Above The Fray

ESG: It’s Complicated

The following article, authored by Jeffrey Stacey, was published in the Toronto Star on March 8, 2021 with the title “Socially aware investing far more complicated than it looks”.

ESG Investing is one of the most important topics in the current Investment landscape with fundamental importance to the future of our planet. ESG is an acronym for Environmental, Social, Governance.  Investors who embrace ESG attempt to incorporate these parameters explicitly into their investment decisions in addition to traditional economic and valuation considerations. In my experience, most investors want to invest in companies that treat all its constituencies fairly. This includes shareholders, certainly, but also employees, customers, suppliers, and the communities in which it operates. Most investors want to own companies which produce goods or offer services that provide some form of utility that benefits society. Specifically, investors want to invest in companies that embrace diversity, inclusiveness, and equality of opportunity; that are good environmental stewards; that act ethically and legally; and that demonstrate appropriate corporate governance.

One of the fundamental difficulties that confronts any investor who genuinely wants to incorporate ESG considerations into their investment decision making process is that it’s complicated. What seems like a simple and important idea, which it is, is not so easy to do. Part of the difficulty lies in the plethora of different rating systems that have arisen to help investors make decisions based on what constitutes ESG best practices. Most of these systems apply a checklist approach to judging companies against all the various ESG considerations and come up with a grade. A company either passes or fails. These ratings systems are both mechanistic and absolute. In my view, we live in a messy, nuanced, difficult, yet exciting and stimulating world that requires investors who are serious about ESG to think about investments comprehensively and attempt to parse what is going on at a company contextually.

Let me provide some examples to attempt to illustrate what I mean. On behalf of our investors, our firm owns shares in a financial services company that has a dual class share structure. In most ESG circles, this is considered bad corporate governance and as such this company would have that box checked with a fail. In this case, I think the record definitively proves that all of the company stakeholders have been well served by this structure primarily because it has allowed the company to embrace a longer term time horizon than might otherwise have been the case. I believe that what might constitute good governance practice in most cases may not be the best answer in all cases. It requires thoughtful, reflective judgment, not box checking.

We own shares in a mining company with an open pit project in Canada’s far north. I am certainly cognizant that this project is in an area of pristine wilderness and sits on traditional Indigenous land. Most ESG rating systems would immediately deliver a failing grade to this company because it is fraught with environmental risk. When parsing the situation contextually, it should be noted that the mining process at this mine does not involve the use of significant chemicals as part of the extraction process. The mine has an award-winning reclamation plan that will be used to restore the area at the end of the useful life of the mine in 25 to 30 years. Local Indigenous leaders were consulted and involved at every stage of the development process and are fully supportive of the mine. At the opening ceremony for the mine, local Indigenous leaders performed a traditional native ceremony to bless the mine. It should also be noted that the mine is providing good employment opportunities for many local people. While I understand the failing grade this mine receives based on a traditional ESG scorecard, in my view a more subtle, nuanced perspective gives this mine a passing grade overall.

We own shares in two financial companies that have directors who are over 80 years of age.  One of the checklist items in most ESG rating systems is having mandatory retirement ages for board directors as a company policy. In the case of these two companies, I will just state that the directors, who would be forced to step down under most ESG compliant checklist systems, are harder working, more skilled and energetic than most 50 year old people I know. They are performing their duties exceptionally well on behalf of shareholders. Again, what may be right in most circumstances may not be right in all circumstances.

We own shares in a natural gas energy company in Africa. If the examples listed above seem controversial, I can safely state that owning companies engaged in fossil fuel production is ground zero in any ESG discussion for many investors. For many, owning fossil fuel companies is an immediate fail from an ESG perspective. Let me be clear that I fully support the efforts to develop all renewable energy sources. I believe that the world needs to embrace renewables and stop the use of fossil fuels to the greatest degree possible as quickly as possible to secure a future for our planet. However, I also believe that this situation is much more nuanced than many might believe. Even those who are unwilling to invest in fossil fuel companies in any form will begrudgingly acknowledge that natural gas is cleaner and less polluting than oil or coal from a greenhouse gas emissions perspective. In this situation, the company sells most of its natural gas to the state electric power utility which in turn uses it to produce electric power for the country. The natural gas is required for roughly half the year when the rivers dry up and are unable to facilitate the production of hydroelectric power. If the natural gas was not available, this African country would go dark for a good part of the year which would likely result in significant environmental and social consequences. Quite frankly, at present this is the best and only energy alternative for this African country. The company has been a model employer in the country having built homes, schools and a hospital for its employees working at the natural gas development. The work force is almost entirely comprised of locals. So, while I respect anyone’s right to differ, I cannot give this company a failing ESG grade.

While we have no ownership in battery electric vehicles at present, I think this an interesting ESG discussion. If fossil fuel companies are ground zero, then battery electric vehicles are the current champion of the ESG movement.  I think that almost everyone would agree that battery electric vehicles bring a huge environmental benefit to our society. Certainly, I believe that. However, the case is not a perfect one and it illustrates the need to take a nuanced and contextual view when thinking about how to make investment decisions based on ESG considerations. At present, most batteries use cobalt as the prime cooling agent. It is estimated that about half of the world’s supply of cobalt comes from the Democratic Republic of Congo. A few years ago, Amnesty International reported that as much as 25% of the labour force mining cobalt in Congo are children including many as young as the age of seven. Given the deplorable working and safety conditions also documented by Amnesty International, it is a certainty that many children die every year working in these mines. While I am not suggesting that this human tragedy invalidates the positive environmental scorecard of battery electric vehicles, it does highlight the nuances involved in making ESG judgements. A further issue that has not been widely commented upon is how to effectively repurpose or dispose of spent electric vehicle batteries. While I claim no expertise about this, it does strike me as a significant environmental challenge. Finally, I know that Bill Gates, a real champion for tackling some the world’s most difficult environmental and health issues, has been actively investing for several years in battery development start-ups that use less or no cobalt and other metals but can still deliver performance efficacy. While that is certainly great news for society, he has admitted that he has lost more money than anyone else on the planet in trying to come up with solutions to this issue.

So where does this discussion leave us? I would suggest that investing with an ESG lens is important, perhaps critical, to the survival of our planet for our children and grandchildren. Understand and accept that incorporating ESG practices into your investment decision making is complicated and not easy to do. Recognize that we live in a messy, nuanced, difficult yet exciting and stimulating world that does not lend itself to making investment decisions based on simplistic checklists that deliver passing or failing grades. Don’t be afraid to bring your personal perspective in thoughtfully reflecting on any potential investment you are contemplating. I believe that most investors want to do the right thing and that those embracing ESG considerations in their investment decisions will only continue to increase over time.

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