financial risks (and opportunities) associated with climate change. 

Leading mainstream brokers and advisers such as Citi, Towers Watson, HSBC and Mercer have published reports recognising the risk of fossil fuel asset 'stranding' due to shifts in emissions regulation and renewables technologies.  Industry funds including HESTA ($29 billion under management – see here) and Local Government Super ($7.4 billion under management – see here) have announced policies to negatively screen investments in thermal coal (and, for LGS, other ‘high carbon sensitive’ activities such as tar sands mining and coal-fired electricity generators) based on the best financial interests of members.  No retail or sovereign wealth funds have followed suit.  Until now.

Last week, the Norwegian parliamentary Standing Committee on Finance and Economic Affairs passed a bi-partisan, unanimous resolution to direct the world's largest sovereign wealth fund, the US$902 billion Norwegian Government Pension Fund Global, to divest or exclude investments in companies 'who themselves or through other operations [that] they control base 30% or more of their activities on coal, and/or derive 30% of their revenues from coal' (see here).  Similarly, French insurance giant AXA announced that it would exclude 'mining companies deriving over 50% of their turnover from coal mining and electric utilities deriving over 50% of their energy from thermal coal plants' (see here).  These exclusion policies represent a significant inflection point in the 'fossil fuel divestiture' debate, with both funds making an express choice to prioritize ESG factors, specifically divestment or exclusion in the thermal coal industries, in the portfolio composition for their financial risk/returns. 

Beyond 'divestiture' – new norms of engagement 

The examples set by AXA and the Norwegians do not mean that, overnight, retail funds should adopt a herd mentality to divest or exclude assets in carbon-intensive industries.  Any such knee-jerk reaction would itself be inconsistent with trustees' fiduciary duties.  Such a complex issue demands diligent consideration of both portfolio impacts and treatments (from asset allocations to sectoral tilts, engagement, hedging and beyond).  Many institutional investors have in fact determined, upon due deliberation, that it is not in their beneficiaries' best financial interests to divest from or exclude fossil fuel assets.  Often, funds prefer to keep 'a seat at the table', and engage with investee companies on the relevant commercial risks and opportunities. 

However, a decision to 'engage' cannot be seen as merely taking a passive strategy. The bar on 'active ownership' by mainstream investors is being raised, with the actions taken by leading funds increasing pressure on both investee companies and asset managers to review and assess their approach to actively manage ESG risks.  For example:

  • In the current northern hemisphere reporting season, asset owners are engaging with portfolio companies on the topic of climate change at unprecedented rates.  More and more, general corporate assurances around 'sustainability', and plans to incrementally reduce operational emissions, are failing to satisfy investor demands.  An active, substantive approach to ESG risk governance is increasingly required – with evidence that its implications for medium-long term strategy have been duly considered and meaningfully disclosed.  It is important to remember that this is not just from 'ethical' shareholder activists, but also from mainstream institutional investors whose concerns remain squarely centred on risk and return.  Earlier this year, special shareholder resolutions were passed at the AGMs of oil giants Shell, BP and Statoil requiring them to stress test their forward strategies against potential climate change futures endorsed by the International Energy Agency.  Notably, these resolutions were passed with a resounding majority of 98.3, 99.8 and 99.9% of the shareholder vote, respectively.  In each case, less than 3.5% of votes were withheld.
  • In the United States, a letter co-signed by more than 60 large institutional investors (representing USD1.9 trillion in assets under management) has been sent to the Chair and Commissioners of the Securities & Exchange Commission (SEC) (see here).  The letter expresses concern that 'oil and gas companies are not disclosing sufficient information' about 'carbon asset risks'[1] in their statutory filings with the SEC and requests the SEC to address these deficiencies in direct correspondence with the filing companies.
  • In addition to the divestiture actions discussed above, in recent months two of the world’s largest institutional investors, the Norwegian sovereign wealth fund and the US$305 billion Californian pension fund CalPERS, have announced statements of expectation for portfolio companies (Norway) and external investment managers (CalPERS) around the integration of ESG issues into standard financial risk assessment processes. 


There is significant momentum behind the recognition of the financial risks and opportunities associated with ESG factors over current investment horizons.  This momentum is not driven only by 'ethical' shareholder groups but also by leading mainstream institutions who are engaging with associated valuation, risk management and disclosure issues.  Arguably, this represents a tipping point that portfolio management companies and retail trustees would be ill-advised to ignore.