Is it OK to hold BHP shares if you're investing sustainably?

When investing sustainably, is it OK to have big emitting fossil fuel companies like the big miners in your ESG portfolio?

"Of course not," I hear you say. And not so long ago, I was with you, but now I have a different perspective.

We all know there is global consensus amongst scientists that burning fossil fuels is a big contributor to climate change.

One of the most impactful actions we can take to halt the effects of global warming is to wean ourselves off fossil fuel and transition to cleaner renewable sources of energy. In fact, decarbonisation is a mega theme in ESG investing as climate change is considered one of the biggest challenges of our time.

Do ESG funds have a fossil fuel problem?

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.

Most notably, the Australian stock market is skewed to miners and energy companies that produce varying levels of fossil fuels. Within our listed large-cap market there are 22 such companies including BHP. These companies make up just over 20% of benchmark exposure in the S&P/ASX 300 benchmark.

Investors are also increasingly recognising that companies are interested in cleaning up their assets to better meet their ESG objectives and potentially to better align to the requirements of ESG investors.

For example, BHP, sold its petroleum and gas assets to Woodside which helped BHP with its decarbonisation strategy. Some sustainable fund managers have indicated to Morningstar that the sale of fossil fuel assets has allowed BHP to be included in their investment universe for the first time, although for others it still fails to meet their criteria as some coal exposures remain.

This is because BHP maintains its Mt Athur coal mine, although it's planned for closure by 2030. BHP will also spend $700 million on rejuvenating the land around the mine.

This seems to be a positive and responsible approach; the alternative would have been to sell the coal mine and it's likely the new buyer would want to squeeze out every ounce of profit, which would mean the mine would operate for longer. Yet it fails the 'no coal' assets filter for many sustainable fund investment strategies. That is why for investors it is important to understand what companies their ESG fund invests in.

We should expect to see more ESG-influenced merger and acquisition activity in the coming years, as in the case of BHP.

Active ownership

Engagement and active ownership are also playing an effective role in sustainable investing. Many ESG managers argue that rolling up their sleeves and influencing companies on ESG issues, while time-consuming, is critically important to enact change. Owning fossil fuel companies provides the opportunity for investors to influence the company's decisions.

A prime example of this relates to the proposed AGL demerger. AGL planned to split off its energy-producing assets, including its high-polluting coal-powered plants, into a separate business, but tech billionaire and climate activist Mike Cannon-Brooks, supported by some institutional investors, was opposed to this action, because it would have no effect on reducing Australia's greenhouse emissions in the short to medium term.

Rather, it could extend the life of these high-emitting power plants for decades into the future.

As a billionaire, he was in a unique position to do something about it. Hence he bought AGL shares and lobbied the big investors such as fund managers to support his proposal. The collaborative efforts helped him to successfully achieve the desired outcome.

The demerger failed. This also triggered a review of AGL's long-term strategic objectives, including its approach to the environment.

Given its outsized impact on carbon emissions this is a great step forward. Expect to see more shareholder activism relating to sustainability factors unfold in the future, and not just locally-this is a global phenomenon.

Looking under the hood

Rest assured almost every sustainable strategy within the Morningstar fund coverage universe is investing into assets that are positively contributing to a low carbon economy, such as renewable energy, energy efficiency, and green buildings and transportation.

Morningstar labels these "carbon solutions". In fact, 132 of the 138 sustainable strategies identified by Morningstar, or 95.65%, have varying degrees of involvement in carbon solutions. Further, the majority of sustainable strategies in Australia have either extremely low (less than 3% of the portfolio), or no fossil fuel exposure at all.

Australian sustainable investment funds are in reasonably good shape; fossil fuel exposures are generally low as outlined within funds' product disclosure statements, while investment in carbon solutions is high and most sustainable portfolios have lower carbon intensity than their respective benchmarks.

The decarbonisation party is just getting started, and the better-quality companies are actioning their net-zero plans and attracting investor capital in the process.

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