Will Portfolios Weather Carbon Tax?

Australian Financial Review, PUBLISHED: 22 Aug 2011

Sally PATTEN

Participants:

Karen McLeod, Ethical Investment Advisers
Elio D'Amato, Lincoln Indicators
Greg Liddell, Russell Investments

THE AUSTRALIAN FINANCIAL REVIEW : Should investors be reviewing their portfolios in light of the carbon tax?

KAREN MCLEOD : Yes, investors must consider how their portfolios will be affected by the carbon tax. Climate change and carbon reduction initiatives will continue to impact the value of investments in the 21st century; there will be winners and losers.

Listed companies that fail to address the risks posed by climate change and the carbon tax will be less profitable and therefore less attractive to shareholders. Those companies that are proactive about integrating smart technologies - such as energy efficiency measures, water-saving technologies and participating in the carbon disclosure project - will stay ahead of the pack and it's likely their share price will do the same.

The tax will apply to greenhouse gases released due to activities at power stations.

Paul Jones

ELIO D'AMATO : Investors should always review their portfolios in light of new legislation. Although much of the focus has been on the negatives the tax places on business, there may also be opportunities. The key is to not panic, do your homework and make informed decisions about where to invest and think about the time frame.

The effects of the tax will essentially be drip-fed through to the market as direct impacts to most firms will be mitigated in the short term by the government assistance packages. Expect well-managed firms to adapt accordingly and be prepared for the unassisted environment when the packages run out. Issues to consider are things like whether the firm is sensitive to local production or has the capability to relocate this capability offshore or whether it has the ability to pass any cost increases through to its customers.

Firms indirectly impacted (i.e. those that are customers of the directly impacted firms) should also be reviewed in light of their ability - and activity - to respond to changes.

GREG LIDDELL : There will be winners and losers from the carbon tax, and investors should review their portfolios accordingly. However the legislation is not yet passed and, until it is, the lack of a stable policy framework will continue to act as a handbrake on investment.

AFR : How can SMSF investors take advantage of the new carbon tax regime?

KM : SMSF investors can pick and choose their shares. As a result, they can be quite proactive in choosing carbonefficient businesses and avoiding those that will be most affected by the tax.

Investors should start by reviewing their existing portfolios: they should identify which companies or industries will be most affected by the carbon tax. The tax will apply to what are known as "scope 1 emissions" (these are greenhouse gases released due to activities at a mine site, power station, or industrial facility, for example).

The carbon tax will be paid by those companies that fall into the top 500 list of scope 1 emitters. These companies include coal-fired power stations; steel, aluminium and cement manufacturers; oil and gas producers; airlines; and mining companies. This list includes: Santos, Macquarie Generation, Qantas, BlueScope Steel, BHP Billiton and Rio Tinto.

Investors also need to consider the scope 2 emissions (these are the greenhouse gases emitted at a second facility for electricity, heating or cooling). The top 25 scope 2 emitters include quite a few companies featured under scope 1 such as the miners BHP Billiton and Rio Tinto, but also some surprising additions such as Woolworths and Telstra.

Some of these companies have stated they will simply pass the full cost of the carbon tax on to consumers; however, the smarter companies affected by the carbon tax have already started to reduce the carbon intensity of their products and services by implementing energy efficiency measures. Qantas, for example, is looking at improved aircraft and is exploring the use of biofuels.

ED : This will depend on the individual case. As mentioned above, this is a good time to re-evaluate any portfolio, consider the impacts of the regime on the portfolio, and make any necessary changes.

GL: The complexity of the legislation poses challenges for analysing the impact on individual companies as multiple considerations need to be taken into account including tax, the amount of compensation available and the funding set aside for investment in low emission technology. Investors including SMSFs should avoid making simplistic assumptions and closely monitor the disclosure of individual companies around the issue. In return we would hope to see companies being transparent and not engaging in overly rent-seeking behaviour.

Once passed, the package will bring more certainty and confidence for investors and create more opportunities in the market, particularly in the area of renewable energy, which investors will be able to assess on their merits.

AFR : Which individual shares should they be considering for their portfolios to exploit the carbon tax and climate change?

KM : Ultimately, the carbon tax will affect company profitability. Smart investors should seek out companies proactively reducing their carbon footprint or those that will benefit under that carbon tax.

The government has announced a range of clean-energy programs and agencies designed to help carbon-intensive manufacturers improve their energy efficiency by making renewable energy technologies such as solar, wind, geothermal, wave, and biofuels, more cost competitive.

Companies that should benefit from these initiatives include wave-energy business Carnegie; solar and wind energy business CBD Energy; wind energy business Infigen Energy; and carbon offset provider CO2 Group. Many of these companies are still developing their technologies and therefore they are at a challenging stage in the business cycle where they are looking to find acceptance for their product while still requiring substantial capital to help fund their research and development. For the most part, these companies are speculative renewable energy stocks which have a high level of risk.

In addition to companies that will directly benefit from the carbon tax and the shift to renewable energy, companies that currently disclose their carbon footprint via the carbon disclosure project and take active steps to reduce it should also be considered. For example, metals recycler Sims Metal Management currently participates in the carbon disclosure project.

ED : Short-term winners are likely to be stocks representing development in alternative or renewable energy sources. However, most of these firms are in their infancy with largely unproven – or, in the least – uncommercialised concepts. Therefore they are likely to represent a speculation not an investment. Investors interested in these exposures should look for firms that have proven technology, a sound commercial history and an articulated path to growth.

Retail energy distributor Origin Energy (ORG) will be a likely winner as it can pass through higher costs. We also like ORG for its direct exposure to gas and renewable energy. LNG companies will also likely see net positive impact as gas replaces coal over time. However, in the short term these firms will face higher costs as they use large energy during development. An LNG play that comes to mind is Oil Search (OSH).

Expect growth in sectors that may support impacted firms in managing the requirements of the tax or to climate change in general. These less obvious prospects are more likely to offer better value to investors now. This support could come by way of services or products: SMS Management and Technology (SMX) offers a wide range of management services including process improvement and should be able to leverage the anticipated demand for increased operating efficiency; whereas engineering product supplier Legend Corporation (LGD) could benefit from increased demand for control systems in their various forms, as firms (and indeed individuals) seek to actively monitor and manage energy use.

GL : While there are upside opportunities for investors, I’d caution against making any investment solely on the basis of the tax. Consideration should be give to the quality of management, the operating environment and ongoing price regulation before deciding to make any investment. In relation to energy companies for example, the consequences of the mix of fixed and variable-price contracts should be understood.

At Russell, we have not adjusted our asset allocations in light of the tax but we have been working to ensure managers have the resources and processes to adequately factor the carbon tax and climate change into their analysis. The processes managers need to embrace include supply-chain analysis for manufacturers and retail operations, and adaptation measures for physical assets such as property and infrastructure against the physical risks of climate change. The insurance industry’s response to climate change is also something we’re monitoring closely.

Digging deeper into the upside opportunities, there will be two types of winners from the tax. Firstly listed and private equity companies in the areas of clean energy and energy efficiency. Access to good technology will be a prime driver, which makes ongoing research and development important. Companies with access to low-cost clean energy generation or those able to drive cost-effective improvements in energy efficiency should do well.

Secondly, there may be some short-term gains in unexpected areas. When we move from the fixed-price period to the emission trading scheme (ETS) in three years time, those emission-intensive, trade-exposed companies receiving government subsidies may be able to abate their emission levels below the threshold, enabling them to generate surplus credits as an additional source of revenue. In my view, this is one of the strengths of the scheme relative to the direct action alternative as it provides a financial incentive for companies to seek out cost-effective abatement opportunities.

AFR : Are these shares reasonably priced at the moment?

KM : Yes, the share price of many of these companies has fallen with the market and could be reasonably priced. We would suggest that SMSF investors speak to their investment professional to consider if the shares are appropriate for their portfolio in terms of risk profile and current pricing.

ED : The overall price reaction when the tax was introduced was fairly muted because it had been anticipated for 24 months or so. In some cases, things were not as bad as anticipated and this is why stocks like Onesteel (OST) and BlueScope Steel (BSL) actually rose after the announcement. Small alternative energy stocks have already shown a significant level of price appreciation post-announcement.

SMX and LGD are Lincoln Borderline Star Stocks which we currently consider to be undervalued. ORG is not a stock we follow closely but its current P/E ratio compared to historic P/E suggests there may be value to be found. OSH is more suitable for investors who are risk tolerant: the company’s earnings and share price are volatile.

AFR : What are the portfolio pitfalls of the carbon tax? Are there any investments that should be avoided?

KM : Investors that ignore the carbon tax are putting their portfolios at risk and stand to miss out on some big gains for their portfolios. Investors should remember that the focus of the carbon tax is towards cleaner renewable energy economy. Those that embrace this shift should be rewarded if they make savvy investments.

Like any investment decision, the investors need to avoid speculative companies, which are akin to gambling. There will no doubt be an influx of these companies trying to “cash in” on the move to a clean energy future. Investors need to be aware of this. They also need to refocus on the basic fundamentals: look at the company’s historical earnings, management’s track record, independent directors on the board and the liquidity of the stock as a starting point. Ask yourself: “What am I looking to receive from my investment? Is it capital growth or income?” Many smaller companies have never paid a dividend, so this may not suit SMSF investors that need to fund pension payments.

Ultimately, SMSF investors need to review their portfolios to see how they will be affected by the carbon tax. They should then decide how their portfolio can be repositioned to benefit from the shift to a cleaner, greener economy.

ED : Alternative energy firms will be in the limelight over the coming months and years, but be wary of jumping on the “next best thing” bandwagon. Avoid any stock that has significant price appreciation without a sound business reason for that increased value.

Brown-coal generators are high polluters and also an inferior economic proposition due to the low energy content of brown coal, placing them near the top of our avoid list. Brown coal will eventually be completely phased out, but in the short term the government will buy the output. The speculation will centre on what price the government will pay and whether shareholders will be compensated for the value of remaining assets when production ceases.

Virgin Blue Holdings’ (VBA) large exposure to domestic flights also makes it vulnerable. While airlines will be able to pass through some of the carbon tax imposts through price rises, it is unclear just how much they will be able to pass on – especially if the domestic travel market is subdued.

GL : While the proposed introduction of the tax has sparked debate – and in some instances controversy – it’s fair to say the impact of the tax will be less than many people think. Initial calculations indicate the gross cost of the tax on listed Australian equities will be approximately $6 billion per annum, or 4 per cent of earnings. To offset this, the government will be compensating corporate Australia with injections of $3 billion per annum (2 per cent of earnings) whereas for households the government’s compensation package of $4 billion a year will effectively neutralise the demand impact.