Portfolio Manager Tal Lomnitzer on the Global Natural Resources Team discusses why, while standardized ESG reporting is necessary, investing in high-quality companies also demands an assessment of corporate culture.

Key Takeaways

• Particularly in the resources sector, we believe a robust, responsible and quality-driven investment process should always consider environmental, social and governance (ESG) factors as a quality identifier and risk mitigant.
• Companies that perform well when benchmarked against ESG measures have tended to face lower idiosyncratic risks, which can often lead to better risk‑adjusted returns over time.
• In our view, resource companies should move toward more integrated and consistent ESG reporting. However, we believe active investment managers also need to scrutinize the quality and sincerity of companies in their analysis.

Environmental, social and governance (ESG) considerations and sustainability have become buzzwords; barely a day passes by without their being mentioned. Rising pressure from investors and regulators is driving assets toward companies that are considered “good.” According to the Global Sustainable Investment Review 2018, sustainable investing strategies now represent 26% of total investment assets under professional management in the U.S.

As sustainability gains prominence in the public agenda, asset managers and asset owners are increasingly considering it a third dimension to complement risk and reward. Evidence is mounting that company performance and thus investment returns may be improved by adhering to an investment approach that integrates ESG factors. It is a genuinely powerful trend, akin to an unstoppable train that is picking up speed.

From Risk Control to Investment Opportunity

Particularly in the resources sector, we believe a robust, responsible and quality-driven investment process should always consider ESG factors as a quality identifier and risk mitigant. ESG factors are intertwined with resource companies’ licenses to operate and, given the sector’s extractive nature, these factors are arguably for important for the resources sector than for any other sector. Companies that perform well when benchmarked against ESG measures have tended to face lower idiosyncratic risks, which can often lead to better risk‑adjusted returns over time. In the past few years, ESG has moved from a risk control to an opportunity, which can help drive revenues and expand (or protect) profit margins for certain companies while compromising the same for others.

As ESG and sustainability gain popularity, many corporates and money managers are taking the opportunity to extol its virtues. Concerns now arise, however, as to whether ESG is becoming a box-ticking or “greenwashing” public relations exercise. Sustainability and ESG are complicated multi-layered subjects with many factors that are sometimes difficult to measure quantitatively and therefore lend themselves to qualitative description and judgement. What one person considers material and important may seem trivial to someone else, while claims around ESG may lend themselves to exaggerated statements and the need for further clarification.

We believe that if the past 10 years were all about ESG awareness, the next 10 years will be focused on data quality, consistency and monitoring. It is not good enough to say that ESG is important and integrated; increasingly, a burden of proof will rest with the investment manager to show how it is integrated against objective numbers. It is now becoming possible to measure the outcomes of an investment portfolio and show that it has a lower carbon footprint, lower ESG risks, higher water efficiency, better safety or more socioeconomic benefit, and investors should demand this type of proof.

Measuring the Impact of ESG in the Resources Sector Is Complex

The next step is to identify and attempt to measure the contributions that a resources portfolio makes to United Nations Sustainable Development Goals. Complexity abounds here. Extracting copper comes with a cost to the environment, but the copper that is produced is key to decarbonizing the global economy by virtue of being the conduit through which electrons flow. No copper means no electric vehicles. Similar arguments can be made for nickel, lithium, cobalt, iron ore and so on. Furthermore, the financial contribution from resource extraction can make a major contribution to local and national economies (often in the developing world). The jobs created and associated multiplier effect can trickle down to positively impact thousands of people.

The leading edge of ESG integration takes these various impacts into account and attempts to measure the impact of positive and negative externalities of a portfolio on the global economy and society at large. To this end, companies should be encouraged to move toward integrated reporting, which looks at the value created for multiple stakeholders.

Consistency in Reporting and Auditing of ESG Data Is Lacking

This may begin to address one of our frustrations as resources investors — how many investors automatically shun the resources sector. The fact is, without resources the world cannot function or feed itself; resource companies play an integral role in helping the world decarbonize and develop sustainably. Therefore, avoiding resources can be self-defeating for investors who want to encourage global development and potentially improve portfolio returns. Analysis has shown that adding resource stocks to an equity portfolio (based on an allocation to S&P 500® Index stocks including resources, energy, mining and agriculture) over the long term has the potential to improve returns and lower volatility.*

For years, there was a frustrating lack of data, and our engagement with companies was aimed at improving disclosure. While there is now plenty of data, what is lacking is consistency in reporting and auditing of that data. We would like to see ESG reporting move from the front half of the annual report, where it does not necessarily need to be substantiated, to the back half, where it should be audited and consistently reported.

Producing ESG data today is entirely at a company’s discretion in terms of what is disclosed and when. A number of initiatives such as the Sustainability Accounting Standards Board (SASB), Carbon Disclosure Project, The Task Force on Climate-related Financial Disclosures and Global Reporting Initiative are pressing for more widespread standardized disclosure of data, and it appears likely that the extent of ESG reporting will continue to increase and become more reliable in the future. Ultimately, we hope that the SASB is absorbed into the Financial Accounting Standards Board in the U.S. This would lead to integrated ESG reporting in financial statements, and concerns around data integrity, timeliness, universality and comparability would essentially evaporate.

Standardized Reporting and Disclosure Is Not a Silver Bullet

There is danger that highly standardized ESG reporting results in box ticking, providing excuses for inaction. In our view, active investment managers need to scrutinize the quality and sincerity of companies in their analysis. Investing in high-quality companies demands an assessment of corporate culture; it is culture that binds environment, society and governance together alongside company financials.

People and planet are the pillars that support profitability. For us, that means hard hats and steel-toe-capped boots will remain as important forms of investment tools as spreadsheets and annual reports. Culture is most effectively assessed by getting out there and talking to people in the field, as well as company management. This is where the ESG rubber meets the road.

 

*Source: Janus Henderson Investors and Factset. Rolling 10-year standard deviation and returns based on hypothetical portfolio allocations to the S&P 500 Index and resources equities (energy + mining + agriculture). Monthly observations from November 1993 to June 2019. Standard deviation is a statistic that measures the variation or dispersion of a set of values/data. A low standard deviation shows the values tend to be close to the mean while a high standard deviation indicates the values are more spread out. In terms of valuing investments, standard deviation can provide a gauge of the historical volatility of an investment. Past performance is not a guide to future performance.

Note: A version of this article was first published in Mining Journal (https://www.mining-stakeholders.com) on April 29, 2020.