How long before climate change risk becomes an issue for small caps?
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Climate risk is the cause du jour as global fund managers, regulators and even a litigious super fund member make noises about what need to be done to carbon-proof companies and investments from a hotter Earth.
Currently, small companies are still somewhat immune from the court cases and boardroom activism beginning to plague those at the top end of the ASX.
With investors focused on short-term revenue and growth wins, small businesses are yet to feel the impact of regulatory and activist attitudes.
However, signals are appearing that may, in the longer term, require investors in small companies to consider the risk and the opportunity climate change presents.
This week global fund manager State Street said its $US3.1 trillion ($4.6 trillion) passive investing arm would begin voting against boards that didn’t follow through on environmental, social and governance (ESG) standards.
Last year it introduced a “responsibility factor”, where it graded companies on ESG metrics, and this week said it would start wielding that at companies in the US, UK, Australia, Japan, Germany and France.
Initially it’s targeting the worst performing companies, but will include all of its invested stocks by 2022.
“Ultimately, we have a fiduciary responsibility to our clients to maximise the probability of attractive long-term returns — and will never hesitate to use our voice and vote to deliver better performance for them,” State Street Global Advisors chief Cyrus Taraporevala wrote in a letter to companies this week.
“This is why we are so focused on financially material ESG issues.”
State Street has eight ASX funds, one of which is a small cap index tracker.
The smallest market cap in the State Street ASX Small Ordinaries Fund, as of January 30, was Syrah Resources (ASX:SYR) at $210m, and the index held 35 companies with market caps under $600m, of a total of 181.
Come 2022, according to the fund manager’s latest diktat, these companies will come under scrutiny according to its ESG metric.
Tim Buckley, director of energy finance at the Institute for Energy Economics and Financial Analysis (IEEFA), says where State Street goes, other major fund managers will have to follow.
Black Rock said it was already doing this in its $1.8 trillion actively managed investment division, but also has a $3-4 trillion passive arm. Vanguard has not made any announcements on this front. Both have ASX small cap index funds.
At issue is the fact that index funds are required to own all of the companies that meet an index size and weighting requirement, so instead of selling State Street said it would begin moving against boards that don’t meet its ESG metric.
Buckley says with Australia’s two strikes rule — where an entire board must be put up for re-election if a remuneration report is voted down at two consecutive AGMs by 25 per cent or more of shareholders — means ESG may need to become a board focus for smaller and smaller companies in future.
Right now there isn’t much for small cap directors and investors to be worried about because investors are not yet punishing small companies for climate change exposure.
But the ASX, banking regulator APRA, the RBA and ASIC have all issued comments over the last few years around climate risk and climate risk disclosure.
In August, corporate cop ASIC updated its guidance on disclosure to help directors understand they needed to, among other things, highlight climate change as a systemic risk that may need to be disclosed in an operating and financial review.
Agricultural companies are likely to take a hit from a business perspective, says Cyan Asset Management fund manager Dean Fergie.
“The likelihood that the market is prepared to pay a higher multiple for these things is less certain,” he says.
However, small caps are small for a reason: they’re growing or still on their way to making it big, either as a resources producer, a successful drug developer, or a tech company, and as such focused on much shorter-term goals than climate risk mitigation.
Global Compact Network Australia executive director Kylie Porter says small caps are vulnerable.
“Small caps are the ones that are probably at risk of not being able to respond adequately to climate risk,” she says.
Being smaller they don’t have the same access to human capital to develop policies around climate risk, it’s harder to capture opportunities around climate change, and most won’t have a transition plan to cope with longer-term climatic events.
Porter says conference chatter last year was that money may be better invested in heavy emissions intensive companies that have a clear transition plan, and not companies that are low emitters but don’t have a transition plan.
While some small cap directors and their backers are not shy of becoming caught up in legal kerfuffles, they’re yet to feel the heat of climate-related lawsuits.
The Melbourne Law School Climate Change Litigation database cites 194 cases between 1994 and 2019.
The Climate Change Litigation database records 95, including McVeigh v. Retail Employees Superannuation Trust which alleges the latter violated the law by failing to disclose information on climate business risks and its strategies to address those risks.
While lawsuits have caused entities to change their ways — shareholders withdrew a suit against CBA in 2017 after the bank acknowledged the risk of climate change and pledged to estimate the risks — none have succeeded yet in Australia.
Importantly, none have succeeded in making climate risk a fiduciary duty for company directors, says the IEEFA’s Buckley.
Directors in Australia can be held personally liable if they breach fiduciary duties, that is if they haven’t acted in the best interests of shareholders.
ASIC said in its August guidance update that it wanted to be clear the “risk of directors being found liable for a misleading or deceptive forward-looking statement is minimal, provided the statements are based on the best available evidence at the time, have a reasonable basis and there is ongoing compliance with the continuous disclosure obligations”.
Porter believes Australia is ripe for litigation. She says climate activism is gaining more momentum as are investor activists like the Australasian Centre for Corporate Responsibility (ACCR), powerful super funds, a government with unsatisfactory climate policy and emissions targets, and a large number of companies that are still opposed to or on the fence about climate risk.
What she isn’t sure about is whether litigation will have an effect. Even if McVeigh wins against REST, that may not mean other industry super funds change their ways.