Ethical investing: What are ‘ESG’ metrics and are they the zenith of being ethical?
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Last week in our series on ethical investing, we heard Vanguard’s process for choosing an ethical investment. But the most important aspect is judging whether or not a company is ethical and ESG (Environmental, Social and Governance) metrics are one way to determine this.
It is difficult to track this on a small cap basis because many do not. But Oxford University professor Robert Eccles recently told Harvard Business Review the gradual rise of ESG disclosure is just like the rise of accounting standards.
He noted that before the Great Depression there were no uniform standards for accounting but now, “that is a bedrock for the capital markets”.
“Think of it as plumbing or infrastructure. We don’t have that plumbing or infrastructure for environmental, social and governance information, and I think until we do, it’s going to be very difficult for companies to manage their performance, to report on their performance, for investors to be able to evaluate their performance.”
Here’s Stockhead’s overview of basic ESG metrics.
The most obvious environmental impacts are energy consumption and greenhouse gas emissions. But industrial waste and water consumption are just as important.
It is easy to point the finger at miners but tech companies are arguably just as culpable.
By encouraging people to buy more of their products tech firms are encouraging more energy consumption and waste in landfill.
Even some healthcare firms do not have clean hands, some of their activities (particularly with chemicals) can cause water contamination, soil depletion and biodiversity loss.
Unfortunately, for all but the largest companies, the most ethical investors can do is look at the impact of entire sectors.
Again, it is obvious to think of charity donations and activities. But to treat them as the “be all and end all” of social ethics would make them done in vain.
Social impact can be measured within a firm’s operations, two examples of social metrics are employee turnover and incident rates.
A company with high employee turnover likely has problems. Delisted retailer Sunbridge Group (ASX:SBB) was suspended when two directors quit, leaving it with just one. Initially the company did not provide a reason, which intrigued the ASX.
It turned out they resigned due to their concerns about company dysfunction, including non-payment of salaries and the implications of the one remaining director in suspected fraud.
Even if incidents occur, the way firms respond to them are critical. Mid-cap NRW Holdings (ASX:NWH) announced on Monday that one of its workers died on the weekend at the Baralaba North coal mine in central Queensland, which is operated by a NRW subsidiary.
NRW extended its condolences to the workers’ family, friends and colleagues and provided the latter with access to counselling services. It also launched an investigation with the Queensland police and mining inspectorate and has halted mining operations at the site.
In contrast, Ardent Leisure (ASX:ALG) was widely condemned for its response to the Dreamworld tragedy. It was accused of being disrespectful to the victims and their families by talking about the revenue impact the tragedy would have on its bottom line.
Traditionally, the sole factor for governance is the ability to achieve profits. One factor, however, is the number of women on the board. Earlier this year Stockhead found less than 24 per cent of small caps had at least one woman on their board. There are exceptions though: 60 per cent of Alexium International’s (ASX:AJX) board are women and half Australian Ethical Investment’s board are women.
A second factor is executive pay. This could be considered in isolation or compared to average employees. Alternatively, as a proportion of operating expenses, market cap or profit.
One company that caught our eye was Freedom Oil and Gas (ASX:FDM), which spent $US1.2m ($1.7m) in executive compensation in 2018 ($US800,000 of which was to chairman Michael Yeager) and the company’s annual loss was $US900,000.
You could look at the percentage of independent directors and equity owned by the executives. Prior to his departure and consequent share sale, Frontier Resources (ASX:FNT) director Yun Wei Dong held 68 per cent of that company.
When individual executives, or even an entire board, hold such a high portion of shares it limits the power of all other shareholders.
But are ESG metrics the “be all and end all” answer to the question of being ethical?
Last week JP Morgan released its annual ESG path finder. The two takeaways for this author was that a company’s “ethics” are determined on a holistic basis considering all of a firm’s activities.
Here’s a local eyebrow raiser: two of JP Morgan’s three top rated companies for disclosure were National Australia Bank (ASX:NAB) and BHP (ASX:BHP). How could the bank worst hit by the Royal Commission and Australia’s largest miner be “ethical”?
JP Morgan acknowledged customer and employee satisfaction was falling at NAB. But it liked three particular traits in the business. First, NAB’s $55 billion Low Carbon Shared Portfolio; second, that at least 40 per cent of either gender was represented at all levels of the business; and third, micro-finance projects for low-income Australians.
As for BHP, JP Morgan was swayed by its support for gender diversity in its executive leadership team, support for Indigenous recognition in the constitution, disclosure of its payments to governance, and battery metals becoming an increasingly large part of its business.
However, it acknowledged BHP’s water intensity was on the rise and a class action loomed from its Brazilian dam failure. It also noted Norway did not see BHP as ethical enough to remain in its sovereign wealth fund.
Another takeaway (explicitly stated by the Wall Street bank) is that once you’re disclosing, its a habit that sticks. JP Morgan noted companies in the top and bottom of ESG rankings have stayed there. Director Stephen Blagg argued, “There appears to be a degree of inertia in company ESG disclosure”.
Evidently even if you’re not perfect, it would seem honesty is a great policy in JP Morgan’s eyes.