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ESG Focus: What Happens When You Flout The Rules?

ESG Focus | Jun 17 2020

FNArena's dedicated ESG Focus news section zooms in on matters Environmental, Social & Governance (ESG) that are increasingly guiding investors preferences and decisions globally. For more news updates, past and future:

Rio Tinto's decision to destroy a historical landmark containing information on the world's oldest known human civilisation has had repercussions with institutional investors across the globe. The question arises: is ESG lip service, or does ESG represent the new balance of power in a post-Cold War world?

ESG: What Happens When You Flout The Rules?

By Sarah Mills

Rio Tinto’s ((RIO)) decision to destroy a landmark 46,000-year-old Aboriginal rock shelter in Juukan Gorge, in the Pilbara, one of the oldest sites documenting human civilisation in the world, and one considered to be “of the highest archaeological significance” has sparked considerable consternation among the ESG investing fraternity.

Firstly, the news caused an outcry among some of Rio Tinto’s institutional investors, triggering an apology from chief executive iron ore, Chris Salisbury.

Secondly, the news was particularly concerning to institutions with best-in-class ESG portfolios which may have decided to include Rio Tinto after the company’s exit from coal and the 2018 sale of its copper interest in Indonesia (which had been reported for committing human rights and environmental violations). Rio Tinto’s management described the Juukan Gorge incident as “galling” given its potential to undermine these efforts.

Institutions’ reputations as ESG investment vehicles hang on just these type of decisions by companies such as Rio Tinto. Many now have to determine if Rio’s inclusion can stand up, not just to the street test, but to regulatory scrutiny, or even their own portfolio requirements.

The Financial Times reports that financial services Legal & General, one of Rio Tinto’s top-10 shareholders, has criticised the incident, and The Guardian writes that Rio Tinto’s chairman Simon Thompson has reportedly scheduled meetings with shareholders in the United Kingdom to repair the damage caused by the incident.

He said the company would “overhaul” its heritage process and take a “leadership position” on the reform of the Aboriginal Heritage Act, which has been under way since 2018.

Despite the brouhaha, Rio Tinto’s share price rose sharply in the proceeding month, in line with commodities prices and the broader global share and commodities markets rally.

BHP’s Pilbara activities in the spotlight

The event has also drawn the spotlight to BHP Group's ((BHP)) activities in the Pilbara, where the company was reported to have been poised to destroy at least 40 and as many as 86 significant Aboriginal sites to expand its $4.5bn South Flank iron-ore mining operation, in the face of strong opposition from traditional owners. 

BHP has announced it will temporarily halt these plans but still expects the project to meet deadlines. Unlike Rio.

These events come just months after BHP announced a $400m Climate Investment Program to mollify ESG investors, and have the potential to significantly undermine the miner’s fledgling steps to build its ESG credentials and retain its position on best-in-class ESG lists. To be scratched from these lists could significantly damage its share price.

Like Rio Tinto, BHP had received approval from the Western Australian government, which is widely considered to be little more than a rubber stamp for resource company ambitions. 

Of the 463 sites that mining companies operating in Western Australia have applied for permission to destroy or disturb since 2010, not one application has been refused, according to The Guardian.

That both Rio Tinto and BHP had been prepared to proceed with this type of corporate behaviour, which clearly flouts the spirit of the ESG mandate, is indicative not only of the strong political influence of miners in Australia, but recognises both companies’ track records in this area – centuries-long abuses of indigenous rights globally, and a willingness to ride roughshod over white community expectations as well.

According to the United Nations Sustainable Development Goals, this is exactly the type of behaviour that ESG social impact investment aims to curb. But how serious are the UN and the institutional community in enforcing such breaches?

Rio Tinto dashes prospects with not-for-profits

Rio Tinto’s move not only damages its ESG credentials and prospects among major institutional investors, but its image as a corporate citizen, proving it cannot even live up to the much less arduous challenge of corporate social responsibility.

 It also jeopardises the miner’s capacity to attract not-for-profit partnerships that might also have boosted its reputation and ESG credentials and prospects.

Reconciliation Australia has already revoked its endorsement of Rio Tinto, describing the Juukan destruction as a “breathtaking breach of a respectful relationship”.

Zooming out to the global ESG picture

More interesting than all of this are the broader reaching repercussions for ESG and investors globally, and the role of government.

Both Rio Tinto and BHP received ministerial consent under WA legislation to the destroy the respective sites – legislation that does not give traditional owners the right of appeal.

The West Australian government is as complicit as the mining companies, and the situation highlights the lack of checks and balances in the two-party democratic system that presides over the Western world. 

Two party systems are notoriously corruptible and corporations from all industries have been found guilty of buying undue influence at the lobbying table.

This has always been the case but has intensified over the past 30 years since the fall of the Berlin Wall and the shift in the global balance of power.

While the unfettered flows of capital have brought positive outcomes for many, they have also exacerbated social inequality, unrest and environmental degradation – a state of affairs that, according to the United Nations, must be managed.

Enter ESG. The world needs a new balance of power, but is ESG the answer, or will it too prove corruptible?

It is billed as a system designed by the world’s leaders to foster social stability and the sustainable use of the world’s resources. Perception or reality?

It is incidents like the Juukan Gorge, and others that may soon decide the fate of the ESG brand, for which perception is reality.

Every such incident that is not responded to in kind by the ESG community represents a chink in the ESG brand armour. Yet all businesses rely on resources.

Quandary for investors

It is early days yet, but already the “best-in-class” ESG list is drawing scepticism, and not just from financial commentators in the land of the free, who regularly conjecture that ESG is a way to make investors pay for the sustainable transition to the fourth industrial revolution.

As a case example, a director for an Australian not-for-profit explained to me that he was responsible for organising the investment strategy for his member organisation, which had opted for an environmental social and governance “best-in-class” lens.

He reported that more than a few puzzled eyebrows were raised when it was discovered that both BHP and Santos ((STO)) were included in the portfolio, and questions ensued.

BHP has a poor environmental record going back to Ok Tedi and beyond, and is one of the few majors to retain an exposure to thermal coal, albeit a small one, having divested the majority of its thermal coal assets over the past few years. However, the company's recent $400m commitment to improving its ESG credentials was well received by the investment community, triggering a share price gain at the time.

Santos, meanwhile, had just recently gained media attention for contamination and continues to encounter opposition to its coal seam gas operations in the Pilliga, not just because of its effects on farming and agriculture (an ESG theme) and riding roughshod over farmers and traditional landowners (social impact), but because of the insidious and polluting nature of CSG extraction and its location above Australia’s most important aquifer (water is another key ESG theme as is carbon dioxide).

The Pilliga forest grows above one of the few areas known to provide groundwater recharge to the Great Artesian Basin, Australia’s largest and most important groundwater system, which has been described as one of the seven hydrogeological wonders of the world. Meanwhile, from an investment perspective, Santos has written off nearly -$7bn since 2014 on its CSG push, according to IEEFA’s energy finance analyst Bruce Robertson.

Gomeroi Native Title applicant Polly Cutmore says the traditional owners are fighting Santos tooth and nail. “We want them to update their environmental impacts statement – the last time it was done was 2007. No-one knows what they have been doing, we have been trying to get tests on the water because our people have been dying but they won’t let us. But we are going to fight this (the recent government approval for Santos to proceed in the area). We are coming in numbers.”

It is arguable that the Pilliga gas field would constitute a greater ESG crime than Juukan Gorge, and that is not for a second to underestimate the significance of the Juukan Gorge, a site that pre-dates the Ice Age.

The argument from the investment adviser was that both BHP and Santos were considered to be best-in-class investments and important from the viewpoint of diversification, particularly in a resources-heavy economy such as Australia; and while it was early days yet, the principle was that it would incentivise resources companies to improve their game, plus it takes time to turn a big ship around.

The directors accepted this advice. 

Such decisions are being made around the globe by not-for-profits and other investors a million times over. 

Linking impact to risk and return

This state of play ties in to a recent impact investment survey by the Responsible Investment Association Australasia which linked impact to risk and return as a core investment principle. This would appear to include negative as well as positive impact, with negative impact appearing to fall more squarely into the risk department, and the positive department into rewards.

Previously, boards such as the one above, may have been vulnerable had they made envirionmental or social exclusions which affected risk-management issues such as diversification that resulted in a big loss.

Now, that is no longer the case. It is the opposite.

Ignoring ESG factors carries risk for boards.

How vulnerable might those board members be if one or more of their portfolio stocks such as Rio Tinto failed to justify their inclusion, and the member’s portfolio suffered a considerable loss as a result (think Enron and other environmental disasters). 

None of this has been tested in the courts as yet, but many board members are aware of the potential risk of litigation on this front.

However, litigation has occurred in the United States against several ESG exchange-traded- funds, because the composition of their portfolios failed to meet the requisite standard.

How defensible is the inclusion of diversified miners in a best-in-class portfolio?

Which takes us back to Rio Tinto and BHP and traditional landowners and international reputation. 

Rio Tinto continues to have a poor environmental record, particularly when it comes to recognising indigenous rights, as do most of the world’s major resources companies.

It raises many questions for ESG investors. How defensible is the inclusion of major resources companies in an ESG portfolio and on what basis does that defence rest? 

Also, what separates the Juukan Gorge incident from any other of the daily incursions committed by resources companies across the globe? And what is the appropriate response from investors to such incursions, and how should it vary?

It may well be though, that the likes of Rio Tinto, Adani and Santos may find some protection from the Transpacific Partnership now that governments have approved the projects.

This would have to be played out in the courts and, as with everything in this area, it’s early days yet with zero precedents – hence the rising risk for investors in the resources sector. 

Market reaction zero, media reaction massive

With the exception of Legal & General, which was reported to have described the incident as “disappointing”, not one ESG investment vehicle has (to FNArena's knowledge) publicly denounced the Juukan incidence. Given the share-price rallied in line with commodities and share markets, it appears there was no significant re-weighting of portfolios.

In fact, according to the Australian Financial Review, Salisbury was recorded by employees in an address saying that Rio retains tacit bipartisan political support, and support from many stakeholders.

Surprisingly, the AFR was one of the few to take Rio Tinto to task, having published several articles on the subject.

The Responsible Investment Association of Australasia chief executive officer, Simon O’Connor, says that responsible investors globally have taken note of the Juukan Gorge destruction and have turned the spotlight on to Rio Tinto in a bid to encourage the miner to improve its indigenous heritage protection/destruction practices.

But is media pressure enough in the absence of legislation or regulation? Or as a resort, will institutions succeed by pressuring management who damage the ESG brand to resign?

Still, the RIAA expects there will be ramifications.

Responsible investors will have a variety of responses to this, from choosing to exclude Rio Tinto from their portfolio to engaging directly with the company to seek to better understand where these internal failings occurred and how they will ensure they cannot be repeated,” says O’Connor.

“This represents a massive lesson for all Australian companies as to how essential it is that they are placing adequate focus on indigenous relations and protecting indigenous heritage, and that expectation will go beyond just what the law requires, to what ought to be considered.

Where is the line in the sand?

So, if the ESG institutional community has drawn a line in the sand, where is it? Is ESG just lip service; a barrier to entry for smaller operators; a genuine attempt to ensure a better use of the world’s resources; a vehicle for wealth distribution; or something more?

This is important information, not just for ESG investors but for both the resources companies and general investors. 

This lack of clarity extends to many other ESG thematics, such as the weighing up of “green investment” and “blue investment” priorities. For example, is creating oil from plastic good or bad, and what are the weightings? And who decides?

To date, the focus has been primarily on environmental benchmarks: on improving carbon and water efficiency, dealing with the plastics issue, and avoiding environmental disasters and breaches of international reporting regulations.

But the SDGs also include social impact and if so, investors need solid guidance on the type of social breaches that might affect share prices. Of all the SDG’s, social impact draws the most scepticism and may have the greatest potential to tarnish the ESG brand. 

The destruction of a pre-Ice Age site has not yielded any noticeable impact on either BHP or Rio Tinto’s share prices, nor even a publicly announced single institutional funds' withdrawal. 

Does this mean investors should perceive this type of breach as acceptable, and business as usual? Similarly, Santos does not appear to be suffering from its activity in the Pilliga.

Big institutional investors are, at this stage providing the lead, but if governments are not on board with legislation, ESG appears to represent a separate, more arbitrary power and poorly defined construct.

These are issues that will have to be addressed soon if ESG is to be perceived as more than a toothless tiger, or a fickle master. 

It is early days yet. Reporting systems have only recently been developed to improve transparency but as the Juukan Gorge episode demonstrates, more clarity is needed.

No one wants to get caught holding a hot potato.

FNArena's dedicated ESG Focus news section zooms in on matters Environmental, Social & Governance (ESG) that are increasingly guiding investors preferences and decisions globally. For more news updates, past and future:

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