Houston, we have a problem. Human-generated greenhouse gas emissions are warming the planet and causing climate change. This is having such a detrimental impact that climate change is considered one of the biggest challenges of our times. There is wide acceptance, including scientific consensus, that emissions from fossil fuels are the primary contributor to global warming. A 2018 report from the Intergovernmental Panel on Climate Change quantified 89% of global GHG emissions came from fossil fuels. To try to combat global warming, 193 nations have signed up to the historic Paris agreement, providing a united commitment to reduce GHG emissions targets to net zero by 2050.

Australia, as a net exporter of coal, oil, and gas, ranks amongst the highest carbon emitters in the world on a per-capita basis, according to Climate Analytics' 2019 report. They advise that Australia’s carbon footprint would be 9 times greater than China's, 4 times greater than the United States', and 37 times greater than India's on a per capita basis, if exported emissions were included. When you look at data like this, it is not surprising that low-carbon strategies and techniques to minimise fossil fuel exposures are becoming increasingly important to Australian sustainability-focused investors, particularly as the world is transitioning to a low-carbon economy.

Investors increasingly are investing in strategies that support climate solutions and Morningstar's global research found global assets in climate funds have doubled over a 12-month period. Beyond Europe, China, and the U.S., Morningstar categorises all other countries as "the rest of the world." Australia has the most assets under management invested in climate-related funds in this rest of the world category, USD 2.45 billion across 18 funds, demonstrating that local investors are committed when it comes to climate solutions.

Given this backdrop can there be any legitimate reasons why a sustainable investment would hold fossil fuels in their portfolio? While likely controversial the answer is yes, for now. As we are in the transition phase of decarbonisation there are a range of reasons why a sustainable fund may have exposure to fossil fuels. Some examples are:

  1. Commitment to net-zero transition. Companies may have fossil fuel exposure but have outlined a clear pathway to transition or are already transitioning to net zero. This could include divestment of fossil fuel assets, investment into renewable energy sources, and retirement of fossil fuel assets or a combination of all three. For example, Contact Energy (NZE: CEN), which is deriving most of its electricity from renewable hydro and geothermal station, still holds some residual exposures to fossil fuel assets.
  2. Engagement. Owning fossil fuel companies provides the opportunity for investors to influence the company's decisions through active ownership—for example, AGL (ASX: AGL), which is discussed in detail further in this report.
  3. Alpha potential. Investors supporting companies that are transitioning to net zero arguably have greater alpha-generating potential, than investing in those companies that have already transitioned. The risk here is that companies fail to transition as expected and the investor ends up with a poorly performing company or stranded assets. One example is BHP (ASX: BHP), which has decreased its exposure to fossil fuels by selling its petroleum and gas assets to Woodside (ASX:WDS), yet chose to retain its Mt. Arthur coal assets with a view to retire them early, targeting 2030 as well as provisioning for a $700 million land rehabilitation initiative.
  4. Investment style. Certain investment styles are predisposed to hold certain companies. For example, value investors seek out unloved and low-priced stocks. For these investors, up until very recently, the most beaten-up and unloved sector was the energy sector. Index investors track a benchmark and will hold the same stocks that are in the benchmark at close to benchmark weight.   
  5. Strategy objectives. There are a range of sustainable strategies targeting a variety of outcomes. Not all sustainable funds target a low-carbon outcome. Strategies can range from mitigating environmental, social, and governance risks via simple exclusions like tobacco or focus on improving S and G risks such as gender diversification, improved workers' rights, or championing more equitable executive remuneration.
  6. Managing market risk. Investors seeking to diversify may want some exposure to the energy sector, which makes up 5.9% of the broad market (ASX 300 as of 30 June 2022). Often the approach here is to buy the best in the sector but it will mean exposure to fossil fuel assets. Other sectors also have fossil fuel exposures, namely materials, which makes up 23.6% (ASX 300 as of 30 June 2022) and encapsulates companies like BHP, Rio Tinto, and Fortescue Metals to name a few.