The resignation of Rio Tinto senior executives after the destruction of Aboriginal sacred sites has again highlighted the reputational risks faced by natural resources companies. But both active and passive funds with an environmental, social and governance (ESG) remit continue to own companies like Rio. Where does that leave investors?

We need natural resources

Ashley Hamilton Claxton, head of responsible investment at Royal London Asset Management, thinks investors may have to consider mining companies like Rio in their portfolio, despite their history of controversies. She says the low-carbon transition is to some extent dependent on mining companies’ activities: aluminium and copper, for example, are used to make electric vehicles.

While ESG funds can take a variety of approaches, Hamilton Claxton says the lines of what an ESG fund is and what it can invest in has blurred as more money pours into the sector. “It’s becoming less common now for a fund to say, ‘you’re a bad company and we’re going to exclude you’,” she says.

Signs of improvement in companies with a chequered past are considered, she says, and the priority now is engagement—making companies change their ways—rather than exclusion.
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Mining companies in general do a “decent job of managing the ESG risk they have”, Claxton adds. An example is how these firms have responded to Vale's Brazil dam disaster, which killed more than 250 people in 2019, to prevent a similar incident occurring again. Beyond large-scale disasters, she says mining companies are more conscious of their day-to-day environmental impact. They are, for example, replacing diesel trucks that carry raw materials with electric vehicles.

Passive ESG investing

But many ESG-focused fund investors may still feel uncomfortable owning mining stocks. Rio Tinto is held by several funds, passive and active, with an ESG mandate. These include the Legg Mason Martin Currie Ethical Income Fund, the Maple-Brown Abbott Responsible Investment Fund, and the SPDR S&P/ASX 200 ESG ETF (ASX: E200), according to Morningstar data.

This occurs globally. In the UK, the ASI UK Responsible Equity Fund, the Schroder Sustainable Multi-Factor Equity Fund and the Royal London UK FTSE4Good Tracker Trust all hold the stock.

The SPDR fund tracks the S&P/ASX 200 ESG Index which counts Rio as its ninth largest holding. The index is designed to "measure the performance of securities meeting sustainability criteria, while maintaining similar overall industry group weights as the S&P/ASX 200 Index". This market-cap weighted approach will therefore feature the largest ASX-listed companies.

The index does actively remove some stock. Companies that are involved with tobacco-rated products and services and controversial weapons are excluded, as well as those that hold low scores from the United Nations Global Compact (“UNGC”) and the lowest 25 per cent of companies within industry groups, ranked by S&P DJI ESG Scores. Top ranking ESG companies relative to industry peers are also included.

Head of SPDR ETF Asia Pacific Distribution Meaghan Victor said the ETF, which listed in late-July, sought to meet investor demand for ESG-linked products and serve as a building block for diversified portfolios.

"We're giving investors more choice to be able to align their investment strategies with their values, but also recognising that they're able to do so in such a way that's going to provide them a similar risk, return profile to SPDR S&P/ASX 200 ETF (ASX: STW)," she told Morningstar last month. "This could be a core holding in their portfolio."

Asked about a hypothetical investor's objection to including Rio in the index after the Juukan disaster, Victor says there needs to be room for multiple approaches to ESG investing.

"People have different views of E, S and G—your view might be completely different to mine," she says.

"When we're looking at the companies that are included or excluded, I go back to the process from an S&P Dow Jones indices perspective.

"Every company may be in a situation where on the E, the S and the G that they're screened for, they might have different ratings for each of those scores, which means that their rating is not necessarily as high or as low as others in their industry.

"It's about choice. With any investment, not everyone is going to be open to every stock that's in that portfolio.”

Active approach

Some ESG funds are responding. Ausbil's Active Sustainable Equity fund dropped Rio from the portfolio in August, noting the Juukan Gorge blast. The company featured in the fund's top 10 holdings just a month earlier. Ausbil said they were "continuing to engage with Rio regarding the blast", including a "discussion with the company about their submission to the joint parliamentary inquiry".

Several major Australian superannuation funds spoke up in the months following the blast, saying that the bonuses forfeited following the company's internal review didn't go far enough.

Rio's statement accompanying the board changes suggested that investor pressure had been brought to bear: "Significant stakeholders have expressed concerns about executive accountability for the failings identified.”

Has Rio done enough?

Janus Henderson natural resources manager Tal Lomnitzer says the resignations draw a line under the controversy that the loss of bonuses couldn't achieve.

"We support the management change announced by Rio Tinto’s board in response to the destruction of culturally significant sites in Western Australia," he says. "Our investment process places great importance on ESG considerations and our team had been calling for further action following the Juukan Gorge debacle."

Morningstar mining analyst Mathew Hodge says that a clean sweep of Rio's board will help the company and investors move on.

"We think new management will do what it takes to avoid a recurrence of the Juukan Gorge mistake,” Hodge says.

ESG ratings agency Sustainalytics (a subsidiary of Morningstar Inc) downgraded Rio Tinto's Community Relations Event Rating to a Category 4 late-last month and warned of heightened ESG risks stemming from damage to the company's social licence to operate.

A version of this article originally appeared on Morningstar.co.uk.