Decarbonising the Australian Equity Portfolio: Searching for the Holy Grail

We explore how some Australian companies contribute to climate change and the challenges of building a climate aware Australian equity portfolio. We also review the evolving landscape of methodologies and climate metrics that could support decarbonising an Australian equity portfolio.

ESG Investment Strategist

Much momentum has been achieved in the past year in the climate front, including many countries joining the race to ‘net zero’ before COP26.1 A growing number of investors and listed companies have also declared publicly their commitment to achieving net zero emissions by 2050. Global ‘net zero’ by 2050 is needed to limit global warming to well below 2, preferably to 1.5 degrees Celsius, compared to pre-industrial levels.2

For Australian investors contemplating decarbonising their investment portfolio an obvious place to start is Australian equities. It is true that changes within Australian companies will be a key part of the race to ‘net zero’. In this paper however, we focus on changes within a portfolio; which companies an Australian equity investor might include or reject.

How Australian Companies Contribute to the Climate Challenge

Australian companies contribute to the global climate change challenge in at least three ways:

  1. Some Australian companies generate their own greenhouse gas (GHG) emissions. Some examples include energy generators such as AGL (burning coal to generate electricity) and Origin Energy (mainly generating energy through burning gas) as well as Woodside Petroleum which burns gas to support the energy need of its own operations.
  2. Some Australian companies extract and export fossil fuels to other countries where they are burned and generate further GHG emissions. Taking Woodside again as an example, while its GHG emissions associated with its operations is high, its exported emission is even higher (12 times of its operational emissions);3 another example is Whitehaven Coal, with its high emissions associated with exporting coal primarily to Asian countries.
  3. Some Australian companies play an active role in developing new solutions for a green future. For example, Sims Ltd is one of those companies that support the building of a circular economy through recycling.

We look at each of these three below.

Emissions from Our Industries

Figure 1 shows that the Australian equity market has a much higher carbon intensity than international Developed Markets (DM), although it is lower than Emerging Markets (EM).

Figure 1: Weighted Average Carbon Intensity

Source: State Street Global Advisors, S&P Trucost, MSCI as of 31 May 2022. Shows contributions to Weighted Average Carbon Intensity for MSCI Australia IMI Index vs. MSCI World ex Australia Index vs. MSCI Emerging Markets Index using S&P Trucost Direct and First tier Indirect GHG emissions data.

The materials sector makes up more than half of emissions intensity of MSCI Australian IMI Index, which is much higher than other DM (18%) and is even higher than EM (40%). Within Materials, it is Diversified Metals and Mining that dominates emissions intensity – companies like BHP, Rio Tinto and South32. A close examination of the underlying data suggests this dominance has less to do with the emissions intensity of the industry in Australia4, and more to do with its large weight in the index; Diversified Metals and Mining make up 18.6% of MSCI Australia IMI Index compared to only 0.5% in DM and 0.8% in EM.

Figure 2: Top 10 by Carbon Intensity in MSCI Australia IMI Index and their Index Weight

Source: State Street Global Advisors, S&P Trucost, MSCI as of 31 May 2022. Past performance is not a reliable indicator of future performance. This information should not be considered a recommendation to invest in a particular sector or to buy or sell any security shown. It is not known whether the sectors or securities shown will be profitable in the future.

Our Contributions to Global Emissions Via Extraction and Export

We are a major exporter of fossil fuels, particularly coal. As the global economy rebounded from COVID, global energy demand grew 6% in 2021, with coal (the most carbon intensive energy source) growing at 9%; coal accounted for over half of the additional demand in 2021.5 Figure 3 shows the distribution of global electricity demand growth from 2015 - 2024.

Figure 3: Global Change in Electricity Demand (2015 – 2024)

Source: IEA 2022, ‘Electricity Market Report’, p10. Retrieved from:

Global growth in energy demand is concentrated in countries such as China and India; the Utilities sector in China and India only accounts for 1.5% of total EM market capitalisation, but makes up 13.5% of the total EM carbon intensity. With China targeting carbon neutrality by 2060 and India by 2070, the fossil fuel share of electricity generation will have to drop over time.

Australia is one of the main trading partners for China on fossil fuels. Figures 4 & 5 below illustrates Australian Fossil Fuel Exports by values and energy mix of our major trading partners.

Figure 4: Australian Fossil Fuel Exports (as a share of 2019/20 total export values)

Source: RBA 2021. ‘Towards net zero: implications for Australia for energy polices in East Asia’, p34. Retrieved from:
*refined and unrefined petroleum.

Figure 5: Energy Mix (by source, share of total energy supply, 2018)

Source: RBA 2021. ‘Towards net zero: implications for Australia for energy polices in East Asia’, p31. Retrieved from:

Figure 4 shows that the lion’s share (based on value) of China’s fossil fuel import from Australia is LNG, followed by Coking Coal, thermal coal and oil. In China’s case, its energy mix is still predominantly made up of coal and oil (Figure 5). With energy transition playing a crucial role in achieving the Paris Agreement and China’s own net zero by 2060 target, how and how fast the energy mix will transition will likely to impact the valuation of major fossil fuel exporters in the Australian equity market.

A shift from high emissions to low or net zero emissions either within Australia or among countries like China and India presents an additional risk to the Australian market. A number of Australian Energy, Utilities and Materials companies own significant Fossil Fuel Reserves.6 Depending on how the energy transition plays out some of these reserves could become ‘stranded’ and ‘unburnable’. Companies like New Hope, Whitehaven, Washington H Soul Pattinson and South32 loom large in this list.

Australian Contributions to a New Green Future

Despite the direct and indirect contribution to carbon emissions by some Australian companies, others contribute to a new green future via their business activities. So called “green revenues” can come from a range of activities like renewable energy generation, energy management and efficiency, transport solutions, food and agriculture, water infrastructure and technology, and waste and pollution control.7 We believe this is an area of potential growth for the Australian market, which lags both developed and emerging markets in its exposure to “green revenues”.

The Challenge of Building Climate Aware Australian Equity Portfolios

The large exposure to high carbon emission sectors such as energy, materials and utilities, combined with high individual stock concentrations makes building a low carbon portfolio in Australia more difficult than in DM or even EM. Simply screening out high carbon emitters typically leads to a high tracking error against standard indices like MSCI Australia IMI Index or S&P ASX 300 Index.8

One alternative to simple exclusions is to find the best balance between reducing carbon emissions intensity and active risk or tracking error. This is achieved by underweighting (or excluding) high emissions companies and then selecting overweights based on their ability to reduce tracking error.9 Figure 6 shows three portfolios covering Australia, DM and EM that demonstrate different trade-offs between tracking error and reductions in average carbon emissions intensity.

Figure 6: Hypothetical Carbon Reduction vs Tracking Error

Source: SSGA, Axioma, as at June 2022. “Australia” = A low carbon optimization on the S&P/ASX300 Index, “International” = A low carbon optimization on the MSCI World ex AU Index, “Emerging” = A low carbon optimization on the MSCI Emerging Markets Index. The results shown represent a hypothetical point-in-time analysis to demonstrate different trade-offs between tracking error and reductions in weighted average carbon intensity. The results do not reflect actual trading and do not reflect the impact that material economic and market factors may have had on SSGA’s decision-making. The results shown were achieved by means of a mathematical formula, and are not indicative of actual future results which could differ substantially.

This chart provides a concrete example of the challenge for Australian investors. For a 0.20% pa tracking error budget, we could achieve a more than 50% reduction in carbon emissions intensity in DM and EM. The same tracking error budget in Australia would only deliver a 20% reduction.

An Evolving Landscape

Decarbonising Australian Equities – Key Carbon/Climate Metrics to Consider

So what are the alternatives to an immediate reduction in simple carbon emissions intensity leading to a high tracking error? Investors could explore building a progressive carbon reduction target year-on-year to gradually lower carbon intensity over a longer time frame. For example, the European Union (EU) Technical Expert Group (TEG) for Climate Transition Benchmarks suggests a 7% reduction year-on-year.10

Alternatively, investors could explore combining multiple carbon and climate related metrics in portfolio construction. These might include reducing exposure to companies that have higher carbon intensity, higher fossil fuel reserves and brown revenues and increasing exposure to companies that have higher green revenues and are successfully adapting to climate change.11 The obvious questions to ask when constructing the portfolio would be:12

  • What is the impact of reducing the investment universe?
  • What is the impact on tracking error?
  • How is carbon intensity reduction measured?
  • How are green opportunities evaluated?

The climate objectives can be achieved through mitigation, i.e. reallocates capital away from companies with high current and embedded carbon emissions and brown revenues to companies that generate green revenues from low-carbon technology; as well as adaptation, i.e. build a more resilient portfolio by increasing exposure to companies scored higher on climate change preparedness.13

New Climate Metrics to Consider

The datasets available to climate sensitive investors continue to evolve. In addition to the climate metrics above, other metrics such as Climate Transition Value at Risk (TVaR) and Implied Temperature Rise (ITR) have more recently become available.

Using scenario inputs such as Policy, Technology and Market transitions risks and opportunities, and company-specific exposure data, Climate TVaR analysis helps quantify financial impact of both transition risks and opportunities on companies and portfolios.14 Implied Temperature Rise (ITR) is designed to show the temperature alignment of companies with global temperature goals, based on a company’s carbon emissions and reduction targets,15 which can be expressed as a single numeric value-generally in the range of 1.5 degree Celsius to 4 degree Celsius.16 Company level ITR can also be aggregated to an investment portfolio ITR, which calculates how much the global temperature would increase if the entire economy were to over- or undershoot its allocated carbon budget by the same amount as an individual company.17

While both Climate TVaR and ITR are forward looking (unlike carbon intensity data), they have their own challenges. For example, within Australia energy, utilities and materials sectors have much higher ITRs than other sectors, and a simple exclusion approach would again lead to very high tracking error. Furthermore, many forward looking metrics involve complex modelling and significant assumptions.

In addition to methodology considerations, significant corporate actions such as the recent merger of BHP’s oil and gas portfolio with Woodside Energy Limited can make sourcing accurate, up to date, climate data difficult. The (failed) demerger of AGL is another example that would have had significant implications for low carbon Australian equity portfolios.

Final Remarks

At State Street Global Advisors, we are exploring innovative ways to build resilient climate-aware Australian equity portfolios. We will continue to assess climate-related methodologies and data sets available in the market, and develop customised solutions for our clients. The search for solutions to decarbonising Australian equities continues.

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