The Government’s recent announcement of a 43 percent reduction in carbon emissions by 2030 is a huge step forward in our goal to be net-zero by 2050. However, this steep reduction will not easily be achieved. For Australia to reach this target—and hopefully go further—we need our financial system to be working in a way that maximises its fundamental role in allocating capital and deploying it to projects that drive carbon reduction. Both public and private capital will be needed to achieve our climate targets. With superannuation now a $3.4 trillion industry, and growing at 10.5 percent annually, changes to YFYS will be critical to success.

The role of superannuation is to protect member interests by securing strong returns and minimising risk to protect retirement outcomes. The performance test within YFYS sets out to achieve this by introducing a performance benchmark which restricts underperforming funds from continuing to accept contributions should they fall short of the required returns two years in a row. However, it is crucial that the way performance is measured does not unintentionally drive a short-term investment culture.

For Australia to reach this target—and hopefully go further—we need our financial system to be working in a way that maximises its fundamental role in allocating capital and deploying it to projects that drive carbon reduction.

Currently, the YFYS performance test raises the risk of unintended consequences that need to be resolved and we welcome the review announced by the Minister for Financial Services, Stephen Jones, to ensure the legislation continues to provide a guide for relative performance for members, while also supporting longer term responsible investment and net-zero commitments.

There are two main issues that need to be resolved. Firstly, due to its short-term horizon, the current performance test impedes the ability of superannuation funds to strategically deploy patient capital for investment opportunities aligned with longer-term goals. This is particularly the case when it comes to ESG, including investments in carbon reduction technology and industries and social infrastructure, such as affordable housing, which may have a longer payoff profile versus the short-term performance benchmark.

Adding to this concern, the benchmarks used to value non-listed assets potentially distort investment away from renewable energy. For example, benchmarks used to assess Australian unlisted energy infrastructure assets held by superannuation funds are heavily weighted towards US infrastructure – much of which is older established carbon intensive energy production. This distorts the comparison with renewables, which have a different forward-looking return profile.

To put it simply – coal burning energy infrastructure has often been operating for decades and does not have the high upfront costs of renewable energy. Renewable energy also has longer investment return profiles.

The result is the performance benchmark discourages investment in renewable energy as funds risk “underperforming” relative to carbon intensive energy investment.

…it is crucial that the way performance is measured does not unintentionally drive a short-term investment culture.

Even with listed investments, the combination of the eight-year time frame of the YFYS test, together with substantial short-term blips in the price of companies heavily involved in coal and gas production, can disadvantage funds that have taken steps to reduce their exposure to carbon intensive investments.

Impeding superannuation’s ability to invest in the transition to a lower-carbon future is particularly concerning when the data shows that ‘green’ investments can lead to outperformance over longer-term horizons.

The second key issue is that the performance benchmark’s methodology does not take into account whether the strategic asset allocation is optimal for a particular fund. That is, different superannuation funds have different member demographics and require asset allocations appropriate for that demographic. The performance metrics in the current form could lead to a misalignment between strategic asset allocation and member expectations.

The Government had proposed that faith-based superannuation funds be subject to a supplementary performance test that considers the faith‑based investment strategy, should the fund fail the original test. This measure was withdrawn from Parliament and the Government has indicated it will consider it as part of the broader YFYS review. We think this approach should also apply to other funds. For example, a superannuation fund with a young demographic may seek to maximise returns over a longer timeframe than the eight-year horizon the performance test uses. Additionally, in line with member values, funds with younger members may also have a more rigid approach to ethical investing. The supplementary performance test ensures super funds can deliver outcomes that are aligned with their members’ best interests.

The supplementary performance test ensures super funds can deliver outcomes that are aligned with their members’ best interests.

Achieving carbon reduction of 43 percent by 2030 and net-zero by 2050 cannot be done without long-term patient capital and harnessing the $3.4 trillion superannuation sector. A review of YFYS is needed to resolve significant fundamental issues and ensure reforms continue to support monitoring of fund performance while also being aware of longer-term exposure management such as that of climate risk. Engaging with the financial services industry, including superannuation, funds management, and banking will ensure the YFYS legislation achieves its ultimate goal of funding a comfortable retirement for Australians.