June 2020

Where the ESG rubber meets the road

Tal Lomnitzer, CFA
Senior Investment Manager

Key takeaways

Companies that perform well when benchmarked against ESG measures have tended to face lower idiosyncratic risks, which has been shown to be able to lead to better risk-adjusted returns.
Arguably in the resources sector, a robust, responsible and quality-driven investment process should always consider ESG factors as a quality identifier and risk mitigant.
In terms of ESG measurement and reporting, the team would like to see resource companies move towards integrated reporting, and for this information to be audited and consistently reported.

Environmental, social and governance (ESG) considerations and sustainability have become buzzwords; barely a day passes by without mention. Rising pressure from investors and regulators is driving money towards companies 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 US.

As sustainability moves up the public agenda, asset managers and asset owners are increasingly considering it as 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, 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 a license to operate and are arguably of more importance for resources than any other sector given its extractive nature. 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 as to what extent it is becoming a box ticking or ‘greenwashing’ public relations exercise. Sustainability and ESG are complicated multi-layered subjects with many factors that are sometimes hard to measure quantitatively and lend themselves to qualitative description and judgement. What is considered material and important by one person may seem trivial to another and claims around ESG may lend themselves to exaggerated statements and the need for further clarification.

The past ten years was about ESG awareness and the next ten years is going to be about 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. Measuring the outcomes of an investment portfolio and showing that it has a lower carbon footprint, lower ESG risks, higher water efficiency, better safety or more socioeconomic benefit are becoming possible and should be demanded by investors.

Measuring the impact of ESG in the resources sector is complex

The next step is to identify and attempt to measure the contributions that the 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 decarbonising 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 towards integrated reporting, which looks at 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 that without resources the world cannot function or feed itself; resource companies play an integral role to help the world decarbonise and develop sustainably. Therefore, avoiding resources can be self-defeating for investors that 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 and resources (energy, mining, 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. That has changed and there is now plenty of data. What is lacking is consistency in reporting and auditing of that data and it is here that there is work to be done. 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 standardised disclosure of data and it appears likely that the extent of ESG reporting will continue to increase and become more comparable and reliable in the future. Ultimately, we hope that the SASB is absorbed in the Financial Accounting Standards Board in the US. This would lead to integrated ESG reporting into financial statements. Concerns around data integrity, timeliness, universality and comparability would evaporate.

These demands for disclosure are increasingly collective. As a member of the global investor initiative on tailings (mining by-products) facilities, Janus Henderson is an advocate for the call for uniform tailings data disclosure in financial statements, and urges all mining companies to engage in this conversation, or risk being left behind. As universally-accepted standards for ESG compliance and disclosure emerge, mining companies and investment managers who do not truly understand that providing for the needs of today should not come at the expense of the needs of tomorrow are likely to be exposed. Resources funds that consider ESG factors should be able to demonstrate lower carbon footprints, lower controversy risk and lower overall ESG risk than the fund’s benchmark.

Standardised reporting and disclosure while necessary, is not a silver bullet

There is danger that highly-standardised ESG reporting results in box ticking, providing excuses for inaction. Active investment managers need to scrutinise the quality and sincerity of the 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 investment tools as important 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.

Idiosyncratic risk: inherent factors that can negatively impact an individual security or a specific asset group rather than the market as a whole.

Risk-adjusted return: assessing an investment’s return through how much risk is involved in producing that return.

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

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