PREFACE

We live in interesting times. In a globalised world, offshore trends filter through to local markets. A company's value is linked to its ability to operate sustainably over the longer term. The game has changed. From the pursuit of short-term profits for shareholders, the approach has shifted to generating value for multiple stakeholders while making sustainable profits that take into account environmental, social and governance (ESG) factors. In a nutshell, profits still matter but how those profits are generated matters just as much.

BlackRock chairman Larry Fink coined the phrase 'stakeholder capitalism' to describe this phenomenon. He laid out the groundwork for this concept in his 2018 letter to CEOs, asserting that to be prosperous in the long term a company needs to benefit all stakeholders. And for the successful long-term investor, a company's ESG attributes are increasingly important: ESG capability has become a proxy for quality.

Grappling with ESG issues can be daunting. Determining which factors matter most can rest on an individual values decision. Climate change, however, has emerged as a mega-theme. Increasingly, investors and regulators are pushing companies to report on climate-related activities, including data related to transition and physical risks as well as their plans to manage those risks. To that end, many large-cap Australian listed companies have made net zero carbon emissions commitments, despite there being no regulatory requirement (yet) to do so. According to KPMG, approximately three-quarters of listed companies are reporting to the Task Force on Climate-related Financial Disclosures (TCFD), which has been the gold standard for the depth and breadth of reporting. TCFD reporting will be incorporated by the International Sustainability Standards Board from 2024, requiring baseline sustainability disclosures to help inform investors.

After years of limited activity in the ESG space in Australia, regulatory changes?- particularly in relation to climate risks?-?and opportunities are proliferating. Australia is expected to introduce mandatory climate reporting through a staged approach in 2024. With changing requirements and expectations as we transition to a low-carbon economy, investors are being encouraged to consider the management of ESG risks and opportunities to help identify companies likely to be successful in the long term.

Different sectors face inherently different ESG risks, and some companies will find the transition to decarbonisation easier than others. A company's management of ESG risks is an important component of its likely transition success. The data shows us that the two best business sectors from an ESG perspective, taking into account both the risks inherent in the sectors and the management of those risks, are Industrials and Australian real estate investment trusts (REITs). Companies facing the highest risk are those operating within the materials sector (specifically diversified metals mining) and the energy sector (especially those involved with coal and oil and gas exploration and production). Typically, sustainability investors have avoided companies operating in the energy and materials sectors because of a lack of alignment, as these companies have rated poorly from an ESG perspective. That said, there is plenty of room for improvement across the board. Only 10 listed companies in Australia have achieved the top-ranking Morningstar Sustainalytics five-globe ESG risk assessment, which signals they face negligible ESG risks. Interestingly, though, there are far more companies to choose from if only climate risk is considered: 68 companies are rated as having 'negligible risk' for overall carbon risk.

Given that many sustainable investors tend to have systemic sector underweights and overweights to align with their values, recent market conditions have been tough for them to navigate. The energy sector, which is either not held or is underweighted by sustainable investors, had a significant performance boost in 2022. This was due largely to the Russia-Ukraine conflict. As Russia is a significant supplier of global crude oil and natural gas the conflict caused an energy supply shock, which buoyed the energy sector's returns. Fossil fuel companies' stock prices catapulted as a result of the imbalance between supply and demand and, after years of benign returns, energy became the standout sector on a returns basis in the 2022 calendar year. Those not holding this sector missed out on this short-term performance uptick in 2022, although it was short-lived, as energy subsequently became one of the worst performing sectors in the ASX for 2023.

To combat rising inflation caused by an expansive monetary policy used to stimulate economies during the disruption caused by the COVID pandemic, central banks around the world, including the Reserve Bank of Australia (RBA), started to raise interest rates. The RBA hiked rates 13 times between May 2022 and December 2023. This strategy created jitters in the stock market and impacted investor confidence.

This, in turn, has contributed to recent pockets of scepticism in relation to sustainable investing, particularly in the US where some states have gone so far as to seek to restrict ESG considerations through anti-ESG bills. This action is out of step with a global commitment to transition to net zero carbon in order to slow climate change, which includes imposing more reporting on ESG risks and opportunities alongside financial metrics. Even in purely investment terms, to ignore the collaborative global decarbonisation commitment is ill-advised, because the trend is clear: 193 nations signed the Paris Agreement commitment to net zero carbon emissions by 2050. As they say in the markets, 'the trend is your friend'; you disregard it at your peril.

Mandatory reporting of climate-related risks is already in place in many countries around the world. Such regulation is being developed in Australia, but we are late to the party and local companies face the real risk of losing out to competitors who have already committed on ESG issues. Predictions are that they may find it increasingly difficult to attract capital. They may potentially find themselves holding 'stranded assets' that have no financial value because of lack of demand or because of a change in regulations or laws.

Recognising the changing landscape and global commitment to ESG, prudent investors will carefully assess the risks and opportunities ahead. They will pay attention to how companies are transitioning their operations as the market evolves into a more regulated ESG environment, which is leading to better ESG reporting and standards.

There are clear signals that embracing ESG factors is likely to secure long-term financial prospects for companies. KPMG's 2022 Sustainability Reporting Survey found that 90 per cent of the ASX top 100 companies by market capitalisation recognise climate as a financial risk; 89 per cent report on carbon targets. Despite pockets of dissent, most governments, companies and investors are committed to ESG and particularly to managing climate risks, although not all share the same level of commitment. The purpose of this book is to help investors identify the best-in-class in relation to ESG, both overall and particularly from a carbon perspective.

The absence of legislation, or even agreed terminologies, around what constitutes a sustainable/ESG or 'green' investment makes decision making difficult for investors. Given the importance of investor confidence in relation to green claims, the Australian regulators ASIC and ACCC have made 'greenwashing', when a company overstates its green credentials, a top priority.

Aside from regulatory changes, investors are demanding more from companies in relation to ESG. Arguably, it has been investors who have driven the ESG investing mandate and the legislators who are catching up. Investors are increasingly seeking to invest in line with their personal values. While they still seek a return on their investment, they care how this return is generated.

The problem with ESG investing to date has been a lack of objective standards. The industry is still maturing, so while the data is improving, it is still not robust or completely reliable. Further, the lack of standardisation has given rise to many different methodologies, which makes it hard to compare companies and confidently sort the good from the great. On top of all of this, ESG is very broad, which is likely why the Australian government have been focusing on one specific aspect, climate, via mandatory climate related financial disclosures.

While decarbonisation and other environmental issues are perhaps the major theme in ESG investing, it also encompasses social issues?-?from workers' rights, diversity and inclusion to modern slavery and good governance. Essential to a company's overall success, good governance considers issues such as board composition and competency, executive remuneration, ethical policies and a social licence to operate.

While this book considers all ESG elements it has leaned into the E, given climate change-related initiatives have been an area of focus in Australia. Mandatory climate reporting requirements set to kick off via a phased approach from 1 July 2024 for large businesses, many of which are ASX-listed companies. The Australian Institute of Company Directors have advised their members that this is the biggest change to corporate reporting in a generation.

I have selected top ESG stocks from among ASX...