As we’ve written in previous ESG Diaries (Defining the Value (and Limits) of ESG Integration), identifying risks and flagging portfolio holdings involves looking at ESG from multiple angles. For example, you can focus on absolute risk scores, industry/sub-industry relative rankings or by controversy. Each has a distinct purpose and responsive action has varying impact on portfolio composition:
- Focusing on industry-relative scores will enable you to preserve sector weight, while agitating for a shift to the best ESG performers within each industry
- Focusing on absolute scores will put pressure on your ability to have exposure to certain sectors
- Focusing on controversies allows you to identify holdings which have had specific incidents that may impact stakeholders, the environment or the company’s operations
Our approach (Five Things We’ve Learned About Our ESG Approach) starts with a sweet based on industry-relative scores before turning to controversy. We had identified risks and taken actions in response to the former, but there was something not wholly satisfying about beginning to understand how meaningful an absence of policy or engagement with the ESG service providers was in penalizing companies versus actual instances of wrongdoing.
There is a logic to this, of course – an absence of policy is an indication of risk that is more forward-looking in nature, whereas controversy tends to be more backward-looking. Each perspective has its role, but the nice thing about looking at a company with evidence of controversy in its past is that it gives you the opportunity to see how a given company has responded, made remedy and taken concrete actions to reduce the likelihood of repeat.
We use Sustainalytics as our third-party provider for ESG data and analysis. The process they carry out to identify and evaluate controversy is as follows:
- News monitoring for events that may have ESG significance
- Identification of incidents and events through further research and aggregation
- Controversy analysis across a set of 10 topical areas and classified by severity
- Outlook for how the rating will evolve
Let’s consider this in the context of an example, Freeport McMoRan Inc.
As you might logically expect from a mining company, Freeport was flagged for high controversy in environmental impact of operations and social impact on community.
Freeport operates the Grasberg mine in Indonesia, one of four mines in the world to use riverine tailings disposal, which is banned in most countries. Simply put, tailings are discharged directly into a river system.
NGOs and local communities have raised persistent concerns about potentially irreversible environmental degradation, impacting agriculture, human health and wildlife populations. This has been going on for five decades now and the company maintains that, for technical reasons, there is no viable alternative to manage mine waste, despite it not being supported as best practice by mining industry guidelines, the World Bank Group and the International Maritime Organization.
There’s a great deal more detail on what the company has done to mitigate and remediate the damage, but the final analysis is that the outlook around this risk is neutral. In other words, there is no expectation of material improvement and Indonesian state investment in the project further muddies the waters from a regulatory and conflict of interest perspective.
Mining is a tough business to execute without impact on the environment and proximate communities, but we determined that the risks to this investment stemming from this issue were particularly material and persistent and decided to exit the position from the fund in question. This was a valued-based decision, but also taken in light of how this information changed our perspective of risk/return and our ability to replace the position with a comparable one, if necessary.
This decision, and others like it, are representative of how we are integrating ESG into funds across our product lineup. We believe this has improved the sustainable impact of our funds to some degree, and critically for our clients, will result in higher-quality returns over the long-term.
— Graeme Cooper is Vice President of Product at Purpose Investments
All data sourced from Bloomberg unless otherwise noted.
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