Balancing returns while excluding mining

Domestic investors need to balance their desire for the yield provided by mining companies with their ethical values as the sector’s large stockmarket weighting in Australia makes this a harder decision than in global portfolios.

As issues such as Juukan Gorge, where Rio Tinto was accused of ‘cultural vandalism’ for destroying two 46,000-year-old caves, flare up in the news, more investors are asking their advisers about the possible consequences of excluding mining companies. However, the 18% weighting in the Australian Securities Exchange (ASX) is far larger than the weighting in other countries.

Australia is the world’s largest exporter of iron ore and coal, particularly to China which depends on the country to support its resource demands for its infrastructure plans. During 2019 to 2020, exports of iron ore accounted for 56% of all Australian goods exported to China. 

According to the Australian Bureau of Statistics, mining recorded a growth of 4.9% during 2019 to 2020 which was driven by increased capacity at oil and gas extraction facilities. Metal ore mining also recorded a strong year driven by iron ore due to international supply disruptions and increased demand from China.

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But research by the Responsible Investment Association of Australasia (RIAA) found two-thirds of investors consider environmental issues as the most important theme they would want to avoid in their investments. This was in response to the growing threat of climate change, evidenced in Australia’s bushfires, floods, and droughts.

This was subsequently being reflected in the activities of firms with the most common negative screening being for fossil fuel exploration, mining and production companies followed by companies which generate power using fossil fuels. 

But some commentators are worried that excluding such a large sector would contribute to lower diversification and higher active risk within a portfolio.

Stephane Andre, principal at Alphinity Investment Management, said: “If you excluded energy and mining then you would be withdrawing close to quarter of the index. You could still outperform if the market was under pressure but when they are going through a cyclical recovery like we are now then you would struggle if you were out of them.

“You would have to be concentrated in other sectors such as consumer discretionary, IT, and healthcare but they have their own ESG challenges. It is not impossible but it would be challenging, excluding miners would be a serious constraint.”

The largest mining companies were BHP, Newcrest Mining, and Rio Tinto while others included Fortescue Metals, Whitehaven Coal, and Pilbara Minerals.

Over the past 12 months to 25 February, 2021, Pilbara Minerals returned 310%, Fortescue Metals returned 164% while Rio Tinto and BHP both returned 46% compared to returns by the ASX 200 of 2.3%. The performance of the first two firms was on par with some of the best-performing stocks such as Afterpay (262%) and Temple and Webster (179%).

“If you exclude Fortescue Metals then you would need to hold a lot of Afterpay,” Andre added. 

Rachel Farrell, chief executive of J.P. Morgan Australia, said: “With regards to it being a high-yielding sector of the index, there are other ways to generate yield such as unconstrained fixed income or credit, you would need to generate 3% to 4% to make up for what you would be giving up. But you would need to rebalance and perhaps have more in financials instead.

“If a client was set on exclusion, we might direct them to a fund with an ESG [environmental, social and governance] tilt but there is still a lot to be defined there and parameters set so we are all speaking the same language. Europe is already there and Australia is right behind,” said Farrell. 

However, commentators pointed out that mining companies were not necessarily the ‘villain’ of the stockmarket despite their poor ESG reputation. As well as improving their

ESG profiles, many companies were pivoting their business models towards minerals needed for renewable energy such as lithium and copper. They also suggested advisers encourage their clients to focus on the individual companies, rather than taking a broad-brush approach and excluding miners completely.

Daintree Capital senior credit analyst, Brad Dunn, said: “Investors need to be very clear on their philosophy, if they are against it for environmental reasons then yes, mining has a severe impact. But we think there is lot of mining that is OK because we want to see more renewable energy and that needs a lots of resources such as lithium for batteries and copper for it to move onto the next stage”.

“Most companies have taken positive steps and some are no longer even active in those areas, there are some companies which are better than others, some which people think are villains are not. The change has been huge, meeting the goals of the Paris Agreement is not easy but there is commitment to the goal which is positive and willingness to address these issues,” Farrell said.

ENGAGEMENT V EXCLUSION

An alternative to exclusion would be holding onto the companies and trying to positively engage with them on topical issues. It was important to question firms on how they were enacting ESG principles and demand evidence on whether the process was working. 

Relating back to the Juukan Gorge issue at Rio Tinto, Aberdeen Standard Investments, which was one of the firm’s largest shareholders, said it had been ‘saddened and deeply concerned’ by the action. It said it expected companies to comply with local laws and regulation, incorporate additional standards into their operating systems and be fully transparent about their approach and their progress.

In response, Rio Tinto said: “It is our collective responsibility to ensure that the destruction of a site of such exceptional cultural significance never happens again, to earn back the trust that has been lost and to re-establish our leadership in communities and social performance”.

A change in recent years, Aberdeen Standard ESG investment director Danielle Welsh-Rose said, was the focus on outcomes rather than purely process. 

“We have access to Rio Tinto if we need to talk to them and we have already engaged reactively in the past. Engagement is part of the investment process to understand the culture of the company, we do it pretty regularly and disinvestment would be the last step, only if they were not handling risks appropriately,” she said.

“Investors are asking for evidence of what firms are doing to support things like the Paris Agreement and wanting them to demonstrate they have a plan or are successfully shifting their business models.”

This was echoed by Andre who said, even if a firm had good ESG ideals, it was important to test those out, to ask for transparent data and conduct independent surveys.

Emma Pringle, head of ESG at Maple-Brown Abbott, said: “Engagement is essential, it can protect invested capital and help make better informed decisions. For fund managers to understand a company’s exposure to climate risk we need to understand how the company is assessing and dealing with those risks. 

“The feedback loop is clear, there is no doubt companies understand how investors view climate risk and we have seen examples of companies such as BHP benefit from being proactive in their engagement.”

Dunn said: “We have excluded fossil fuels and energy but kept materials, we will hold them and engage when appropriate. We hold Fortescue and they are very clear about what they do and why they do it, projects need to be done in the right way and if they make decisions which don’t gel with that then we will go down the engagement route”. 

As a fixed income manager, rather than equity, Dunn said ESG engagement tended to come up when a firm was issuing a new bond. 

Commentators also focused on the ‘social licence to operate’ of mining companies, which was defined as the perceptions of local stakeholders that a project or industry that operated in a given area was socially acceptable or legitimate. 

Federated Hermes engagement lead for industrials and capital goods, Jaime Gornsztejn, said: “Investors and clients of mining companies expect them to secure their social licence to operate by developing a mutually constructive relationship with the communities where they operate, including a sustainable legacy that endures beyond the life of a mine.

“The safety of employees, contractors and communities must be a top priority for mining companies with a strong ‘tone from the top’ by senior management and the board of directors. We see the safety performance also as an indicator of the quality of management.”

Andre added there had been a transition away from a focus purely for health and safety to one focused more on climate and wider issues.

“It is about treating the community and the environment well, miners have a huge focus on this because any mistake will create huge reputational damage. They used to focus on health and safety and local employment but this focus has shifted to heritage, decarbonisation, climate change and modern slavery. The ones doing this better are the ones who have a good culture and systems in place,” he said.

Ultimately, commentators said the transition was underway but mining would remain a large part of Australia’s economy for years to come. If investors were considering exclusion, it was up to the adviser to understand their clients’ individual philosophies, their ESG preferences and how much they would be willing to sacrifice for returns. 

“The volume of resources in Australia is both a blessing and a curse,” Farrell said.