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ESG Focus: BHP and Rio Defy “S” in ESG – Part 2

ESG Focus | Mar 08 2021

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ESG focus: BHP and Rio defy “S” in ESG – Part 2

The Apache land transfer to BHP Group and Rio Tinto in Arizona (see link below) has been rescinded and more heads topple at Rio Tinto as global resolve steels to reinforce ESG narratives.

(BHP And Rio Defy The "S" In ESG – Part 1:

-The deal in Arizona has been reversed, signalling social intent
-More investors focusing on social investing
-ESG narrative critical to winning younger generations
-Zooming in on social materiality

By Sarah Mills

The United States Government has reversed a decision to transfer Apache land in Arizona to Resolution Copper, a joint venture between mining giants BHP Group ((BHP)) and Rio Tinto ((RIO)).

The land was earmarked for an underground copper mine. Billed as the largest in the world, it contains enough copper to supply US demand for 40 years.

The US Agriculture Department, responsible for the rescission, concluded additional time would be necessary to "fully understand" the concerns outlined by Native American tribes and to "ensure the agency's compliance with federal law." The process could take several months.

The battle for Oak Flat is not yet over, but the government's decision is telling on many levels.

Should it hold, it speaks to the future demand for copper post 2035; the potential pace of disruption in electrification; progress on circularity; and the global commitment to the "S" in ESG. 

Meanwhile, closer to home, Rio Tinto announced chairman Simon Thompson and non-executive director Michael L'Estrange, a former Australian High Commissioner to the United Kingdom, would leave the company.

Mr Thompson will seek re-election as chairman at this year's annual general meetings in April and May but will retire from the board next year. Mr L'Estrange will step down after this year's annual general meetings.

The recent transgressions on indigenous rights by BHP and Rio Tinto in Australia’s Juukan Gorge and Arizona’s Oak Flat Arizona have served to undermine the ESG narrative, particularly the “social” component.

They have also raised questions about the environmental narrative: How successful will the green transition be if highly polluting copper, which is totally recyclable, is still being excessively mined in “the largest copper mine in the world” in 15 years? But we will save that question for future articles on circularity.

This article explores the ESG narratives and the strength of big capital’s commitment to the "social" reform of corporate activity: because plausibility of the narrative is critical to gaining social agreement. 

The Oak Flat and Juukan Gorge incidents are interesting because, as FNArena wrote previously, every such incident that is not responded to by the ESG community represents a chink in the ESG brand armour.

This is critical in these early stages because the ESG and climate change narratives are essential for gaining the support of not just investors, but millennials and succeeding generations for the green transition; and its fallout.

The social setting – inspiring a new generation for a new world

ESG is very much a story of the new world replacing the old.

The world is on the cusp of a one-in-centuries transition, and the captaining of this transition is being vested largely with the younger generations.

In the West, young people are demonstrating a clear desire to favour the environment – so much so that many would prefer to jump off the development merry-go-round altogether.

They wish to avoid their parent’s experience of being bound by financial chains and trapped in an endless cycle of productivity improvements and long work hours, often at the cost of what they consider to be their basic rights such as freedom of movement, and natural access to resources such as air, food, and water.

Given the existence of contraception and powerful technology, many feel that such sacrifices are unnecessary and the system should be better managed – at least that is the conclusion to be drawn from several millennial-futurists’ blogs that this intrepid journalist blundered into. 

And, just like the baby boomers before them, this generation has a great confidence in its ability to change the world and aligns its fortunes to technological advancement (another strong narrative).

Carbon super-cycle exhausted

With the growth benefits of the oil super-cycle now exhausted, many are pinning their hopes on the green transition to keep the economic wheels turning.

But how much productivity can the world take? And at what cost? 

The whole premise of modern monetary theory is that supply in the West and many parts of Asia already outpaces demand. And let’s not forget the demand-sag associated with ageing populations. 

A range of social solutions has been proposed for this situation, including a universal basic income: we all get $200 when we “pass Go”. Sound familiar? 

Corporations will be offered stimulus, lent to them by the people to provide jobs for the people and to clean up the environment. This is the social contract. Trillions are being lent and breaches are unlikely to be taken lightly. 

Law suits are already rising for breaches of the ESG mandate. German banking giant DekaBank, for example, is being sued for misleading retail investors over both the social and environmental impacts of its fund. I think the emphasis here has to be on "retail" investor and its implications.

Emerging economies may also offer greater demand elasticity.

And, just like Monopoly, the winners of the oil supercycle may have to waive a few debts from people landing on their hard-won assets if the game is to continue. 

At the moment, society appears to be borrowing from itself and banking on the prospect of future rises in productivity; which many say can only come from the green transition. 

So everyone is invested. Supposedly.

Narratives are critical for gaining support

Financially people may be invested. Psychological investment is another thing.

The image of the curtain being drawn on the supposedly omnipotent Wizard of Oz is the archetypal symbol for the role of narratives in our society.

The ESG and green transition narratives are considered to be an important part of the “social” solution and they work on several levels.

ESG appeals to the younger generation’s social conscience, ambitions and sense of progress; with the promise of raising the “poor” out of poverty and improving general living conditions for all, including animals.

On the environmental level, it appeals to their instinctive understanding of their connectedness with the natural world. Like Dorothy, everyone wants to “go home”.

As a narrative, it also carries the concept of sacrifice and belt-tightening now for the sake of the environment and broader society, which is useful. The covid narrative is also now intertwined with this concept.

And it contains a quest: the prospect of circularity, which to many translates to living happily ever after.

When it is combined with the climate change narrative, the very future of humanity is at stake – the narrative becomes existential. 

But as we see in the Wizard of Oz, like all narratives, it has to gain consensus and is vulnerable to reality checks.

Enter Rio, BHP and indigenous rights

The incursions over the past year, while suitably mobilising the media and chattering classes, have also weakened both the social and environmental narratives, given the lack of material consequences

The Oak Flat transfer even undermined the circularity narrative. Humans are often prepared to make sacrifices for a quest, but generally not if they are the only ones; and not if they do not believe the quest will end within their lifetime. 

While the occasional setback to a quest is permitted, progress is critical to maintaining a narrative’s momentum – and perhaps this is the best lens through which to view the BHP and Rio incursions.

A 15-year lead-in to the biggest copper mine is not inspiring to a generation used to instant gratification.

The narratives are unlikely to sustain too many such disappointments, so it is telling that the US government stepped in to reverse the Apache land transfer.

There are several months to go before the matter is resolved; but all eyes will be peeled to the outcome as a test of the social narrative; and as a potential indicator to the likely pace of disruption in the electrification market.

ESG is more than just a story

ESG is more than just a narrative. The financial investment from all parts of society is indisputable; and government is weighing in

Big capital is in play. 

It will wreak profound physical effects on society, and the decisions governments and institutions take today will either feed or sap the narrative – and will either feed or sap investors' funds.

As Goldman Sachs said to 

“Covid is ushering in a new era of policies aimed at social need instead of financial stability [which] will likely create cyclically stronger, more commodity intensive economic growth, that should create the elusive upswing in demand.

“Spending on green infrastructure could be as significant as the BRIC investment boom of that decade while the redistributive push in developed markets is likely to lead to a large boost to consumer spending, comparable to the lending-fuelled consumption increase in the 2000s.”

Funds also flowing to social investments

Back to the “social” component?

While not as strongly supported as green investing, “social” funds under management are rising sharply.

A recent MSCI investor survey notes that more than one third (36%) wanted the social component to comprise a larger proportion of the mix in 2021.

This makes sense given the focus on the covid stimulus-led recovery. 

This increased to 50% and 48% in the UK and US respectively, where respondents cited covid-19 coinciding with a reassessment of inequality in society as a driving factor,” says MSCI.

But how does one assess inequality for investment purposes?

And amidst the political noise and media chatter arising from incidents like Juukan Gorge and Oak Flat, what information can ESG investors rely on?

Investors need to sharpen their focus on materiality

Russell Investments advises ESG investors to focus on materiality, with environmental priorities foregrounded over social priorities.

“The demand for ESG is going to broaden – E is going to be the biggest focus but we do expect the social and governance aspects are going to become a greater focus for investors as well,” says Russell Investments in Investor Daily.

The analyst advised that, rather than adopt a one size fits all approach, investors should focus on the small number of sustainability issues that have the biggest impact for that company – the old 20:80 rule.

As Juukan Gorge and Oak Flat show, indigenous rights in even transition-critical industries are increasingly proving to be material issues for investors. 

Previously, it had become clear that incursions on indigenous and community rights were proving to be a material issue for a vulnerable carbon producer. Australian coal producers have already lost several legal battles – Gloucester Resources being just one example.

Watch supply chains and living wages

In terms of best-in-class stocks, investors are also likely to be evaluating progress on metrics such as ensuring employees have a living wage, supply chains, modern slavery, health & safety and on-shoring.

Modern slavery is already in the spotlight for a number of geopolitical reasons, particularly Sino-relations, and it might be wise for investors to prioritise this issue.

Responsible Investor (RI) uses the Uighurs as a classic example, noting that the Chinese state has conscripted more than one million civilians into its workforce. Analysts and academics note that China is using its supply chain power as a tool of aggression with trading partners, who are less than impressed, especially given the state-sponsored use of slave labour allows China to muscle out its competitors.

The West's argument may be: what the "Lord" giveth, the "Lord" can taketh away.

"This is an opportune time for investors to clarify whether they need to be funding China's dictatorship," writes Heather White in RI. "If one wishes to avoid complicity in slavery and gross human rights abuses, a continued presence in China seems incompatible with even the most lenient ESG standards."

She adds that factory management cannot be relied upon to disclose they are using forced labour. "In fact, they never admit to it, even when challenged directly."

Like all social imperatives, cleaning up supply chains will come at a cost, but given the implications for international security, one suspects the issue of modern slavery and supply chain management is swiftly rising in priority. 

If not China, then where? Investors will be keeping a keen eye peeled.

In the United States at least, there is a strong push for investment in on-shoring, which would require considerable infrastructure spend. Many nations are also eyeing India.

Social concerns, such as health & safety, are already recognised as factors that have the potential to destroy long-term shareholder value, as has been the case with various mining disasters.

But even treatment of contractors is in the spotlight.

Cimic Group ((CIM)), for example, has fallen foul of “social” expectations for its factoring practices and supplier and contractor payment practices. Assuming the infrastructure boom arrives, it is possible that time-pressed suppliers and contractors might deprioritise them.

Much will depend on labour supply post-covid but Australia is generally short of skilled tradespeople.

Lendlease ((LLC)), meanwhile, is being examined by the Australian Tax Office. Some sources say that tax is going to be a “social” issue going forward.

One of the company's developments in the Macarthur region was recently downsized after a battle with locals over land clearing that threatened the local koala population, which related not only to a green theme but the social theme, given the campaign was led by the community: 

"Experts have warned property developer Lendlease that its reputation as one of the most sustainable housing companies in the world could be damaged if it proceeds with a controversial development on the outskirts of Sydney," said the ABC.

Social bond issuance

Companies may be able to issue social bonds for the purpose of reorganising supply chains or domiciling operations, for example, giving them an advantage over those who have been unable to secure support.

The social bond issuance market may provide signals to the winners on this front, given companies will need to define key spending areas and performance metrics to attract stimulus funds.

In terms of growth/impact stocks, many investors are opting for ready-to-market biotech companies with several years of development under their belts and a proven technology with a competitive advantage; or health-tech companies in markets such as telehealth with ready-to-market software and hardware. 

These generally have low risks associated with manufacturing, such as on-shoring, and energy and water use; while dovetailing into UN Sustainability Goals of improving human health and reducing energy consumption by transferring interactions on-line.

Meanwhile, EuropeanIssuers, which represents more than 70% of European public companies is lobbying against legislation that will require company directors to take into account the interests of all stakeholders, including local communities and the environment, in addition to mandatory supply chain due diligence.

Without such legislation, it would be difficult for investors to have a sufficiently firm foundation upon which to take the "social" component of investing seriously at all. It would all boil down to a game of information and nous.

Regulation is a key social investment theme

From a social-risk perspective, interesting industries to watch will be the “wages of sin” sextet: weapons, alcohol, gambling, tobacco, pornography and nuclear power (although the latter industry has a considerable degree of backing for it in some quarters as a substitute for fossil fuels). 

The SIX Swiss Stock Exchange, for example, recently launched ESG indices in the Swiss equity and bond markets. For a company to be included in one of the 20 bond indices or two equity indices, it must secure an ESG Impact Rating of C+ and generate no more than 5% of its revenue from "critical" sectors, including coal and tobacco.

Education campaigns and media documentaries to wean people away from these industries are already on the rise. 

All face the very real prospect of regulation, although history shows that regulation typically just sends many such markets underground. 

Still, regulators can make life very uncomfortable and unpredictable for investors with a bit of tweaking here and there.

Fossil fuels are also considered a social risk, and may face regulation – although this is generally viewed under the broader green transition risk.

Business model resilience

Russell Investments also advises that one way investors can engage in ESG forecasting is by monitoring Business Model resilience and evaluating how a company is preparing for transition. 

This will include making social reform in return for social stimulus and ESG capital (which might include employing more people to enable a pivot to circularity where necessary).

Amundi, for example, has launched two early-stage "Improvers" funds, a take on the "best-in-class" concept, that contain companies that progress and continue to progress on ESG matters.

Corporate governance is also expected to have a material focus by improving transparency and accountability, and board and management remuneration and accountability.

However, this particular metric also takes a fairly regular battering. Michael West Media notes that only two Crown Resorts ((CWN)) directors resigned after the not inconsiderable scandal arising from the Bergin Report, which found several executives and directors should be considered unfit to continue. West also notes that Woodside Petroleum ((WPL)) dodged a massive clean-up bill in Bass Strait.

As has been the case in the past 30 years, the level and regularity of scandals, and their general lack of consequences, makes even covering such incursions tiresome and an unrewarding job for those tasked with maintaining any kind of narrative.

Something will have to change fast for the new narratives to gain credibility. Covid was the first shock. The world's biggest copper mine has been knocked back. What will be next?

Social materiality

It is difficult to ascertain how the “social” is going to fit in from a materiality aspect, and one suspects it could easily be deprioritised in the first instance as businesses rush to prepare for the green transition.

Ensuring a living and gender-equal wage, removing slavery from supply chains, and on-shoring will come at a cost, and will only prove material in the sense that institutions are likely to penalise offending companies by withdrawing capital, as they are doing with carbon producers.

Although now, the Oak Flat reversal suggests governments may also be willing to step in and regulate on social issues when self-regulation fails: another issue for investors to beware.

However, there is a considerable amount of literature about the long-term financial benefits to corporations from staff retention and low churn rates, and perhaps now is the time that investors will take these issues seriously.

Social scorecards monitoring performance against a range of social criteria are likely to proliferate. 

As tools to estimate materiality grow, difficult-to-weigh social criteria are likely to be first out the window; and staff retention and satisfaction are easily-weighed low-hanging fruit. 

The old hoary chestnuts – transparency and accountability

Apart from these standard metrics, determining materiality can be challenging, particularly for the social aspect of ESG, given the lack of ESG transparency in corporate reporting and the complexity of the area. 

What is materially relevant can differ from company to company and industry to industry; carbon being a more material issue for an airline than a biotech, for example. And a service company will have different social issues to a resources company.

Multinational corporations also operate in many different jurisdictions so global standardisation is needed.

Sustainability mapping should help with this.

The US Sustainability Accounting Standards Board (SASB) has merged with the International Integrated Reporting Council to create a global reporting standard. The first brush is expected to be available within about two years. 

The metrics chosen should provide investors with a standardised view into an organisation’s performance against sustainable criteria. Until that time, institutions are likely to direct capital to corporations they believe they can trust to carry out the social imprimatur.

Still, many less well-known quantities are jostling for funds, as Friends Provident Foundation, the Joffe Trust and Blagrave Trust discovered when fielding applications for their “ESG Olympics”.

The three published a "state of the sector" report based on the pitches received and noted many of the funds disregarded social criteria, investing in sectors with high social risk, or which have been in the news for fostering poor working conditions, according to RI.

Several pitches did not mention social issues at all, and many did not include social risk in their exclusions.

A foundation representative said that  "… there are also risks to the credibility of ESG as a concept if the approach taken is too piecemeal or tokenistic."

SASB materiality maps will be accessible to even small investors, as the numbers will eventually just be inputs in a spreadsheet, easily extractable by simple software. The cost of advanced software should also fall. 

Once in place, investors will soon be able to access corporate governance scores, social scores and open-sourced environmental data from multiple providers, including forecasting tools. 

For now though, they will have to use their nous and check sustainability highlights in annual reports.

Measuring circularity

The initial transfer of Oak Flat may have raised serious questions over the pace of circularity, (and circularity appears to be going nowhere fast in Australia, despite China's refusal to process Australian plastic) but it remains a key policy agenda for the next three decades.

But the reversal puts the narrative back in the spotlight.

It is one of the strongest investment lenses for ESG given that, all things being equal, circularity comes with that coveted "sustainability premium".

Meanwhile, the Global Reporting Initiative (GRI) has developed a tool to help measure a corporation’s progress towards circularity, which will also be critical to estimating a corporation’s business model’s resilience during the transition.

“GRI 306: Waste 2020 is the first globally applicable reporting standard for companies to provide a complete picture of waste impacts along their value chain,” says the Initiative.

The tool maps these waste disclosures against relevant Circulytics indicators, allowing companies to assess their performance towards achieving circularity.

“Circulytics from the Ellen MacArthur Foundation – the global thought leader for the circular economy – is a tool that enables any business to assess circular economy performance in its operations,” says GRI.

The tool is free for organisations to help inform their strategy in the transition to a circular economy. 

Elsewhere, JSS Sustainable Asset Management has rebadged a water fund as a "Green Planet" fund, according to RI. The fund continues its focus on ecosystems while launching investments in the circular economy, green energy and electric vehicles. It was among the top performing funds in its Morningstar peer group in 2020 and the shift recognises the shift in focus to "green" investing in 2021.

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