Indigenous Rights and Reconciliation are Material: How Can Investors Support Due Diligence?

Investors across the country recognize the importance of ensuring Canada’s transition to a net-zero economy distributes the benefits and challenges fairly among Canadians—often referred to as a Just Transition. At the center of the discussion are Canada’s Indigenous peoples, who have historically been excluded from the benefits of Canada’s economic successes, while also bearing the brunt of its environmental and social fallout. For investors today, this translates to Indigenous rights and reconciliation risks and opportunities related to their investments. 

With Canada’s mining sector expected to grow to meet demand for the minerals and metals to green the world’s infrastructure, investors have to evaluate how companies are considering Indigenous reconciliation and rights issues in the near term. For example, as recently as October 2022, an Australian company walked away from two mining projects in Quebec due to opposition from the Kebaowek First Nation. There are various ways that these are material to investors, making improvements to related disclosures from issuers essential.

Why Corporate Disclosures on Indigenous Rights and Reconciliation Are Material

The moral case for ensuring Indigenous communities and their lands are treated appropriately is clear and self-evident for investors of all types; the Truth and Reconciliation Commission provides a historical account of past and ongoing atrocities committed against Indigenous peoples. The “business case” for investors is also substantial. It includes several key considerations:

  1. Delays – delays on large mining projects from failing to account for the impact of development on and near indigenous lands can cause major financial losses. Perhaps one of the most famous examples is the Dakota Access Pipeline (DAPL), originally estimated to cost $3.8 billion USD, which ended up costing the Energy Transfer Partners (ETP) closer to $7.5 billion. In its own court filings from the period, ETP estimated a year’s delay on the project would cost $1.4 billion, and even a temporary delay at $430 million, with demobilization costs alone $200 million. 
  2. Public perception and partnerships – during the DAPL case, over $5 billion was divested from banks which funded the pipeline. Individual account holders, Indigenous tribes, and cities such as Seattle divested from Wells Fargo and other banks over concerns about the lack of responsiveness to Indigenous claims. 
  3. Share prices – when it became clear via a lawsuit from the B.C. Court of Appeal that Minera San Rafael, a subsidiary of Pan American Silver operating in Guatemala, was not disclosing opposition from the local Indigenous Xinca communities, share prices fell from $27 to $5.
  4. Lawsuits – A string of lawsuits resulted from the above case, along with the suspension of the mining activities by the Guatemalan court. Legal disputes continue beyond Canada’s borders, with ongoing attention to international subsidiaries headquartered in Canada. 

Many investors may still require guidance on how to ensure these issues are reflected in a company’s disclosures and in their investment decisions.

Approaches to Improving Indigenous Rights and Reconciliation Disclosures

A key step for many investors to consider is company Reconciliation Action Plans. These plans lay out clearly and publicly an organization’s goals and roadmap for how they will engage and collaborate with Indigenous communities, often in the context of key frameworks, including:

Reconciliation Action Plans are an important tool that investors can request and review to see how a company is progressing in its work towards improving Indigenous disclosures and beyond. Investors should look for quantifiable goals, clearly disclosed methodologies, and mechanisms that provide regular updates so stakeholders can gauge progress. Investors can ask follow-up questions even if no Reconciliation Action Plan is available, including how and where these and other frameworks are addressed. 

Further questions investors can ask of their asset managers and issuers:

  • What has been submitted to regulatory bodies/government or other third parties with respect to Indigenous permitting and disclosures? Where can investors and the public access this information?
  • What issues have been flagged when carrying out due diligence with respect to Indigenous rights, title and lands? How is the company addressing them?
  • How are subsidiaries and contractors/subcontractors accounted for and involved in this work? What are the processes and where is the reporting to ensure they also comply with the above?

While legislation which reflects much of the issues above may arrive soon in Canada, investors need not wait. The moral and business case is clear for investors. Asking these questions is a first step to ensuring due diligence in Indigenous rights and reconciliation disclosures, and ensuring material considerations for communities and portfolios are successfully managed.

We thank Joseph Bastien and the Reconciliation and Responsible Investment Initiative (RRII) for their contributions to the research involved in this article.

How Investors Can Amplify Human Rights Issues at Information and Communications Technology Companies

Human rights are fundamental – the bedrock of society. Yet, our society is constantly confronted with risks to those rights, and digital rights issues have been prominent in this discussion. 

In this dialogue, Michela Gregory of NEI Investments and Anita Dorett of the Investor Alliance for Human Rights discuss the benefits of investor collaboration on human rights issues, especially in the information and communications technology (ICT) sector. 

The Investor Alliance for Human Rights is a collective action platform for responsible investment that is grounded in respect for people’s fundamental rights. Investors have a responsibility to respect human rights, in accordance with the UN Guiding Principles for Business and Human Rights. The Investor Alliance has published the Investor Toolkit on Human Rights specifically for asset owners and managers to address risks to people posed by their investments. This toolkit provides the building blocks for investors to create their approach to addressing human rights risks within their organization and in relation to their investment activities.

Anita: Collaborating on human rights issues brings many benefits. By sharing knowledge and experience, investors can increase their understanding of human rights risks connected to portfolio companies, and how this is critical to long-term portfolio value. Collaboration increases investors’ leverage to push companies to undertake human rights due diligence that will enable rights-respecting business practices. It allows investors to engage with a broader set of portfolio companies through using shared resources.

The Investor Alliance also provides a platform for investors to converse with civil society organizations advocating for adversely impacted rightsholders. This collaboration provides insight into the human rights risks and resulting harms that will help inform investors’ engagements.  

Michela: In the course of our engagements, one challenge we’ve noted is that company attitudes toward human rights engagements can vary greatly. For investors to fulfill their responsibility to respect human rights, they must understand how their portfolio companies are responding to potential and real human rights impacts, and investors (and other stakeholders) are asking for robust reporting. 

Sometimes companies who may be ahead of their peers in addressing human rights impacts are more inclined to limit their public disclosures. Others may have strong commitments, but their actions are hard to assess due to limited disclosure. Collaboration in multi-stakeholder forums can allow investors to amplify informed, clear asks of investees. This is especially important as we are still in the midst standardizing disclosure expectations, even with resources such as the UN Guiding Principles Reporting Framework that provide guidance

Anita: Disclosure is a critical point, particularly when we talk about gaps in disclosure. The growing influence of the ICT sector has reconfigured every aspect of our lives, especially following the COVID-19 pandemic.

For example, Meta’s business model relies almost entirely on advertisement revenue, accounting for almost 98% of its global revenue in 2020. Meta relies on artificial intelligence (AI) that uses algorithmic systems to deliver targeted advertisements. However, there is little public disclosure on how these systems operate to determine the ads a user sees, nor whether there are any potential or real resulting human rights risks.

This past proxy season, investors filed a proposal with Meta asking them to conduct a Human Rights Impact Assessment (HRIA) on their targeted advertising policies and practices. The proposal secured 23.8% of the vote, which represents over 77% of the “independent” vote, once shares controlled by the CEO are discounted. This should send a clear message to the company that investors are demanding more on human rights. Similar proposals asking for HRIAs on various aspects of business operations or relationships were filed at Alphabet and Amazon, also with strong support from independent shareholders.

Investors recognize that respect for people and planet is at the core of long-term value creation. Assessing human rights risk in their portfolio requires investors to ask their portfolio companies to do the same. Companies should take an iterative approach to ensure their decisions on all aspects of operations and value-chain relationships account for and prevent adverse impacts on stakeholders and rightsholders.

But uptake of human rights due diligence has been slow and disappointing. The Corporate Human Rights Benchmark, which assesses the human rights performance of the 230 largest publicly traded companies in high-risk sectors, revealed that as of 2020, nearly half the companies scored zero on all five human rights due diligence indicators. More than 200 global investors representing over US$5.8 trillion in AUM, brought together by our organization, sent a statement to 106 companies calling for urgent action to implement human rights due diligence. Some investors indicated that in the absence of improvement, they would be prepared to invoke the proxy process to motivate laggards.

Michela: Even as we see more disclosure on human rights commitments, there is still much that companies are not disclosing about how they are implementing policies. Disclosure can help investors verify the type of action companies are taking on human rights issues. This is becoming an expectation, as we see regulations being passed in jurisdictions such as the European Union. 

Collaborating with like-minded investors positions us and companies for more mutually effective engagements. Of course, one of the key asks is for more disclosure around how companies are actioning their human rights commitments and policies. Through collaboration, we can increase our ability to make a meaningful impact.

RIA Disclaimer
The views and opinions expressed in this article are solely those of the authors and do not necessarily reflect the view or position of the Responsible Investment Association (RIA). The RIA does not endorse, recommend, or guarantee any of the claims made by the authors. This article is intended as general information and not investment advice. We recommend consulting with a qualified advisor or investment professional prior to making any investment or investment-related decision.

There’s More to ESG Than the Environment: Advisors Going Beyond Emissions

Over the past decade, interest in environmental, social and governance (ESG) has soared – with responsible investments (RI) accounting for more than 62% of all professionally-managed assets in Canada, according to the Responsible Investment Association (RIA) of Canada¹. Yet, many advisors are hesitant to bring up ESG with their clients. An RIA-led investor opinion survey found that 77% of investors want their advisors to talk to them about responsible investing, yet only 27% reported having had those discussions with their financial professionals².

If ESG is becoming a bigger part of the investing conversation overall, why aren’t more advisors bringing sustainability up to their clients? The problem is that ESG is still largely misunderstood, with many in the investment industry struggling to see beyond the E. 

Emissions are only one piece of the puzzle

To many, ESG is thematic, often seen exclusively through the lens of climate change. Journalists and experts have criticized ESG for having unclear goals, inconsistent measurement and too many objectives to be meaningful. One story goes so far as to say that ESG should be distilled into one simple measure: emissions.

While defaulting to the environment and even emissions is understandable – emissions are the most easily quantifiable ESG factor – that’s an extremely narrow view. If emissions were the only consideration, portfolios would be heavily weighted toward clean tech, alternative energy, and other climate-focused concerns. This also assumes investors only care about the environment, but social and governance issues, such as gender balance in the boardroom or fair labour practices, are also top of mind for many Canadians. 

Unlock value with ESG

ESG has long evolved from being a vehicle solely used to align investments with investor values. It’s now far more holistic. A large focus in ESG is on reducing risk and identifying emerging opportunities, which is one of the central reasons institutional investors have integrated it into their investment processes. 

Boston Consulting Group (BCG) notes that ESG appeals to sophisticated investors because it blends financial accounting requirements with non-financial performance metrics, which can not only help the planet and the greater good, but also help investors achieve their financial goals. 

Does ESG hurt returns?

Some investors may be concerned about whether ESG metrics hurt returns amid heightened market volatility, but the data doesn’t justify those fears. According to RIA, the MSCI Canada ESG Leaders Index has outperformed the MSCI Canada Index over the long term. 

We believe this is because ESG, which is a lens under which all companies can be viewed, enhances the investment process by providing an additional filter to screen out bad actors, assess risks and identify opportunities. ESG integration does not need to be considered an investment style in and of itself. 

Investors increasingly recognize that governments and regulators will continue to impose stricter rules, particularly around harmonizing climate-related disclosures. As those regulations come into focus, companies that haven’t taken issues like climate change seriously risk exposing themselves to stiff penalties and potential lawsuits that can cut into their bottom line. 

Companies take note: ESG continues growth in Canada

Canadian companies are taking this seriously. According to a 2021 report by Montreal-based ESG consulting firm Millani, more than 70% of companies on the S&P/TSX Composite Index now have dedicated ESG reporting, up from 36% in 2016 – including some energy companies. 

The increased interest shouldn’t come as a surprise. According to an Ipsos survey conducted between August 27 and 30, 2021, two-thirds of Canadians consider ESG factors important when deciding on investments³. The desire for RI is even more pronounced among up-and-coming investors, with 71% of people aged 18 to 34 taking ESG factors into account. 

If companies are going to succeed – both from a revenue and share price increase perspective – they will likely need to prove to their customers that they care about ESG issues. 

More education and discussion needed

If these misconceptions are going to change, more education is needed. A study by the Ontario Securities Commission found that a third of investors say access to ESG information helps them make better investment decisions. Many investors are still unfamiliar with ESG, so advisors who can educate have an opportunity to improve their value to their clients.

Perhaps a good place to start is to underscore that there is more to ESG than climate change. 

As values shift around environmental and social issues, it will open new industries like electric vehicles, new markets such as carbon credits and create opportunities for overdue themes to thrive, such as welcoming more women into leadership roles.

For advisors who want to continue to deliver value to their clients, it is important to think beyond the “E.” As BGC notes, the innovations and investments being made by companies looking to improve in all three ESG categories could inject trillions into the global economy by 2050. By applying an ESG lens, investors will be in a better position to identify these companies and participate in potential investment returns. 

It’s time for the investment industry to look at the wider implications and potential of ESG to identify opportunities for how it can help manage risk. Not every investor will share the same values, so it’s up to the advisor to bring up ESG with their clients and determine where they are on the ESG spectrum. As an advisor, you don’t have to pick sides, you just need to focus on the big picture.

[1] As of December 21, 2019
[2] As of September 2021
[3] As of November 2021

Contributor Disclaimer
The viewpoints expressed by the Author represent their assessment at the time of publication. Those views are subject to change without notice at any time without any kind of notice. The information provided herein does not constitute a solicitation of an offer to buy, or an offer to sell securities nor should the information be relied upon as investment advice. This communication is intended for informational purposes only.

BMO Global Asset Management is a brand name under which BMO Asset Management Inc. and BMO Investments Inc. operate.

®/™Registered trademarks/trademark of Bank of Montreal, used under licence.

RIA Disclaimer
The views and opinions expressed in this article are solely those of the authors and do not necessarily reflect the view or position of the Responsible Investment Association (RIA). The RIA does not endorse, recommend, or guarantee any of the claims made by the authors. This article is intended as general information and not investment advice. We recommend consulting with a qualified advisor or investment professional prior to making any investment or investment-related decision.

The Role of Shareholder Engagement in Executive Compensation

Executive compensation is one of the most visible aspects of a publicly listed company’s corporate governance program and needs to be competitive to attract and retain executives. From a shareholder perspective, best practice is to align with financial performance and how well an executive delivers on the company’s strategic objectives.

Performance metrics have typically focused on financial or operational objectives and shareholder returns. However, as companies continue to place more emphasis on Environmental, Social and Governance (ESG) strategies, metrics tied to ESG performance or goals are increasingly becoming an additional element in executive pay. This creates an additional layer of evaluation for shareholders in deciding how to vote on Management Say on Pay (MSOP) proposals. 

ESG Accountability

Including ESG performance metrics into executive compensation planning is a relatively new development, although it is more common in larger companies versus smaller peers. In 2020, 57% of S&P 500 companies included ESG metrics in executive compensation plans, compared to 10% of Russell 3000 firms (excluding S&P 500 companies); as of the 2022 proxy season, 75% of TSX60 companies have incorporated ESG metrics into executive compensation or have noted an intention to do so within the year. These findings may not be surprising given larger companies tend to be further along in their ESG journey.  

Varying Applications

Many companies incorporate ESG performance measures into short-term incentive plans (STIP); in 2022 thus far, 68% of the TSX60 companies that incorporate ESG metrics in incentives do so only in the STIP, 27% include ESG metrics into both the STIP and the long-term incentive plan (LTIP), and 2% include ESG metrics only in the LTIP. Many of these companies use a scorecard approach, where various ESG metrics are grouped with other corporate objectives, typically without a specified weight. Others employ standalone weighted ESG goals, and some use ESG performance as a modifier to increase or decrease the entire payout.      

ESG metrics can be forward-looking, such as emissions reduction targets, or lagging indicators, such as health and safety performance or customer satisfaction scores. There are numerous ways companies can structure executive compensation goals. Investors would expect a company’s objectives to be relevant and significant to the business. Human capital and social issues comprised the majority of corporate ESG objectives, although 2022 saw an increase in the number of environmental and climate-related metrics added across sectors among large Canadian companies. 

Investor Considerations

With so much variation and limited historical precedent, below are some considerations for investors when engaging with a board around executive compensation:

  1. The board should be able to explain the rationale for choosing certain ESG metrics and goals, and how they align with the company’s business and financial significance.
  2. The board and compensation committee should be able to discuss why the ESG measures selected are incorporated into the specific compensation components, such as the STIP and/or LTIP.  Backward-looking operational metrics are typically considered short-term measures and likely better suited for the STIP, whereas forward-looking targets are reflective of the long-term vision, and more suitable for the LTIP. Too many ESG metrics could indicate a lack of focus and come at the expense of other important business goals, while an emphasis on operations based ESG objectives only may be insufficient to incentivize the progress needed to address ESG objectives.    
  3. The board should be able to articulate its governance oversight process to monitor the selected ESG metrics

The ESG measures and goals chosen should be supported by data that is accessible and transparent to stakeholders. Many companies include human capital objectives, such as diversity and inclusion (D&I) and employee engagement and culture. However, D&I disclosures are still an area for improvement for many companies, and corporate culture remains intangible. Having clear measures helps shareholders understand how ESG performance is aligned with executive compensation.  

Inclusion of ESG metrics in executive compensation is a relatively new area and is nuanced and contextual to each company. Investor expectations and evaluation frameworks should continue to reinforce best practice principles such as pay-for-performance and transparency. 

RIA Disclaimer
The views and opinions expressed in this article are solely those of the authors and do not necessarily reflect the view or position of the Responsible Investment Association (RIA). The RIA does not endorse, recommend, or guarantee any of the claims made by the authors. This article is intended as general information and not investment advice. We recommend consulting with a qualified advisor or investment professional prior to making any investment or investment-related decision.

Are Railroads the Most Environmentally Friendly Solution in Freight Transportation?

According to the United States Environmental Protection Agency (EPA), the largest sources of greenhouse gas emissions in the United States are from burning fossil fuels for electricity, heat, and transportation. The Transportation sector generates the largest share of greenhouse gases (GHG) at 27% of the total emissions from the economy, followed by Electric Power (25%), Industry (24%), Commercial and Residential (13%) and Agriculture (11%). 

The Transportation sector includes the movement of people and goods by cars, trucks, trains, ships, airplanes, and other vehicles. Zooming down into freight transportation specifically, medium-and-heavy trucks accounted for 26% of the total sector GHG emissions, while railroads accounted for just 2%. The GHG emissions mostly emanate from the combustion of fossil fuels for propulsion, and diesel is the most widely used fuel for freight transportation. 

As an active fundamental asset manager we have remained a significant investor in the railroad sector for many years. We see two key ESG considerations when analyzing the railroad sector. Firstly, for a given amount of freight, railroads are a relatively low GHG emission method of transportation.  Secondly, the industry has many initiatives to reduce its GHG emissions profile. We think that favourable and improving environment footprints supports the performance of the industry over time. We also continue to support the many ongoing de-carbonization efforts of the freight industry through active engagement, and we see the potential for attractive risk-reward opportunities by providing capital for those de-carbonization initiatives. 

Railroads are the Most Fuel-Efficient Way to Move Freight Over Land

On broad-based measures, the Association of American Railroads (AAR) estimates that freight railroads are 3-4 times more fuel efficient than trucks, on average. The trade group further estimates that moving freight by train instead of truck reduces greenhouse gas emissions by up to 75%. 

A more extensive study was carried out by the Department of Transportation (DoT) in 1991 by running simulations to compare rail and truck between the same origin-destination locations. Although the study is dated, both rail and truck technologies have improved since, and as such we believe that the broad findings remain relevant to this day. The DoT study found that rail achieved from 1.4 to 9 times higher fuel efficiencies (ton-miles per gallon) than competing truckload service. Rails compete most directly with the highway in moving shipping containers. In this category, rail was 2.51 to 3.43 times more energy efficient than comparable truck moves. The study also found that the fuel efficiency advantage of rail over truck increases as distances increase. 

Rails have vastly improved their operations since the publication of the DoT study, which have led to meaningful improvements in fuel efficiency. First, the industry has pivoted to a precision railroading operating model, which involves running longer trains at scheduled times. This means trains spend less time idling, and fewer assets are required to move the same amount of freight. Second, rails have invested heavily in creating network capacity by adding more sidings and double-tracking key corridors. These investments have improved dwell times and have led to an overall improvement in fuel efficiency. Third, locomotive engines have become more fuel efficient and technologies such as distributed power have further amplified these gains. Finally, adoption of ancillary technologies such as automated inspection portals, inspection cars, and others, continue to enhance the fluidity of railroad networks and unlock additional fuel efficiency gains. 

Renewable Fuel Blends to Unlock the Next Leg of GHG Reduction

Canadian National Railroad was one of the early adopters of the precision scheduling railroading model and has been an industry leader since in terms of environmental leadership. On the back of these initiatives, the company has been able to reduce its GHG intensity by 43% in the 1993-2020 timeframe. Other railroads have been following a similar script and we expect the industry to converge to similar level of GHG intensity in the upcoming years.

Source: Canadian National Rail

We continue to see a long runway for further improvement. Based on our engagement with some of the major railroads, we expect the industry to be able to deliver 1-2% incremental improvement in GHG emissions intensity per year, on average for the next decade. We expect renewal of the locomotive fleet to be the biggest driver of the reduction, complemented by ongoing improvements in technology. 

Cleaner fuels, however, are expected to be the more meaningful driver and our conversations suggest that this initiative could reduce GHG emissions by another 3-4% per year, on average. The easiest opportunity remains in using sustainable renewable fuel blends in existing fleets to immediately realize these improvements.

Future Technologies Could Alter the Relative GHG Dynamics

Outside of incremental gains from opportunities discussed above, there is push underway to explore radically different propulsion technologies that could meaningfully alter the emission intensity of freight transportation in the future. These technologies are being developed and tested both on the trucking side and on the railroad side. 

Electrification of the North American freight network by building high-voltage catenary lines, integrating these to the power grid, and powering them with renewable power would be the most environmentally friendly solution. However, we estimate that the cost of electrifying the entire 140,000 mile U.S. freight network and replacement of the fleet of 24,000 fleet of locomotives could reach $1 trillion, which is likely prohibitive.

As such, we expect other propulsion technologies to remain the primary focus. The railroads are currently exploring battery electric, hydrogen fuel cell, and natural gas-powered locomotive designs. There is active testing of each potential solution by different North American railroads, however there remain several challenges to them that have to be overcome before they can become viable for widespread adoption. We will be following the testing of these potential solutions and their evolution closely as there could be attractive investment opportunities to facilitate their adoption. The opportunities could come from direct investments in the railroads themselves, but also in companies such as Ballard Power Systems that is developing hydrogen fuel cells for rail propulsion, or Wabtec that has designed battery powered locomotives. There could be attractive investment opportunities in the adoption of some of these solutions for lowering GHG emissions from rail freight. 

Investor proxy voting and engagement with companies and policy makers are also having an impact on the adoption of these potential solutions. As a large investor in the freight industry, our engagement and proxy voting efforts support ongoing de-carbonization of the industry.

It is worth noting that these technologies are also being developed and tested in trucking applications. The development of these technologies for trucking could perhaps even progress at a faster pace than for railroading given the larger total addressable market in trucking (bigger pie). Given these dynamics, we would expect the sizeable GHG efficiency advantage that railroads currently enjoy over trucking to perhaps narrow over the next decade. However, despite these gains, we don’t see the gap fully closing and expect railroads to continue to be a more environmentally friendly means to move freight for the foreseeable future. 

RIA Disclaimer
The views and opinions expressed in this article are solely those of the authors and do not necessarily reflect the view or position of the Responsible Investment Association (RIA). The RIA does not endorse, recommend, or guarantee any of the claims made by the authors. This article is intended as general information and not investment advice. We recommend consulting with a qualified advisor or investment professional prior to making any investment or investment-related decision.

Knowing What You Own: Fundamental Analysis and the Use of Proprietary ESG Ratings

Low correlation among third-party ESG ratings providers can be an important signal for investors. Relying heavily on such ratings could lead to very different portfolio outcomes, and differing opinions from third-party ESG ratings agencies can create confusion for clients or investors. This issue supports the case for not relying solely on ratings agencies and speaks to the importance of knowing what you own.

To know what you own, it is first necessary to develop an understanding of a company’s ESG characteristics through one’s own fundamental analysis. This is where proprietary ESG ratings can come into play and provide benefits for stakeholders. Many analysts may find a deeper understanding and analysis of all elements of “ESG” — environmental performance, social factors, and corporate governance practices — better enables informed opinions and engagement. For example, social factors such as diversity, equity and inclusion (DEI), labor/hiring practices, community involvement and reputational issues can be complex and difficult to capture in scores, yet they inform the overall analysis of a company’s attractiveness as an investment and lend themselves to close knowledge of a company and the industry in which it operates.

Expressing this analysis in proprietary ESG ratings, then, provides an internally consistent metric that is both quantitative and qualitative to help measure and analyze a company’s sustainability risks and opportunities. Investors doing this work themselves may see several benefits, including information advantages, risk-reward value and impact potential through benchmarking.

1. The Information Advantage of Proprietary ESG Ratings

Analyzing the ESG characteristics of companies involves using both quantitative and qualitative measures of what is most material and relevant to each company’s industry. In some cases, industrywide data is typically available, such as carbon emissions levels in the utilities sector or employee safety data in the industrials sector; in other cases, however, the analyst must derive primary company research from direct analysis. 

Published research and public disclosures factor into the formation of ESG ratings, but so too should face-to-face meetings and engagements with companies and industry-specific experience. This proprietary work helps determine which specific environmental, social and governance issues are relevant for each company (Exhibit 1). Direct conversations, in a dynamic and symbiotic dialogue with company leadership often over several years, can add perspectives that create an information advantage — one a fundamental analyst with deep knowledge of the company will also have an advantage in using. This information advantage is particularly important in the case of widely owned stocks that present complex sustainability stories, such as large tech platforms, Apple and Google.

Exhibit 1: ClearBridge ESG Materiality Framework™ Sample

Source: ClearBridge Investments

2. Proprietary Ratings Capture Risk-Reward Information, but Are Not Synonymous with It

ESG analysis, expressed in a rating, should be a critical part of the normal due diligence performed in fundamental analysis, which we do as part of our process to help find quality companies with sound fundamentals. At the same time, ESG ratings may highlight ESG-specific factors to be better compared and understood.

Although ESG ratings factor into investment recommendations, ratings by themselves are not recommendations to buy or sell a stock. Nevertheless, we have found they contribute to performance. In recent studies of performance and fundamental characteristics of ClearBridge’s ESG-rated stocks published with the UN-supported Principles for Responsible Investment (PRI), we found that higher ESG-rated stocks: 

  • Outperformed the market more frequently than lower ESG-rated stocks. 
  • Generated higher risk-adjusted returns (as measured by their Sharpe ratios) than lower ESG-rated stocks, with AAA and AA stocks generating higher risk-adjusted returns than the S&P 500 Equal-Weight Index. 
  • Generated higher alpha than lower ESG-rated stocks after accounting for common factor exposures including market beta, size, value, momentum and quality.

These studies show how a proprietary ESG ratings system developed by fundamental investors appears to contribute to performance and have an added benefit beyond that which could be explained by common quantitative factors and fundamental financial metrics. 

3. Benchmarking for Impact

Proprietary ESG ratings are a tool to communicate to portfolio managers our confidence in or expectations for progress on ESG issues. In addition to informing the investment decisions of portfolio managers, these also guide how we use client capital to seek to make an impact in the companies where we invest. 

In sectors where proprietary research has identified an industry leader in sustainable practices, labor and workplace policies or other ESG factors, we will often use that company as a benchmark for quantitative and/or qualitative comparison. We also share best practices during company engagements, recognizing companies may benefit from ideas we offer and feedback we provide on key issues. Examples include feedback on DEI disclosure to help contribute to managements’ understanding of their employee talent pool; recommendations on executive compensation pay practices; and support for decarbonization strategies being employed sooner rather than later. 

Third-party ESG ratings can be a valuable input, of course, and there are many innovators in responsible investing helping improve the quality of data and deepen the ESG knowledge base. But insofar as ESG ratings can benefit from fundamental analysis, which offers information advantages, captures risk/reward information and underpins engagement, developing them primarily from one’s own fundamental analysis makes a lot of sense.

RIA Disclaimer
The views and opinions expressed in this article are solely those of the authors and do not necessarily reflect the view or position of the Responsible Investment Association (RIA). The RIA does not endorse, recommend, or guarantee any of the claims made by the authors. This article is intended as general information and not investment advice. We recommend consulting with a qualified advisor or investment professional prior to making any investment or investment-related decision.

Retrofits, R&D and Regenerative Buildings: Investing in Sustainable Real Estate

In the climate change debate, real estate is the elephant in the room. Our homes, offices, shops and recreational spaces — the physical infrastructure crucial to human wellbeing – account for around 40 percent of global carbon emissions. What’s more, the built environment is also responsible for numerous other ecological problems, including excessive water usage, electricity usage, and waste on a similar order of magnitude.

Figure 1: Building and construction sector: estimated contribution to economy and environment

Circle diagrams showing employment 5-10%; GDP 5-15%; Energy-related greenhouse gas emissions 30%; Energy use 40%
Source: Source: UN Environment Program, 2019

How to shrink the real estate industry’s environmental footprint was the focus of this year’s Klosters Forum on “the future of the built environment”. The Klosters Forum (TKF) is a Swiss-based not-for-profit organisation which aims to accelerate positive environmental change by fostering dialogue and collaborations. Launching the debate during its annual three-day meeting in June, our colleague Zsolt Kohalmi, global head of real estate and Deputy Chief Executive Officer at Pictet Alternative Advisors, explained why assessing real estate’s environmental credentials is fraught with difficulty.  He pointed to the “time value of carbon emissions” as an example of the complexities facing property companies and investors as they attempt to shift to more sustainable practices. 

Embodied Carbon: A Consideration for Investors

Over the lifespan of a building, it is estimated that up to 45 percent of total emissions will occur during the first couple of years, or the construction phase which includes raw materials extraction, transportation, installation and waste disposal. These emissions – otherwise known as embodied carbon – are far greater than those of operational carbon, which is the amount of carbon emitted annually once a building is in use. 

TKF participants, who included architects, urban planners, green building start-ups, material scientists and investors, shared experiences and offered insights on how to tackle real estate’s environmental problem. A few themes stood out. The role of nature in the built environment was one. Participants agreed on the need for the built environment to be reconnected with nature. This would involve a number of novel construction techniques, including incorporating natural and regenerative elements into building designs, experimenting with innovative bio-based materials such as timber and algae and carrying out strategic reforestation, afforestation, and other carbon capture methods.

Mikolaj Sekutowicz, a TKF participant and partner responsible for Strategic Development and Culture at Therme Group, a firm developing a new waterfront project in Toronto, referred to Italian botanist Stefano Mancuso who famously said: “We’re living in nature and plant blindness.” Sekutowicz added: “We have to incorporate nature into our culture; culture is not antithesis to nature.”

Retrofit over demolish and rebuild

But the construction of new buildings, even using sustainable techniques, is no panacea. In many parts of the developed world, where buildings were constructed during the last decades, retrofitting might be a better way to reduce carbon emissions.  In Europe, for example, around 90 percent of buildings were built prior to 1990 and 40 percent before 1960. Studies have shown that refurbishing can result in 70 percent less emissions than new construction given the issue of embodied carbon emissions.

This is not to say, however, that other parts of the world do not need new buildings. Economies in Asia, Africa and Latin America will require more residential and commercial floor spaces to accommodate a growing population. A one size fits all approach doesn’t work in promoting sustainable buildings. Instead, a customised approach is essential, factoring in location-specific features, such as building technologies that are suited for different geographies and the local availability of raw materials.

Venice: Modern and Classic Approaches to Sustainable Construction

The Italian city of Venice – whose very existence is threatened by climate change – can serve as an inspiration. When it was built 1,600 years ago, it used water-resistant alder trees that were abundant in nearby forests as foundations to stay afloat on the marshland. Now, the city is safeguarding its future by turning to new nature-based solutions. For example, it is using locally sourced natural materials and labour to build fortifications in its salt marsh belt, which represents the city’s best defence against storm surges and waves. The bioengineering project has also engaged residents and businesses, providing employment and economic opportunities in the local community.

As Venice’s efforts demonstrate, governments and municipal authorities play a key role in sustainable construction.  Forum participants agreed that policymakers should adopt a carrot and stick approach – incentivising climate and nature-positive companies and projects with tax breaks and smart subsidies while penalising harmful ones.

Investing in R&D and Sustainable Building Approaches

Increasing investing in research and development (R&D) should also be a priority to enhance competitiveness, foster innovation and accelerate sustainable transition. The construction sector’s R&D investment is estimated to be in low single digits as a percentage of revenue, compared with at least 10 percent for healthcare and IT counterparts¹. 

The financial industry also has a duty. Sustainable transition in buildings represents a large, long-term and growing investment opportunity. The industry should therefore attract capital into sustainable buildings to meet increasing demand from investors for solutions which incorporate environmental, social and governance (ESG) aspects and/or drive positive change. As demand for more efficient, environmentally-friendly structures is poised to grow, participants called for a more thoughtful approach to how we construct, run, refurbish and demolish buildings, to make the built environment fit for the climate challenge and equitable for all

As former British Prime Minister Winston Churchill said in 1944: “We shape our buildings; thereafter they shape us.”

[1]  European Commission, OECD and Pictet Asset Management

RIA Disclaimer
The views and opinions expressed in this article are solely those of the authors and do not necessarily reflect the view or position of the Responsible Investment Association (RIA). The RIA does not endorse, recommend, or guarantee any of the claims made by the authors. This article is intended as general information and not investment advice. We recommend consulting with a qualified advisor or investment professional prior to making any investment or investment-related decision.

Investment Diversification Opportunity: Carbon Capture, Utilization, and Storage

Over the past two decades, renewable energy and the electrification of transportation, specifically electric vehicles, have been significant recipients of investor capital. This trend towards low-carbon energy alternatives demonstrates no signs of slowing down as societies race against time to reduce carbon footprints. According to BloombergNEF (BNEF)’s recent report [Figure 1], global investment into the low-carbon energy transition reached $755 billion in 2021, marking a 27% increase from 2020. It is expected that this robust appetite for carbon reduction will remain prominent in the minds of both policymakers and investors as 2030/2050 Net Zero deadlines inch closer.  Net Zero catalyzes a once-in-a-lifetime opportunity for investors. One potentially promising solution within this sector is carbon capture, utilization, and storage (“CCUS”).

Figure 1: Global Investment in Energy Transition by Sector

Source: BNEF, Energy Transition Investment Trends 2022

CCUS refers to technologies that capture CO2 from large point sources. Most commonly, these sources are power generation facilities or industrial processes that use fossil fuels or biomass as fuel, such as cement or fertilizer manufacturing facilities. There are also new technologies under CCUS that capture CO2 directly from the atmosphere known as “direct air capture”, but these large-scale projects are in their infancy. Some projects aim to inject and store CO2 permanently underground, potentially mitigating the harmful release into the atmosphere. Through CCUS, captured CO2 is used in a range of other applications, such as fertilizers production, greenhouses, water treatment, or used as feedstock in synthetic fuels. 

While CCUS has existed since the 1970s, high costs and a lack of economic incentives have hampered its development. However, the future of CCUS is considerably bright given the recent momentum leading to increased development and interest in CCUS in the energy sector. Key drivers of this momentum include a boom in the number of net zero pledges from both governments and corporations, boosts in investor confidence from related policies, and new emerging business models. Supporters of, and the most experienced players in CCUS technology include some of the world’s most active emitters of CO2 – energy producers, with a growing number embracing CCUS as a critical component of their low-carbon transition plans.

CCUS Collaborations

The Pathways Alliance, a coalition of Canada’s six largest oil sands producers representing 95% of Canada’s oil sands production, are actively collaborating to achieve Net Zero by 2050 to eliminate 22 million tonnes of emissions by 2030 via a $24-billion investment in carbon capture and storage facilities. Similar coalitions have formed south of the border as well, such as the Houston Carbon Capture & Storage Alliance (CCS) and Washington D. C’s Carbon Capture Coalition, a nonpartisan collaboration of more than 100 companies, unions, conservation, and environmental policy organizations, building federal policy support to the deployment of carbon management technologies. 

Growth Potential

CCUS also presents significant potential for economic growth as noted by the Houston Carbon Capture & Storage Alliance, which estimates that private investment could be upwards of USD 60 billion and see the creation of more than 18,000 project jobs annually in the state of Texas alone. With the growing acceptance of CCUS technology, energy participants have shifted gears from lobbyists against climate change to champions of Net Zero, highlighting that CCUS is a viable opportunity to secure energy and industrial needs while reducing CO2.

Canadian and US Governmental Support

Activity in the space has also increased with policymakers around the world recently earmarking close to USD $18 billion towards CCUS development and deployment. To date, Canada and the US remain among the most active in support of CCUS. Together, the US and Canada represent 65% of global carbon capture capacity, and new targeted policies signal positive incentives for the development and deployment of CCUS. Positive tailwinds for CCUS include the United States Inflation Reduction Act (IRA) which provides substantial incentives for CCUS projects by expanding the amount of credit (double for power and industrial plants and triple for direct air capture) and extending the deadlines of qualification by 7 years to 2033.

Meanwhile, through the US Infrastructure Investment and Jobs Act, about USD $12 billion will be offered to the CCUS value chain in the form of research and development (R&D) funding, loans, and support in permitting. In Canada, the federal government has proposed a refundable investment tax credit for CCUS projects valued at CAD $2.6 billion between 2022 and 2030. In addition, CAD $319 million will be invested in R&D to advance the commercial viability of CCUS through the federal budget 2021. Furthermore, recent commentary by Canadian politicians, express a near-term desire to increase the Canadian tax credits to match those of the US, likely expediting and broadening the potential for CCUS project development. 

Figure 2: Commercial-Scale CO2 Capture Projects in Development

Figure 3: Potential Project Spending

Figures 2 & 3 Source: IEA, World Energy Investment 2022

According to IEA’s report World Energy Investment 2022, there are now over 300 projects in various stages across the CCUS value chain across the globe [Figure 2]. Strong legislative policy tailwinds and support from both public and private market participants have set the stage for CCUS to be among the most advocated technologies in the fight against climate change. As the world ushers in a new era of decarbonization, all eyes are on the potential of CCUS, allowing investors an avenue to further diversify their energy portfolios beyond, and in addition to, renewable energy and electrified transportation. 

RIA Disclaimer
The views and opinions expressed in this article are solely those of the authors and do not necessarily reflect the view or position of the Responsible Investment Association (RIA). The RIA does not endorse, recommend, or guarantee any of the claims made by the authors. This article is intended as general information and not investment advice. We recommend consulting with a qualified advisor or investment professional prior to making any investment or investment-related decision.

Sustainability Assurance Matters: Building Momentum Against Greenwashing

Environmental, Social and Governance (ESG) investing continues to soar. Bloomberg Intelligence estimates assets will surge from US$35 trillion to US$50 trillion in the next three years. 

These figures don’t include the exploding global sustainable debt market. According to research from the Chartered Professional Accountants (CPA) Canada and the International Federation of Accountants (IFAC), issuances of green, social, sustainable and sustainability-linked bonds hit a record high of US$1 trillion in 2021 and are projected to hit US$1.35 trillion this year.

In both cases, investors are making capital allocation decisions based on the largely voluntary disclosure of sustainability information – information that, in its current state, many find difficult to trust. Organizations can currently pick and choose what metrics to report, focus on favourable elements, and portray themselves as more “sustainable” than they actually are – all leading to concerns about greenwashing.

While one study indicates that more than 90 percent of the largest public companies are disclosing sustainability information, only 58 percent are having this information verified, but not necessarily by accountants – who are arguably best placed to assure financial information. As a result, many investors are turning to independent analysis from ESG ratings and data providers to come up with their own criteria to make investment decisions. 

When it comes to sustainable debt, investors must consider how issuers are determining sustainability metrics and whether those metrics effectively measure the instrument’s performance, in addition to whether and how this information is being assured.

High-quality sustainability information that is transparent and independently verified is necessary to mitigate greenwashing and ensure investors can make sound investing decisions. With so much capital on the line, sustainability disclosure must be as high-quality as corporate disclosures.

Where sustainability assurance is today

IFAC, in collaboration with the AICPA-CIMA, conducted a State of Play benchmarking study that reviewed sustainability-related reporting and assurance practices of 1,400 large public companies across 22 jurisdictions. 

The findings are telling. Most assurance is limited in nature and assurance practices and providers vary globally – potentially creating an expectation gap between what investors expect compared to the reality, suggesting there is room for improvement. Highlights include:

  • More than 90 percent of companies provide some sustainability information, but only 58 percent of companies provide assurance on sustainability information, and in many cases the assurance is only for a portion of the reported information
  • When professional accountancy firms are engaged, 94 percent of the time they use standards from the International Auditing and Assurance Standards Board (IAASB), the organization that sets global standards for auditing, assurance and quality management. The majority of engagements by other service providers use other standards. 
  • There are two levels of assurance: limited and reasonable. Currently, more than 80 percent of sustainability assurance engagements result in limited assurance, which provides a meaningful level of assurance, although less than the level of assurance obtained in a financial statement audit. CPA Canada’s  Sustainability assurance alert: Third-party assurance over sustainability information offers a deeper dive into the topic.

The world is moving towards a common set of sustainability standards

Nearly 20 years after the UN’s landmark initiative “Who Cares Wins” introduced the term ESG, the need for companies to report sustainability information is well understood both by investors and companies of all sizes across industries and jurisdictions. Less clear is how to undertake this reporting given the number of varying voluntary frameworks and guidelines, which have created complexity and confusion for issuers. 

To create a global baseline for sustainability disclosures and ensure investors have access to high-quality, consistent and comparable sustainability-related reporting, in November 2021 the IFRS Foundation launched the International Sustainability Standards Board (ISSB), which will operate in concert with the International Accounting Standards Board. 

The ISSB is moving quickly. In March 2022, it released exposure drafts for its two initial standards: IFRS S1 – General Requirements for Disclosure of Sustainability-related Financial Information establishes overall requirements for disclosing all of an entity’s significant sustainability-related risks and opportunities. IFRS S2 – Climate-related Disclosures sets out the specific requirements to identify, measure and disclose climate-related information. 

Meanwhile, jurisdiction-specific reporting initiatives are also taking shape, with the European Union being furthest along in its journey. In Canada, a Canadian Sustainability Standards Board (CSSB) was announced in June 2022 and aims to be operational by April 2023. On the regulation front, the Canadian Securities Administrators and the U.S. Securities and Exchange Commission are each moving forward with its own proposals to improve and standardize sustainability reporting. Global regulators are part of jurisdictional working groups to minimize differences to the greatest extent possible.

Momentum is building for mandatory sustainability assurance standards

The IAASB is developing a standalone, overarching standard on sustainability assurance, which it aims to release in the second half of 2023 for public comment. It will build on existing IAASB standards and guidance and be designed to assure information reported across all sustainability topics, information disclosed about those topics, and reporting frameworks. 

The International Organization of Securities Commissions (IOSCO) has acknowledged the important efforts of the IAASB, working in cooperation with the International Ethics Standards Board for Accountants (IESBA), stating “This work will serve to support the consistency, comparability and reliability of sustainability-related information provided to the market, enhancing trust in the quality of that information.”

The U.S. and EU are already moving towards setting reasonable assurance as the level of assurance needed for this type of reporting. If the markets are going to treat sustainable information as being as important as financial information, then assurance needs to rise to that level as well. 

Final thoughts

Investors have been a powerful voice in the drive towards high-quality sustainability reporting standards. Now it’s time to focus on the assurance of this reporting to ensure sustainability information is as consistent, comparable and trusted as financial information. We encourage you to follow CPA Canada and IFAC initiatives in the ESG space. Share your insights and engage. Respond to consultations. This is how positive change happens.

RIA Disclaimer
The views and opinions expressed in this article are solely those of the authors and do not necessarily reflect the view or position of the Responsible Investment Association (RIA). The RIA does not endorse, recommend, or guarantee any of the claims made by the authors. This article is intended as general information and not investment advice. We recommend consulting with a qualified advisor or investment professional prior to making any investment or investment-related decision.