What does the collapse of the ambitious Sun Cable solar project say about investing in renewables? Here’s a quick insight from Pendal ESG credit analyst MURRAY ACKMAN

• Sun Cable shows investment in renewable energy is mainstream
• But it raises questions about an Australian export industry
• Find out about Regnan Credit Impact Trust
• Find out about Pendal Sustainable Australian Fixed Interest fund

THE high-profile collapse of the ambitious Sun Cable solar project has sparked debate about the future of renewable energy exports.

What can sustainable investors learn from the failure?

Backed by Atlassian’s Mike Cannon-Brookes and Fortescue’s Andrew Forrest, Sun Cable had grand plans to supply electricity to Singapore from a vast solar array in the Northern Territory (pictured above).

But the venture was placed in voluntary administration in early January amid disagreement between the billionaire backers over the best way to export the energy.

Cannon-Brookes supported the venture’s original plan to run a 4200km high-voltage undersea cable between Darwin and Singapore. Forrest backed an alternative plan of exporting energy in the form of green hydrogen and ammonia.

What can investors learn?

Importantly, the Sun Cable debate demonstrates there is no longer disagreement over the economics of investment in renewable electricity generation, says Pendal credit ESG analyst Murray Ackman.

“The main takeaway for investors is that Sun Cable collapsed over a dispute about exporting – not over the idea of a huge solar array in the Northern Territory.

“That indicates electrification and big investment in renewables has become mainstream.

“No one is ridiculing Sun Cable for building a giant solar farm that even five years ago would have seemed ludicrous.”

Hydrogen investment risks

But the collapse of Sun Cable highlights that nascent technologies like green hydrogen are best left to entrepreneurs and governments until they mature, says Ackman.

“Just like any other boom, a lot of money will be headed into these areas and investors will be wanting to pick the winners and losers out of the transition.

“But historically, it’s governments and private entrepreneurs that are typically best placed to carry the risk of these types of early-stage innovations,” he says.

“For most investors, it’s too early to be thinking about going all-in on hydrogen.”

Ackman says the dispute is an example of the wider questions facing investors in the Australian renewables industry, including how green energy can best be exported and whether it is in the country’s best interests to do so at all.

“The federal government policy is to get to 83 per cent renewables by 2030 – that’s quite a lot, so question number one is should we be exporting at all or should we focus on building green industries rather than just shipping off the power,” says Ackman.

“Question number two is then how do we do it – both hydrogen and long cables have challenges when it comes to electricity loss.”

Political debate

Sun Cable’s collapse also comes amid a charged political debate about the role of green hydrogen and natural gas in the energy transition that investors are having to step through.

Natural gas clearly has a role filling gaps in solar and wind power generation because it can be quickly turned on and off when needed, says Ackman.

But there is growing debate about the health effects of burning gas in homes for heating and cooking, with gas cookers now linked to childhood asthma and other respiratory problems.

And the case for blending green hydrogen into gas pipelines also looks shaky.

“You can only get to about 20 per cent hydrogen for household appliances before everything needs to be replaced,” says Ackman.

“It’s more evidence that electrification seems to be the way forward.”

Some say big-polluting companies should be forced to compensate the community for climate change. Pendal Credit ESG analyst MURRAY ACKMAN explains what that means for investors

• Find out about Regnan Credit Impact Trust
• Find out about Pendal Sustainable Australian Fixed Interest fund

YOU might have missed it, but last week in Egypt there was a big meeting discussing the future of the world.

Amid war, floods and endless news from China, the 27th UN Climate Change Conference of the Parties (or “COP27”) didn’t get the same headlines as last year’s COP26.

So what was decided at COP27 – and does it matter for investors?

The big announcement was a fund to help developing nations respond to the loss and damage associated with climate change. This has taken three decades to agree to.

Bigger polluters – rich countries and potentially China and oil-producing countries – will compensate poorer countries that pollute less.

Countries that are net exporters of carbon – including Australia – are asked to use some of the money they’ve gained to help those most affected.

Some are calling for this logic to be applied to companies as well as countries.

Heavy emitters, such as fossil fuel companies, could be forced by policy-makers to channel revenue into mitigation efforts.

There are three options for high-emitting companies:

1. Give profits back to shareholders and let them decide whether or not to invest those returns in climate change solutions. As net zero gets closer, these companies phase down activity.
2. Heavy emitters invest in transitioning into green companies.
3. Policy makers take the decision out of company’s hands and apply a tax on emissions to fund a transition.

What does that mean for investors?

This has obvious implications for investors.

If the logic is high emitters bear responsibility for mitigating the impacts of climate change, this adds credit risk. Therefore investors need to be aware of the implications of policy changes.

Sustainability-linked bonds are growing fast, but investors should take care they are getting what’s on the label. Pendal’s MURRAY ACKMAN explains

• Sustainability-linked bonds gain traction
• Investors need to understand risks
• Find out about Regnan Credit Impact Trust
• Find out about Pendal Sustainable Australian Fixed Interest fund

MORE and more companies are selling sustainability-linked bonds — but investors should take care issuers are genuinely making changes and not simply greenwashing, says Pendal’s Murray Ackman.

Sustainability-linked bonds are debt securities that pay a coupon linked to the achievement of environmental or social outcomes.

Importantly, these “SLBs” are not linked to a specific project. They instead allow an issuer to set an overarching goal such as reducing emissions or improving diversity at a corporate level.

If an issuer fails to hit its goal, usually it pays a penalty in the form of a higher coupon.

“In theory, they are great — but we’re starting to see some things we are not happy about with these structures,” says Ackman, a credit ESG analyst at Pendal.

“We want to make sure that sustainability-linked bonds don’t turn into greenwashing because that will muddy the whole market,”

Fast-growing market

Sustainability-linked bond issuance reached US$103 billion last year — a one-year increase of 803 per cent, according to World Bank research.

That makes SLBs the fastest-growing sustainable debt instrument — with considerable potential to grow further on the back of strong investor, appetite and supportive government policy.

They are starting to gain traction in Australia.

A leading retailer has issued a bond linked to its move to renewable energy, while a telecommunications company has an issue linked to the rollout of solar panels at its retail stores.

Potential flaws

But sustainability-linked bonds have some important flaws that investors need to understand, says Ackman.

Probably the most fundamental flaw is the fact that if an issuer fails to meet the underlying environmental or social goal, the bond no longer meets the criteria to be called sustainable.

This means it has to be divested by most sustainable investment strategies just as the step-up coupon is due to be paid.

“We invest in these SLBs in our sustainable funds — if they don’t meet the target, we get a coupon step-up. But that means the bond is no longer tied to an environmental or social goal,” says Ackman.

“If it is no longer a sustainable bond, we cannot hold it in a sustainable strategy.”

Another emerging flaw is that the typical coupon step-up of 25 basis points made sense when interest rates were next to zero — but it may be less attractive to investors now that the general bond yields are higher.

A third problem is that some Australian companies are issuing bonds that are not sufficiently ambitious in scope.

“The federal government has a target for the grid to be 82 per cent renewable by 2030.

“If you are in a sector that can reduce emissions by changing where your electricity comes from, your corporate target has to be much more ambitious than the grid target.”

Early days

Ackman says it’s the right time for investors to discuss how they want sustainability-linked bonds to adapt because its early days in the development of the product.

“It is still a novel idea and just because it is the way it is now doesn’t mean it is the only way it can be.

“What we are trying to do is safeguard this market.

“That means talking to arrangers before deals are shared and speaking in public forums about the things we’re not happy about with these structures.

“We want to make sure that these this structure doesn’t turn into greenwashing.”

Can natural gas investors rely on green hydrogen to reduce the risk of stranded assets? Pendal’s MURRAY ACKMAN explains

• Understanding stranded asset risk is critical for long-term investors
• Hydrogen touted as solution for natural gas investors
• Find out about Regnan Credit Impact Trust
• Find out about Pendal Sustainable Australian Fixed Interest fund

REPLACING natural gas with “green hydrogen” is often touted as a way to solve “stranded asset” risk for fossil fuel assets such as gas pipelines.

The International Energy Agency believes hydrogen has the “potential to play a key role in a clean, secure and affordable energy future“.

As part of a renewable energy transition, some natural gas pipeline and storage infrastructure could be repurposed for hydrogen. The clean fuel could even be blended into natural gas.

But is it really a solution for investors worried about holding “stranded” fossil fuel assets that no longer have an economic use due to redundant technology or high costs?

There is no clear-cut answer right now — and advances are required to make hydrogen technology economical, says Murray Ackman, a credit ESG analyst in Pendal’s Income and Fixed Interest team.

Stranded asset risk

“Stranded asset risk is very tangible for fixed income investors when you’re looking at a seven- or 10-year bond,” says Ackman.

“You have to take a view on what may or may not happen during that time frame.

“Credit ratings, access to financing, cost of funding, demand for the products, regulation — those are the kind of ESG risks that we’re looking at.”

Some risks are clear cut: “Coal is something that needs to be phased out very quickly, so if you’re coal or coal-adjacent like a train company that hauls coal from the mines, there is a clear stranded-asset risk in the short term.

“The cost of funding might become higher and there could be a chance of default or ratings downgrades.”

But the risks to natural gas assets — and the potential for hydrogen to be a solution — are more difficult to pin down.

A natural gas replacement

Part of the problem is conflating potential industrial and domestic uses for hydrogen.

“There are some very clear uses for hydrogen as a replacement for natural gas in industrial processes like producing fertiliser, powering heavy vehicles and aircraft or making steel,” says Ackman.

“And there’s this moon shot that it will be a one-for-one replacement for natural gas,” says Ackman.

In that scenario, parts of the natural gas pipeline and storage infrastructure can be repurposed for hydrogen, protecting their value well into the future and saving them from becoming stranded assets.

“This is what industry is betting big on. It’s tricky because the economics don’t stack up yet — but then that was true for solar panels for a long time too.”

For households, the benefits of hydrogen are less clear cut.

Hydrogen can be blended into the natural gas but above about 10 or 20 per cent it can damage some existing pipes.

“And if you go any higher 20 per cent, you need to change household appliances anyway — if you’re changing your stove to something that can accept hydrogen, why not just change to electricity?”

The weighing of these different views is an important part of the investment process, says Ackman.

“It’s very much a question mark whether it is the solution. In our investable universe, we’ve got some gas distribution networks.

“The question is ‘why are you talking about how good hydrogen is?’

“Is it because you really believe it? Or is it because it’s an existential threat and without it you have a potentially stranded asset in the future?”

What will Anthony Albanese’s new climate bill mean for Australian investors? Pendal’s MURRAY ACKMAN explains

• 43 per cent emission reduction by 2030 
• Opportunity for investors in electricity grid
• Find out about Regnan Credit Impact Trust
• Find out about Pendal Sustainable Australian Fixed Interest fund

THE Albanese government’s climate bill has cleared parliament, paving the way for a 43% emission reduction target by 2030 – and net zero by 2050.

How will that impact Australian investors?

Investment in electrification and mandated reductions in emissions for big companies will be features of the new plan, says Pendal’s Murray Ackman.

The bill legislates a greenhouse gas emission reduction target of 43 per cent from 2005 levels by 2030 and net zero by 2050, aligned with Australia’s Paris Agreement commitment to helping limit global warming to well below 2°C and ideally to below 1.5°C.

The three biggest sources of emissions in Australia are electricity, industry – which includes gas for industrial processes, domestic heating and the by-products of creating things like cement and fertiliser – and transport.

Electricity is the biggest category, says Ackman, a credit ESG analyst with Pendal’s Income and Fixed Interest team. 

“Two thirds of electricity in Australia is generated by burning fossil fuels – mainly coal or gas – and one third is from renewables, mainly wind and solar,” he says. 

“Federal Labor policy is to increase the proportion of renewables to 82 per cent.” 

This will be done through a $20 billion investment in the electricity grid to increase the amount of renewables and safeguard the load with community batteries that are charged through rooftop solar.  

“Removing fossil fuels will require significant spending particularly in utilities and infrastructure,” says Ackman. 

“As well as government funding, there will likely be an important role for fixed income investors to provide debt to finance this spend.” 

Ackman says regulators incentivise investment in the grid, which offers opportunity for investors. 

“The way the regulator works is you get a mandated amount that you can get in terms of profit from any investments you make. 

“This will be significant for fixed income investors because much of the development will be debt funded. 

“And it will be significant for equity investors in the big resource companies who will be digging stuff out of the ground to build things.” 

Rewiring the nation

Ackman says the $20 billion in loans or equity to rebuild the electricity transmission network involves establishing a new body, the Rewiring the Nation Corporation (RNC), which will be a government-owned entity. 

“It’s a bit like the NBN using the blueprint outlined by the Australian Energy Market Operator. The RNC would partner with the transmission companies to modify and rebuild the network.” 

Another implication for investors will be in any mandated emissions reductions from the so-called Safeguard Mechanism that requires Australia’s largest greenhouse gas emitters to keep their net emissions below a baseline. 

“The Safeguard Mechanism will begin operation in 2023-24 and apply to 215 entities that currently emit more than 100,000 tonnes of CO2 a year,” says Ackman. 

“They will be required to reduce aggregate emissions by 5 million tonnes a year to collectively achieve net-zero emissions by 2050.” 

These business include power stations, large foundries and mines and will each have a separate emissions reduction trajectory to be negotiated with the Clean Energy Regulator. They can cut emissions or offset them by buying carbon credits. 

Still, it’s important to keep in mind that federal government targets are not the only ones that matter, says Ackman. 

Most of Australia’s emissions are from energy, industry and agriculture which is primarily the realm of state policy. 

“If you add up the state’s policies, Australia already has an effective 2030 target of 37-42 per cent emissions reductions. 

“If State renewable and energy targets for 2030 are met, 55 per cent of Australia’s electricity will be from renewables.” 

Sustainable fixed interest investors should expect fund managers to engage with bond issuers, just as equity managers do with companies. Pendal credit ESG analyst MURRAY ACKMAN explains

• Engagement with issuers is a useful tool for fixed interest investors 
• Emissions and climate reporting are top issues
• Find out about Regnan Credit Impact Trust
• Find out about Pendal Sustainable Australian Fixed Interest fund

ESG “engagement” has long been a feature of successful equity investing.

Now it’s becoming an important tool for fixed interest investors seeking to manage risk and drive change, says Pendal’s Murray Ackman.

“Engagement” refers to dialogue between investors and investees that seeks to improve policies or public disclosure on social, environmental and governance matters.

Engagement is not just intended to create a warm, fuzzy feeling — it’s designed to make change. And there’s plenty of evidence such change is linked to better financial performance.

Engagement is not just for equity investors though.

Since large parts of the market are unlisted, fixed income investors are discovering they have a critical role influencing investment decisions and driving change at some of the world’s most important companies.

“Look at the biggest players in the climate transition — most of the utilities, many of the infrastructure owners — they are not listed entities,” says Ackman, a credit ESG analyst at Pendal.

“But they issue debt — so we have access to influence them.”

Ackman says Pendal’s Income and Fixed Interest team has undertaken 73 engagements so far this year, topping the figure from the previous year in less than eight months.

A different approach

Fixed income engagement is a different operation to the direct engagement and annual meeting voting rights enjoyed by shareholders, he says.

“We’re not owners. We don’t have that direct line.”

But fixed income investors have some important advantages, he says.

“For starters, we have longer time frames — if we’re looking at 10-year bonds, we want to determine what the risk is of stranded assets in that time.

“In fixed income we don’t have the potential for a big gain in one name to potentially offset a series of losses. When you have a portfolio where you need the cumulative effect of basis points here and there to outperform the benchmark, any downgrade can be significant on performance.”

De-carbonisation

Many of Pendal’s engagements this year have focused on the ambition of an issuer’s carbon emissions targets.

“For companies whose scope one and scope two emissions are mainly related to electricity use, they are going to have a natural reduction in emissions by nature of how the grid is transforming to have more and more renewables.

“For us to be excited, we want you to have a trajectory that is quicker than what the grid is doing anyway.”

Better reporting

Another factor is pushing for improved reporting.

“The technical word is ‘additionality’ — if your project did not happen, what would be the difference?”

As well as directly with issuers, fixed income engagement also operates through the banks and other lenders who are the crucial links in both initial lending and the trading of debt on secondary markets.

“By regularly talking to the banks and arrangers about what our expectations are, they can say at the very early stages if a deal is not going to fly.

“We are very explicit about what we want and don’t want to see in deals, and we make that known on investor calls.”

Ackman says ESG expectations are evolving rapidly and new regulations are being introduced, “so what was best practice a couple of years ago might not be in future”.

Pendal’s fixed income engagement is primarily concerned with three issues: the risk of stranded assets, the pricing risk of credit downgrades and the credibility of sustainability-linked issues.

“These discussions have been from the coal face all the way up to the executive level.

“We’ve found issuers are increasingly literate on ESG matters and we’ve seen our frank advice being acted upon,” says Ackman.

Impact investors can make a strong return while helping provide housing for vulnerable Australians. Pendal ESG credit analyst MURRAY ACKMAN explains how it works

• Impact investors can make returns and help homelessness
• Australian social bonds support social and affordable housing
• Find out about Pendal Sustainable Australian Fixed Income Fund and Regnan Credit Impact Trust

HOUSING affordability is one of Australia’s most pressing problems that investors are helping solve by investing in bonds issued by the government-backed National Housing Finance and Investment Corporation.

In its three years, NHFIC has approved $2.9 billion in loans supporting more than 15,000 new and existing homes and issued more than $2 billion in bonds. It also administers government schemes to help people buy their first home, helping more than 61,000 people.

Bonds issued by NHFIC are held in Pendal’s Sustainable Australian Fixed Interest Fund and the Regnan Credit Impact Trust.

The bonds provide low-cost financing to community housing providers, says Pendal credit ESG analyst Murray Ackman, who has recently met with residents benefiting from the arrangement.

Pendal also recently produced videos of Australian financial advisers meeting with residents of Community Housing Providers.

You can see one such meeting below:

Ackman recently visited two new CHP developments in the inner-Sydney suburbs of Redfern and Glebe.

“These are two new buildings have been put up to house hundreds of people,” says Ackman.

“Importantly, this is not about shipping people out of the communities that they’ve got a long association with.

“Glebe and Redfern have long-standing Indigenous communities and these types of buildings make sure that people can maintain a connection with family, while also giving them subsidised rent. “

Performance and purpose

From an investors point of view, not only is social housing delivering improvements to society, but it is also generating stable and safe income returns.

“For one thing, despite the myths, the default rate — the percentage of people that fail to pay their rent — is very, very low. One housing provider told us it was as low as 1 per cent,” says Ackman.

“The reason for this is quite simple — many of these people are getting their income from the government through a disability support pension or age pension.

“The rent takes a percentage of their pension with the rest subsidised by the government.

“So, the rent is partially being paid by the government. That means it’s a safe investment for landlords.”

Ackman says the buildings in Sydney’s inner city are all but indistinguishable from the million-dollar apartments that surround them.

“These are brand new buildings. You walk past them, and you wouldn’t consider that these are different types of buildings to the ones just up the street.

“That’s quite impactful for the people that live in them — it’s a big de-stigmatisation of social and affordable housing.”

He told the story of meeting one tenant who had gone from a successful career to sleeping rough, with a three-year period of not having an address.

“Once he got the keys to this place, he’s crying in the kitchen. The dignity you get from having your own keys is quite profound.

“These are changes that it can be perhaps a little bit difficult for people who have not faced such hardship to relate to, but people aren’t necessarily always given the best deal in life.”

Perhaps surprisingly, one of the fastest growing cohorts of homelessness in Australia is single women over the age of 50, says Ackman.

“Partly it’s just the maths of divorce — if you split the family house, what does that get you? Especially if you don’t have superannuation to rely on.”

Housing essential workers

And the problem of affordable housing goes beyond people living with homelessness — one of Australia’s biggest affordability problems is housing essential workers.

“Nurses, police, teachers and other essential workers simply cannot afford to live in the communities that they’re serving.

“Some have to solve the problem by moving back in with their parents as they try to save up for a mortgage.

“It’s the unseen cost of the housing boom.”

Ackman says organisations like HOPE Housing, a not-for-profit fund manager that co-invests in housing with essential service workers, are trying to help solve this problem.

Part of the difficulty in solving social and affordable housing is jurisdictional, says Ackman.

Federal, state and local governments all have programs aimed at the issue.

“It’s a huge challenge.”

Fossil fuel companies are paying a “brownium” penalty to raise money in fixed interest markets — and are now trading on lower earnings multiples in equity markets. Pendal’s MURRAY ACKMAN explains what it means

• Energy companies’ performance muted due to ESG
• Bond investors risk getting caught with securities they don’t want
• ESG is a long-term thematic, high energy prices are shorter term

WITH high energy prices and oil and gas company revenues soaring, shouldn’t the big fossil fuel companies be outperforming in credit and equity markets?

In a pre-ESG world the answer would have been yes.

But the large fossil fuel-based companies have to pay a ‘brownium’ penalty to raise money in fixed interest markets — and are trading on lower earnings multiples in equity markets, compared to previous years says Pendal ESG credit analyst Murray Ackman.

It’s a demonstration of how fundamental ESG (environmental, social and governance) factors are now to investment decisions, Ackman says.

“When investing, everyone needs to do their fundamental analysis and ESG integration is now a big part of that analysis, just like financial analysis. If you are looking at downside risks, ESG factors can significantly destroy a company’s value.

“Of course, you can win on short-term trades, but the long-terms might be problematic.”

Underlying change

It’s important for investors to understand this underlying change in the energy sector, Ackman says.

“In the bond world, an investor could feel uncomfortable buying some energy bonds and holding them till maturity because the world in seven years or so will be very different.”

Some of the differences between investing in bonds and in equities are accentuated when buying into energy companies.

Liquidity is one difference, Ackman says. Buying and selling an energy company on the stock market is potentially easier than selling a corporate bond from an oil and gas company in the secondary market.

“Also bond people don’t tend to like taking as much risk. And bond investors look at the downside risk of ESG as pretty significant.

“You can buy a bond funding a gas pipeline that has a 20-year maturity. If you do that, you are making a call on the future.

“What if there’s a sudden policy change that no one saw coming. Pricing can be severely affected, and you don’t want to get stuck with a bond that you don’t want until maturity,” Ackman says.

Ultimately, it’s about how much return an investor gets for taking on the risk of buying a bond that finances fossil fuel companies.

Beware the “brownium”

“There is now a ‘brownium’ – energy companies are having to pay more and access to finance is getting trickier.

“Banks are under pressure not to provide finance to fossil fuel exploration. We are seeing more private investment in the sector.”

Ratings agencies are placing greater emphasis on ESG factors, which impacts pricing. And bond funds, like those that Ackman works across at Pendal, assess issuers’ ESG credentials.

“In our vanilla portfolios, if we think there’s an ESG risk but the pricing compensates for that then we might make a trade,” Ackman says.

“But in our sustainable and impact funds, we probably can’t make those trades. And that’s why people invest in those funds.”

ESG is a long-term play

The bottom line for investors is that ESG is a long-term thematic play while energy price rises are much shorter term.

“This isn’t a linear process. There will be times when oil and gas outperform, but that doesn’t mean we aren’t heading towards net zero,” Ackman says.

“In the past few years at every company presentation, the highlights slide at the front almost always has a couple of ESG points.

“Businesses are becoming proud of their achievements in ESG. Investors are asking a lot more questions about it and it is now front of mind.”

Voluntary sanctions of Russia by brands such as McDonalds and Apple shows ESG is now a fundamental aspect of investing says Pendal’s MURRAY ACKMAN

• Global brands are self-sanctioning in Russia
• Voluntary brand sanctions show ESG has normalised
• Find out about Regnan Credit Impact Trust and Pendal Sustainable Australian Fixed Interest Fund

THE wave of voluntary sanctions protesting Russia’s invasion of Ukraine demonstrates a coming of age of ESG principles, says Pendal’s Murray Ackman.

Self-sanctioning has seen some of the world’s largest companies including McDonalds, Apple and Shell go beyond government sanctions and scale back or shutter their Russian operations.

The widespread protest is a new phenomenon for global business and has been spurred on by the highly visible social media coverage of the conflict.

It demonstrates that society expects business to step up and take its environmental, social and governance obligations seriously, says Ackman.

“Going forward, it’s going to be a lot harder for companies to pick and choose their ESG concerns,” says Ackman, a credit ESG analyst who works across funds including Pendal’s Australian Sustainable Fixed Interest Fund.

“What’s interesting about Russia is that everyone is being called to account — by their investors, by their customers and by society — and asked to explain their exposure to anything Russian-related.

“This represents a normalisation of ESG.”

Parallels with early ESG

Ackman says there are parallels between how global business is treating Russia and how early ESG investors operated.

“Negative screens used to be the approach — screen out all the sin stocks. That’s how Russia is being treated now.”

But increasingly in investing, engagement is more impactful than screening.

“Negative screens have a role, but directly engaging and nudging companies towards behaviour can have a significant impact.”

The question for investors is whether corporations will take a similar stern approach to future issues and conflicts between nations.

“We’ve already seen this with some companies under pressure from their investors refusing to use Chinese cotton unless it can be proved free of forced labour.”

But extrapolating a consistent hardline approach is more difficult.

“It’s very easy to say OK to sanctioning Russia but then why do you not care about Saudi Arabia and Yemen?” he says.

“Remember this is not even the first time Russia has invaded a sovereign nation.

“The thing investors need to understand is that there is not a one size fits all approach. Different investors and different clients have different views of the world.”

Ackman says one of the key things for investors to remember is that the world’s response to Russia indicates that taking an ESG approach to investment is the only way to avoid these kinds of risk.

“How do you predict an invasion? Can you forecast when a war will happen?” he says.

“An ESG approach to investing is basically the only alternative.”

Markets have not priced in the possibility of a large, uncontrolled Covid outbreak in mainland China, argues Pendal senior credit analyst TERRY YUAN. Here Terry outlines how that scenario would impact investors

CHINA’S zero-Covid policy is one of the most important under-the-radar issues facing investors.

While most countries have accepted the need to live with Covid, China has decided that uncontrolled spread within its borders is too dangerous.

The impact of China’s Covid policy on markets over the next few years could be widespread, affecting inflation, interest rates, currencies and equity sectors.

Given the extreme transmissibility of Omicron (and potential future variants) as well as the outbreak in Hong Kong, we believe the market has not priced in the possibility of a large uncontrolled outbreak in mainland China.

If there is a big outbreak China’s reaction will likely be swift and heavy handed, including lockdowns, mass testing and stimulus:

• Travel restrictions would remain tight, limiting immigration and associated capital flows into Australia and the rest of the world. The more successful the zero Covid bubble, the more likely Chinese citizen would stay at home for tourism and education (much as Australians did over the past two years). We can assume this would limit supply of labour and put upward pressure on wages, inflation and interest rates. 
  
  
• A bounce-back among Australian travel and immigration companies could be delayed given the dollar-weighted importance of Chinese immigration
  
  
• Lockdowns, quarantines and hospitalisations would impact Chinese workers at factories, services firms and infrastructure providers. This would create bottlenecks in shipping and production, leading to more inflation.
  
  
• Stimulus via fiscal and monetary easing — while the rest of the world was doing the opposite — would put pressure on Chinese interest rates.

China’s zero Covid policy could put upward pressure on wages, inflation and interest rates — and negatively impact sectors reliant on tourism and immigration over the next few years.

This means Australian investors should keep a close eye on airport, airline, hotel and education-related related companies in their portfolios.

Another consideration might be staying away from companies that lack pricing power.

At Pendal, we are carefully weighing this as one possible future scenario.

After navigating the initial Covid sell-off, post-pandemic rally and recent inflation spike, we are constantly looking for the next thing flying under the radar.

We are carefully selecting exposures to companies that have less exposure to China’s zero Covid policy, but have strong earnings stability, balance sheet strength and sustainability credentials. 

Why China persists with Covid-zero

Why does China refuse to let Covid like the rest of the world? 

The answer seems to be a combination of issues:

1. China is more vulnerable

Most of the Chinese population has been vaccinated with lower efficacy traditional inactivated viruses, rather than newer, higher efficacy MRNA vaccines.

Higher population density compared to the rest of the non-Asian world could increase the speed of transmission and more quickly overwhelm the Chinese hospital system.

Healthcare infrastructure in China, even in urban areas, is inferior to Australian standards, notes Pendal’s head of income Amy Xie Patrick

Even if Omicron infections result in a lower rate of hospitalisation relative to prior variants, the absolute numbers would likely overwhelm the hospital system.

Meanwhile, China does not want to rely on US vaccines given geopolitical tensions and potential for the US to threaten a ban on exports of MRNA vaccine supply (as it did with computer chips).

China wants to foster a successful domestic COVID vaccine and pharmaceutical industry for domestic security and a future international export avenue.

2. Political stability and timing

The Omicron wave hit at a particularly sensitive time for China — just before the Beijing Winter Olympics and Chinese New Year, the biggest holiday of the Chinese calendar.

Uncontrolled spread in Chinese cities would have captured global headlines as a failure of the Chinese government.

This would be playing on Chinese leader Xi Jinping’s mind as he approaches the Communist Party National Congress later this year, where he will seek an unprecedented third five-year term.

The last two leaders (Jiang and Hu) only had two terms before being forced to retire.

Positions on various Chinese ruling bodies will also be up for grabs. Uncontrolled Covid would likely hurt the incumbent. 

3. Social contract

Without elections, China’s top leaders understand they must deliver a growing standard of living for most citizens.

Otherwise, the recent Hong Kong riots could spring up all over China. Ubiquitous camera phones would likely capture any heavy handed crackdown by the government.

Every Chinese leader has studied how and why dynasties and governments failed in China’s 2000-year history.

Confucian society centres on the family unit and respecting elders. An elevated hospitalisation or death rate for the elderly would leave a deep scar and resentment for the government.

When might China abandon its zero COVID policy?

China could abandon its zero-Covid policy when a domestic pharmaceutical champion successfully develops a higher efficacy vaccine or treatment and begins manufacturing the product at scale. 

Alternatively, after Xi Jinping’s re-election China could authorise foreign-produced vaccines with higher efficacy (eg Pfizer or Moderna) for a mass domestic booster campaign.

This would allow China to abandon its zero-Covid policy and gradually reopen to the world in 2023.