The resignation of Rio Tinto chief executive Jean-Sebastian Jacques and other senior executives after the destruction of sacred sites in Australia has again highlighted the reputational risks faced by natural resources companies. But both active and passive funds with an ESG remit continue to own companies like Rio. Where does that leave investors?

In response to the incident in May in western Australia, ratings agency Sustainalytics (a subsidiary of Morningstar) upgraded Rio Tinto’s ESG Risk Rating to 4 out of 5. That means Rio now has a “high” ESG rating rather than a “significant” (level 3) rating. “The incident has had a high adverse impact on Rio Tinto’s reputation and social licence to operate, and it has damaged the perception of the company as a leader in responsible mining,” it says.

Enrico Colombo, analyst at Sustainalytics, says the controversy has reversed much of the progress the company had made in improving environmental and social practices and will also made it harder for the company to work with indigenous people in the future. He describes the Australian incident as a “reckoning” for Rio after a string of previous controversies, and thinks mining companies will be more wary in future of operating in "culturally sensitive" sites as a result.

We Need Natural Resources

Given the history of controversies in this area, should ESG investors consider mining companies like Rio for their portfolio? Ashley Hamilton Claxton, head of responsible investment at Royal London Asset Management, think they may have to. 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 explains. 

Signs of improvement in companies with a chequered past are taken into account, she says, and the priority now is engagement - making companies change their ways - rather than exclusion.

Mining companies in general do a “decent job of managing the ESG risk they have”, she 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 investors may still not feel comfortable owning such stocks, and that can be problematic. Rio Tinto is held by a number of funds, passive and active, with an ESG mandate. These include five-star rated ASI UK Responsible Equity Fund and Schroder Sustainable Multi-Factor Equity Fund as well as Legal & General Ethical Trust and Royal London UK FTSE4Good Tracker Trust.

The Royal London fund tracks the FTSE4Good index, in which is Rio the fifth weighting and rival miner BHP (BHP) is number 10. It’s inevitable that resources companies are part of these indices, Hamilton Claxton says, because they take a “best in class” approach and are market-cap weighted so will feature the largest companies.

The index does actively exclude certain sectors, however, such as tobacco, weapons and coal mining. According to FTSE Russell, which puts the index together, a company that falls below a certain ESG threshold is given 12 months to get its house in order before being removed from the index. “This incentivises improvements in corporate practices and reduces the index turnover should the company improve,” according to FTSE Russell’s methodology.

But Morningstar sustainability analyst Elizabeth Stuart says the inclusion of Rio Tinto or BHP in sustainability indices highlights the need for further investor education. While mining companies provide materials for essential sustainable activities like electric vehicles and solar panels, the damage done by Rio in Australia goes far beyond acceptable business practices. "An investor must understand the greater ESG risks when holding companies with the opportunity and means to destroy the environment and communities in which they operate," she says. 

Has Rio Done Enough?

How can asset managers influence the behaviour of companies that have been through an ESG controversy like Rio? Initially Rio Tinto executives forfeited bonuses following the company's internal review, but Australia's largest pension fund, AustralianSuper, argued the loss of bonuses 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.”

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. 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 and preserve social licence."