Since the emergence of “Modern Portfolio Theory” and the “Capital Asset Pricing Model” in the late 1960s, institutional investors have taken a quantitatively driven approach to portfolio construction, looking to create portfolio diversification and obtain better risk-adjusted returns by balancing their asset-class exposures. This journey has seen several important advancements in thinking about how to optimally achieve desired results.
Funds that want to take the total portfolio approach first need to get the total portfolio view. To do that they not only need data – and lots of it – but a rock-solid understanding of exactly how they’re going to use it.
Super funds lag on nature as ‘tipping point’ approaches
Superannuation funds and banks have made significant progress on incorporating nature-related physical and transition risk into their financial decision making, according to research from the Australian Conservation Foundation (ACF), but regulatory uncertainty and a dearth of internal resources is still holding them back.
While they don’t receive as much attention as the transition to a low carbon economy, issues like the decreased availability of natural resources – like timber or fresh water – could impact businesses exposed to them, while new regulatory requirements will saddle big financial institutions with heavier compliance costs. And the deterioration of the natural environment
means ecosystems are “fast approaching tipping points that could cause cascading losses”.
“These impacts have flow-on effects, and as our society and economic systems depend entirely on the health of our natural world, the continued destruction of nature will have major implications for financial institutions,” the ACF report says.
The ACF examined 10 super funds – including Australian Retirement Trust, AustralianSuper, and Aware Super – though only six submitted a response. They found that when it comes to assessing and disclosing nature risks and setting targets for their management, banks have progressed much more quickly than super funds (80 per cent had screened their loan book for nature-related impacts and dependencies, with 40 per cent of super funds performing similar assessments), though institutions from both groups are struggling with data availability, the complexity of nature and regulatory and policy uncertainty.
“Whilst the Australian Treasury has indicated that nature-related risk disclosures will ultimately be introduced as part of Australia’s new sustainability reporting requirements, there remains a clear lack of regulatory momentum locally compared to other OCED jurisdictions in this area,” the ACF report says. “As a result, some banks and super funds report that ‘uncertainty from Commonwealth Government regulators,’ as well as a ‘lack of enabling policy environment’ are negatively impacting their abilities to integrate nature into financial decision making.”
But unclear signals and shifting pressure from regulators isn’t the only thing impacting super fund commitments. Nature is being “outcompeted” for attention by other ESG issues that are believed to be more financially material – like climate change and human rights – while a lack of internal resources is also a key challenge. Banks have had more success making nature a board issue, with just 20 per cent citing internal resourcing constraints as a challenge; because they’re intermediaries – and must know where their loans are located to manage concentration risk – they also have access to spatial and operational data sets that super funds don’t.
“Furthermore, as lenders, banks are highly leveraged, which means they face downside risk (e.g. credit risk from loan default), while super funds are predominantly exposed to upside risk (risk of making below expected returns),” the ACF report says. “Because the financial losses associated with downside risk are of higher magnitude compared to upside risk, failing to account for nature can come at a greater financial cost for banks should unpriced nature risks materialise.”
Currently, super funds are prioritising engagement with investee companies with the greatest nature-related risks before, or in place of, assessing their financed impacts and dependencies, and funds should seek to better understand the nature-related risks and opportunities of their investee companies over time, the ACF report says.
Progress on nature-related target setting is also slow; of the four institutions that have them in place, only one has committed to no financed deforestation despite a scientific consensus that limiting global warming won’t be achieved without preventing and reversing nature loss. Still, nature is fast becoming a target setting “priority” for some banks and super funds, and the ACF expects significant uplift in the area over the next two years.
“The financial system has an influential role to play in the transition to a nature positive world as facilitators of finance to companies driving nature loss,” the ACF report says. “While there are clear signs of progress, momentum must accelerate.”
