How does sustainability affect the way the finance sector views opportunities in extractives? We ask three experts, all of whom will be present at this year's Responsible Extractives Summit
From hydrocarbons to mining and beyond, the extractive sector is a capital-intensive industry, requiring investment at all stages to bring resources to market. It’s also an industry with direct exposure to and impact on the environment and society, so piques the interest of concerned investors. Working together, investors have often helped to raise awareness of good practice at companies of all sizes.
Energy in particular has always been of special interest in responsible investment circles, and affects analysis in many ways.
Paul O’Connor, JP Morgan’s executive director of global environmental and social risk assessment, says: “Fracking, water scarcity, the ‘unburnable carbon’ concept, and oil sands are things that we are looking at more as part of our role in implementing the JP Morgan policy on environmental and social risk.”
Such issues may have a variety of impacts – some at project level, others at a global, cross-industry level – which interest investors in different ways.
Social licence
Roman Novozhilov, senior environment and social specialist at the International Finance Corporation, points to some of the ways in which social impacts can affect operations. He says: “Social licence to operate is becoming really important, especially in developing countries, where you have weaker regulations, less ability to manage social expectations related to land use, very low levels of economic development, and high expectations of extractives companies when they first arrive. In some cases where it’s been mismanaged, the resulting social conflict can be very dramatic and detrimental to the project.” Other big issues receiving investors’ attention include water management and biodiversity impacts.
Investors are often accused of driving a short-term outlook that disadvantages sustainability performance, but this may be an inaccurate view.
Salazar highlights the 2010 Deepwater Horizon oil spill as a key example, which resulted in a plummeting of BP’s share price, and massive fines, in addition to the toll on the reputation of the company and its brand.
There are many other examples that point to a short-term impact of poor safety performance, such as Freeport McMoRan, which had a tunnel accident in 2013 that killed 28 people in Indonesia. The company had to stop work for more than a month, and had to cancel its shipments from the mine affected, as it couldn’t operate.
Similarly, in South Africa, there have been an increasing number of extractive sector safety-related stoppages, affecting output and therefore profitability. So, Salazar argues, the negative effects of a safety management system that isn’t suited to a company’s risks will be in the short-term, even immediate.
And such incidents can also hit the company’s long-term performance, affecting investors’ confidence compared with companies with similar investments but an excellent safety track record.
Unburnable carbon
On the long-term end of the spectrum is one of the hottest topics in responsible investment: the notion that some two-thirds of today’s known reserves of hydrocarbons must be left unburned in order to keep climate change within 2C of pre-warming levels – the limit that scientists agree is the maximum the planet can absorb without risk of catastrophic outcomes.
Whether this is referred to as “stranded assets”, “unburnable carbon” or even a “carbon bubble”, it is the subject of much speculation and study among responsible investors.
“Our clients are very interested in the stranded assets debate,” says Salazar. “What we want to achieve here is to be sufficiently comfortable that the companies we invest in understand the climate change risks associated with their investments in fossil fuels. These are risks that also take into consideration supply and demand factors, and by definition have a longer-term horizon.”
IFC’s Novozhilov says: “IFC is very serious about minimising the climate impact of our investments. We use various tools for tracking the greenhouse gas footprint of our projects and our portfolio as a whole. Reducing greenhouse gas emissions is on everyone’s mind, and has become a significant consideration for project finance. For example, coal mining has become increasingly unattractive to many international financial institutions.”
Supporting best practices
Whether they are involved in asset management, project finance or any other aspect of finance, investors and analysts are aligned in their desire to see good practices expand across the whole of the extractives sector.
JP Morgan’s Paul O’Connor says: “We want to work with clients that demonstrate the right level of management commitment and ability to manage their own risks. We assess that by reviewing their commitment, capacity and track record.”
Commitment is judged by reviewing evidence that suggests a company’s management “acknowledge, appreciate and recognise the risks” associated with their business. “This might be environmental management, industrial safety, resource efficiency or biodiversity, among others,” O’Connor says.
Capacity depends on the organisation’s ability to deliver its outcomes. “This takes the form of classic business controls – governance, functional heads, directors, departmental budgets, external consulting support, policies and procedures and others.”
Finally, according to O’Connor, to assess track record, “we ask what has been the outcome delivered by the company’s combination of commitment and capacity.” JP Morgan’s assessment would therefore look for legal compliance, any incidents or accidents, improvement over time, and the existence of baseline performance targets and objectives.
Better performance
As the private sector finance arm of the World Bank, IFC has been a key player in introducing sustainability management expectations, through the IFC performance standards, introduced in 2006 and updated in 2012.
According to Novozhilov, these standards play an important role in IFC’s relationships with clients. “In our initial project assessment, we evaluate the gaps in relation to the objectives expressed in the performance standards, and based on those gaps, we structure corrective action plans for our clients to reach those goals. If the environmental and social risks of proposed projects are too high to be effectively mitigated, or the company’s commitment is insufficient, we consider whether we will be involved or not.”
Making such assessments relies on good information flows and communication between investee companies and analysts. Experts agree on how important it is for a company to understand the value of communication and work to meet investors’ needs.
JP Morgan’s O’Connor says: “We try to sensitise people to the importance of communication. A lot of investor groups are using ESG [environment, social and governance] as a differentiator, trying to actively select investee companies good at ESG management. Where our emerging market clients are concerned, they need to be especially aware of this – investor orientated groups could screen them out if they’re not careful about communications. We want our clients to work towards achieving that ‘blue chip’ status.”
Information quality
But how well are extractives companies doing in meeting investors’ expectations for information and communication? The extractives sector produces some of the best sustainability reports and communications – but that quality is nevertheless inconsistent.
F&C’s Salazar says: “Extractives companies have come a long way in their sustainability reporting – they provide clarity on material risks, and that’s very helpful. Reports used to be huge; now they are concise, to the point, with more information available on company websites. They are addressing the issues we like companies to address.”
Novozhilov argues that there is often a difference in quality between major operators and smaller or younger companies. “Usually, larger companies with more developed corporate structures report sustainability information better. This sector is also served by a very large and capable industry of environmental and social consultants, who are well-informed at the project level.”
O’Connor agrees: “The big operators have been used to doing this for the past 20 years, they spend a huge amount of time and effort on reporting, and produce credible information. Other companies are just starting on the journey, making some good efforts and working to improve.”
Next steps
Nevertheless, experts are keen to see reporting develop even further.
“On emerging issues, including stranded assets and human rights,” Salazar says, “we are more focused on developing a consensus on what companies should measure and report. For example, the Ruggie principles [on business and human rights] have been out for three years, but there are still a lot of questions on what sort of indicators we would find helpful for companies to measure. We’ve also heard from companies that they are being asked to disclose different things for different investors, so it’s very challenging for them to come up with reporting that caters to the needs of everyone.”
There is also concern about the lack of convergence in reporting frameworks of relevance to companies and investors alike.
“I think this is similar to where the accounting profession was many years ago: not until the profession introduced accounting standards was there real uniformity in financial accounting,” says O’Connor. “Where sustainability is concerned, the frameworks are there or being developed – including the Global Reporting Initiative, integrated reporting and Sustainability Accounting Standards Board – but there are huge numbers of companies that are only getting started.”
“There needs to be convergence on reporting frameworks,” says Salazar. “We are concerned the frameworks are battling against each other in playing to their own strengths, and they run the risk of confusing companies. I don’t see the convergence happening, and that doesn’t bode well for all the progress that’s already taken place.”
Hear more from Paul O’Connor, Roman Novozhilov and Juan Salazar at Ethical Corporation’s Responsible Extractives Summit in June, which will bring together experts from across the extractive sector. Also present will be Unilever, Rio Tinto and BG Group amonst others. Ethical Corporation's RES is the world’s leading meeting place for senior executives looking to put sustainability at the heart of their business operations.
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