How do resource companies—those who extract large amounts of commodities from the earth—meet new ideas on ESG investing?

ESG stands for Environmental Social and Governance, and it means investing money in sustainable ways.

But can resource extraction companies be ESG compliant when they are removing huge amounts of rock—like open pit mines—or bringing billions of barrels of hydro-CARBONs to the surface?

They can…sort of, says Sarosh Nanavati, an investment research analyst with the Pennock Idea Hub in Toronto.He specializes in finding investments that score high in ESG for his clients—the competitive fund managers (the “buyside”).

“Environmental concerns (the “E” in ESG) are generally where most resource companies run into controversy,” he says.

“These relate to the impacts which their operations have on land, water and air.Common examples would be things like waste management, like mining tailings, or excess gas flaring.

Source: University of Oxford/Arabesque Partners

“For a mining company it’s a bit simpler.It’s about using best practices to minimize their environmental impact, and adequately sharing the benefits of resource development with the local communities in which they operate.

Oil producers have another hurdle to face, he says. “Energy companies must of course do the same (manage their “controllables”), but they face additional scrutiny for the environmental impact of their end products.”

Prior to specializing in ESG, Nanavati had a lengthy career on Bay Street on both the buy side and sell side, including 18 years as a fund manager investing primarily in the resource space.So he’s been on the other side of the fence, and he knows what these fund managers want in ESG investing.

“For me, I focus on using ESG analysis to improve investment performance. Fund managers are interested in outperforming their peers, and they’re looking at ESG analysis as a way of doing that.

“There’s a pretty substantial body of empirical research that shows that companies who manage ESG issues which are both relevant and material to their business tend to be more profitable than their peers, and additionally their stocks tend to outperform their peers.Some of the research even suggests that this outperformance effect is most evident in the energy sector.

Source: Fidelity International

“To me that just makes sense.When you have a healthy relationship with your employees, you encounter fewer labor disruptions.When you have a good relationship with the communities in which you operate, your projects are permitted and put into production more quickly.These are real financial benefits, and they show up on your bottom line.”

Can anything resource companies do/be good enough for some investors who care about ESG?

“Well as you can imagine there’s a diversity of opinion. I think that globally we’ve seen a number of large sovereign pension funds step away from the energy space. We’ve seen in Quebec that’s happened as well.”

Nanavati is currently helping raise some capital for a publicly traded coal bed methane play in Botswana based on its ESG principles—which is very counter-intuitive. Methane? From Coal?Those are two of the worst environmental bad guys—how can that be ESG focused?

“Botswana mostly uses diesel and burns coal for electricity. And in the communities, they typically utilize biofuels—wood and dung–in their homes for heating and for cooking, which is very dangerous.

“With the development of a domestic natural gas resource, Botswana could provide incentive for the construction of additional power generation in the country run by natural gas, convert much of the utilization of diesel by local industries to natural gas or compressed natural gas in the case of mining trucks and… local transportation is primarily buses, so local buses.  As well as long-haul trucks, to reduce outdoor pollution in the country.

“So it’s really an interim step, I think, dramatically reducing the amount of particulate matter that is being spewed out into the local communities.”

So he’s really talking about a lighter shade of grey—on the way to white.

I asked Nanavati what the biggest mistake management teams make around ESG, and do small resource companies – like the ones that I mostly cover—have any special challenges around ESG?

“The biggest mistake that management teams are making I think is ignoring ESG. Don’t ignore it. You need to take steps, tangible steps to demonstrate that you understand that stakeholders are looking at it, and that you are looking at it yourself and using it as a tool to manage risk internally.

“I think a lot of times companies shoot themselves in the foot because they’re doing a lot of really good things but they don’t talk about them. So that’s an easy first step, just be more communicative about the positive things that you’re doing in the communities in which you operate.

“Smaller companies in particular are challenged because there is some requirement for resource allocation here, you have to throw some money at this. But the reality is that you will find that you are paid back on that investment … it’s not an expense, it’s an investment with a return.

“The resources that are required are going to be used to perhaps include some additional color in your annual report, or when you’re writing up your conference call scripts you will have to include a section on what you achieved that quarter in the ESG area.

“So I don’t mean to suggest that it’s this huge cash outlay, but typically it’s the utilization of people’s time that is going to be the primary cost.”

“I think the important things for resource companies to focus on are the factors that they have control over.

“I think the things that management can control in an energy company, how they treat their workers, how they operate in their local communities in which they’re located, the safety of their workers … a lot of the social aspects, the “S” components of ESG.  Discrimination in the workplace, workforce diversity, and so on.

“And then on the governance side, governance is essentially oversight of the company’s operations and management.  So again, issues with respect to corruption for example.

“Compliance with the Foreign Corrupt Practices Act.  It also includes board composition — does the board have the appropriate skill sets, is it adequately diverse, does it have sufficient industry experience, etc.

“Management compensation, that’s a big one.  Hiring and firing of the CEO.  These are all governance concerns. That’s the “G”.”

In large cap energy, BP—British Petroleum is a great example of ESG investing at work.

The company had received lots of negative press before the Macondo blowout in the Gulf of Mexico in 2010.

The large index company, MSCI, had already excluded BP from its sustainable equity indices for a refinery explosion at Texas City in 2005.For the five years after Macondo,–one of the best oil bull markets in history–BP’s stock has consistently underperformed its peer group—by a whopping 37%!

And to a large degree, Nanavati’s research for investment firms is to help them avoid ESG blow-ups like this (pardon the pun).

In conclusion, Nanavati says “ESG in investment management is not is a fad. It is becoming pretty much embedded in the investment process for most portfolio managers.  And they use it because it generates better risk-adjusted returns for their clients.”