Financial Services Council Leaders Summit, Sydney
26 July 2017
Dr Raphael Arndt*, Chief Investment Officer
*Prepared speech that was to be delivered by Dr Raphael Arndt. Due to unforeseen circumstances, an abridged version of this speech was delivered by Joel Posters, Head of ESG
Good afternoon, and thank you for the opportunity to speak to you today.
My organisation manages around $150 billion on behalf of future generations of Australians across five separate funds. The largest of these, the Future Fund currently stands at around $130 billion – and is Australia’s Sovereign Wealth Fund. It was established in 2006 with a long term objective to maximise returns without taking excessive risk, with performance to be assessed over the long term.
This long term approach shapes everything we do – including how we incorporate environmental, social and governance considerations into our investment decision making process.
The mandate does not provide specific direction about how to approach these ESG issues. However, it does require us to have ‘regard to international best practice for institutional investment in determining [our] approach to corporate governance principles’.
An integrated approach to investing
We live in an era where trust in institutions has diminished profoundly, and the companies that we invest in are consequently under more scrutiny than ever before.
The wealth disparity which has widened since the Global Financial Crisis, and the corresponding rise in support for populist policies around the world, mean investors must be concerned that companies they invest in maintain their ‘social licence to operate’.
Companies must be mindful of the operating environment and society’s expectations – and where they aren’t, governments are increasingly prepared to step in and regulate or impose other sanctions.
We invest for the long term – and in undertaking our investment activities, we incorporate ESG issues into our consideration of all new investment proposals and investment manager appointments. This ‘integrated’ approach is, in our view, fundamental to being an effective long term investor. For us, ESG issues do not sit separately from our investment function but are integrated into it.
Considering these issues is a key risk mitigation tool in an era where volatility is on the rise and regulatory and policy risks are elevated.
As long term investors, we seek to assess what price we should pay for a series of future cashflows when we make new investments or allocate capital.
Where there is uncertainty over future cashflows – whether due to ESG risks or any other risks – or where there is risk that future cashflows might be impaired, we are inclined to pay less.
We include analysis around ESG risks as a core part of our investment process because we believe that the effective management of material financial and reputation risks and opportunities related to ESG factors will lead to the maximisation of returns over the long term.
Incorporating these considerations into our decision making enables us to better understand the full spectrum of future risks and opportunities to which investments are exposed.
I have discussed the need for companies to be mindful of society’s expectations, and our job as a long term investor is to help identify where we see risks that jeopardise an investment’s social licence to operate. And we communicate our expectations to the companies and assets we invest in, and the managers we invest through.
Our approach is commercially focussed – as a general rule we don’t believe in exclusions.
We believe limiting our investment universe is inconsistent with the mandate given to us by Government to maximise risk adjusted returns. Having said this, a small number of exclusions apply to activities that contravene an international treaty that Australia is a party to – in practice this means companies involved in cluster munitions and landmines. Furthermore, the Board has made a decision to exclude companies directly involved in the manufacture of complete tobacco products.
Where an ESG issue is identified, we prefer to work with companies to improve their performance.
And, to be clear, while the question of what an institution excludes is often of significant public focus, the question of how to integrate ESG into investment decision-making – or put another way, how to make investments that fully and thoughtfully account for the ESG risks and opportunities that exist – is our key focus.
An integrated approach in practice
So what does an integrated approach look like in practice?
It means we have around fifty investment professionals who take responsibility for incorporating consideration of responsible investment matters into the assessment of new opportunities and the management of the existing portfolio. These investors are supported by two dedicated ESG professionals in my team who act as knowledge champions.
The decision to appoint new managers includes consideration of environmental, social and governance issues. Inputs from our ESG team help define the due diligence to be undertaken for each opportunity – and we have rejected investment opportunities on ESG and reputational grounds.
All of this activity occurs to provide the most rigorous and complete assessment of the risk/reward equation for these investments over the long run.
In undertaking this work, our activities include assessing all new proposed investments and managers against an ESG framework – for example, consideration of Board diversity.
To give you an indication of this work program, over the last two years we have assessed 38 of our investment managers on their environmental, social and governance approach. This included the assessment of new managers and refreshing work on existing managers. This process involves face to face meetings or phone contact, and is not just an exercise in filling in questionnaires.
For instance, in the case of an infrastructure manager, it might involve discussing with them how they incorporate thinking around carbon risk and the future path of energy prices into their assessment of investments.
Or in the case of a distressed debt investment manager, it might involve a discussion around how they would behave if a mining company they lent to went into administration and the approach they would take to voting our interests to ensure that the company meets any environmental clean-up and site remediation obligations.
This work is delivering results. For instance, we identified that one of our managers was lagging in their approach to managing ESG issues. We worked with them, and following proactive engagement from us they now more fully incorporate ESG considerations into their investment process. Indeed, they are proudly highlighting their new skills in their market with other investors.
Public markets activity
Public markets activity is one sub-set of our broader responsible investing work program.
The Future Fund is a large investor in public markets, with around $40 billion invested in listed equities.
We believe governance matters. And we believe that well governed enterprises will outperform less well run companies over the long term.
The Future Fund’s investment model involves the use of external investment managers. We work closely with our Listed Equities managers so that the Future Fund and our managers are communicating with ‘one voice’ to our investee companies on ESG matters.
We promote better governance through voting our shares consistent with our publicly available set of governance principles. We focus our efforts on our home market of Australia where we have the most economic leverage through our ownership.
In exercising our ownership rights we develop our own views. In doing so, we are informed by our investment managers and we also selectively take advice from proxy advisers.
In 2015/16 our ownership rights were exercised on well over 1,000 resolutions in Australia and almost 40,000 resolutions globally. In voting our shares, we hold companies to account. In 2015/16 we voted against Board resolutions 5.8% of the time in Australia and 9.7% globally.
We complement our voting activity with direct engagement with company boards where we believe this to be warranted to better communicate our expectations and concerns.
We have an active engagement program with large ASX listed entities in our portfolio – and we have directly engaged with 15 of the ASX 20 companies on governance issues over the last two years.
Australian asset owners like us now have exceptional access to corporate boards, which hasn’t always been the case. Australia is a global leader in this respect – and in our experience we have found ASX listed companies as a whole to be open and willing to constructively engage with us.
I now want to turn to how we incorporate thinking about carbon risk into our investment decision making.
I want to be clear that we have fossil fuel investments in our portfolio – and we will continue to consider fossil fuel related investments where we believe that they provide an appropriate risk adjusted return.
I mentioned that we engage with our infrastructure fund managers to understand how they consider carbon risk when making investment decisions – and for all assets, and especially long lived assets, it is important that we consider all risks.
As prudent long term investors, we seek to understand the risk that cashflows might be impaired due to regulatory, policy or technological change. I might also mention that this goes as much for renewable energy generation as it does for those using fossil fuels.
In the past we have considered investments in ports that are heavily dependent on shipping thermal coal.
In considering this type of investment, we rigorously assess the revenue risks associated with an asset that earns the bulk of its revenue from exporting thermal coal.
We recognise that coal has a role to play in the energy mix – but we also recognise that the energy mix can change over time.
I discussed earlier how we don’t take an exclusion based approach to responsible investing – however we do apply a risk lens to assess risk adjusted returns.
This risk lens leads us to apply a conservative asset life when modelling the revenues from an asset such as this, with a high exposure to the export of thermal coal.
In other words, the cost of capital we apply to this type of investment will reflect our assessment of risk. And that is appropriate given broad global support for decarbonisation policies over time. We also ensure our investment managers adopt the same approach if they operate in an area where they must consider these risks.
Where to from here
Today I have discussed our approach to integrating thinking about ESG into our investment decision making and some of the day to day activities that occur in putting this into practice.
The Future Fund, as Australia’s sovereign wealth fund, also has an important role to play in improving the processes the market in general uses with respect to ESG matters – given we believe that doing so will generate better long term returns.
To this end, we engage and collaborate with our peers through a number of forums such as the Hedge Funds Standards Board and the Institutional Limited Partners Association in seeking to improve terms and governance among the hedge fund and private equity sectors as a whole.
Further to this work, the next iteration of our approach to long term investing involves better incorporating an assessment of other risks and opportunities into our investment decision making.
Last year I asked our ESG team to consider how we incorporate the current innovation wave and risk of technological disruption into our investment decision making and portfolio construction decisions. We are developing our thinking in this area. For us, this is another long term risk issue we have to worry about. Luckily, we already have these skills in house.
The Future Fund has a significant multi-billion dollar exposure to venture capital. Through this, we have exposure to companies that are doing all sorts of innovative things – and through this program we invest the portfolio into the technological innovation theme.
The work we are undertaking is designed to allow us to better capture these insights and better understand the risk that technological disruption poses to assets already in our portfolio.
I have sought to articulate the importance of including consideration of ESG risks into decision making as a long term investor.
In applying this, the Future Fund takes a commercial approach in assessing to what extent risks and opportunities are priced into investments. We have integrated this thinking into our investment process since inception, and we continuously strive to refine our approach.
The next evolution is consideration of technological innovation and associated disruption in our investment decision making.
Let me finish by saying that consideration of ESG issues is not a side activity for the Future Fund.
As a long term investor it is core to our approach – and we play an appropriate role in working with companies and assets we invest in, and our investment managers, to continuously raise the bar.
In this day and age it is essential that every company in which we invest maintains a social licence to operate. Companies that aren’t mindful of their operating environment are finding governments regulating or mandating outcomes for them.
Consideration of ESG issues can no longer sit separately from the investment program, operated by people disconnected from the key decision being made. These issues need to be considered in an integrated way as a core part of the investment process. That is the approach the Future Fund has taken, and the approach we believe managers and companies in which we invest must also take.
We are seeking to do our part to help bring companies on that journey – and believe that in doing so, we will be better able to generate strong risk-adjusted returns in line with our mandate.