Palm oil investing through an ESG lens

Nikko Asset Management's Kenneth Tang shares how palm oil companies are improving their sustainability agendas

The starting point for ESG criteria in palm oil investment can be somewhat contentious given the industry’s perceived links to environmentally unfriendly practices, such as deforestation and land erosion, in addition to poor labour standards. All this makes an objective assessment of ESG criteria-based investing in the palm oil industry particularly difficult.

A commonly used vegetable oil, palm oil is most known for its versatility and high crop yield. The oil, however, is often linked with negative social and environmental issues, such as the large amount of greenhouse emissions and land deforestation that occur as a result of palm cultivation. Palm oil has also in recent years been linked to labour exploitation, highlighted by an import ban on two Malaysian palm oil companies by the US Customs and Border Protection (CBP) agency on allegations over forced labour practices.

This leads us to instil a more vigorous internal assessment of ESG in our investment process of palm oil companies. It is of paramount importance to understand the key materiality issues facing the palm oil sector and their impact on future investment returns.

Evaluation process

Our ESG evaluation process starts with identifying the key material issues for shareholder returns for each company we cover. These issues could be risks to returns, which include potentially disruptive events and risks that lead to a gradual erosion of shareholder returns. They also include ESG-related opportunities that could result in a material enhancement of shareholder returns. We further access the scorecards for the palm oil companies in the following issues of materiality, which we believe are the most important issues for ESG and sustaining returns. The issues of materiality are: 1) emissions and energy management, 2) land, 3) biodiversity and 4) labour management.

In emissions and energy management, we focus on rehabilitation plans for peatland, which is used extensively in southeast Asia for industrial agriculture; commitment from the company and its suppliers to a “no burning” policy of not using fire to clear land; disclosure on data management in monitoring fires; and commitment to measure and reduce emissions over a specific time period.

See also: – First climate, now nature: How should investors incorporate biodiversity into investment decisions?

Within land, we focus on the company’s ability to conduct proper assessment and mapping of the plantation’s estate and areas for conservation sites. We also look at traceability of palm oil through the supply chain from point of origin of plantation to the refinery. Finally, we consider the certification compliance of RSPO (Roundtable on Sustainable Palm Oil) for the company’s estates and mills, and the timeline expected for the ability to achieve full RSPO certification. (A RSPO certification verifies that the standard of palm oil production from a company is sustainable.)

Regarding biodiversity, we identify sustainable palm oil companies by evaluating their commitment towards zero deforestation and if this extends to their suppliers. We also consider the restoration plans of these companies and whether they address non-compliant areas and conversion timelines for plantations and suppliers to reverse deforestation.

In the area of labour management and development, we focus on the labour conditions of workers in the plantations and assess wages and other ancillary costs, such as insurance and accommodation. We also look specifically at the support schemes for small holders or contract farming (plasma ) practices in assessing the labour standards of the companies.

It is worth noting, in recent years palm oil companies have accelerated their sustainability goals by improving palm traceability, complying with RSPO standards and increasing their commitment towards NDPE (no deforestation, no peat and no exploitation). Some companies have extended such commitment towards their suppliers, holding them accountable by applying similar sustainability standards.

Engagement

Finally, another aspect to address is continuing engagement with companies. These include outstanding ESG issues that companies are in the process of resolving or opportunities that are being developed.

Engagement with the palm oil industry is possible through two channels. The first is through individual engagement with palm oil companies. The second is through participation of the United Nations Principles for Responsible Investing (PRI)’s working group for sustainable palm oil. We have been a participant since 2018, taking part in a collective effort by investors to engage in palm oil matters and accelerate sustainability.

The PRI working group helps its participants engage with ESG topics in the palm oil industry, develop guidance documents and drive collaborative initiatives and help lead efforts with the primary objective of highlighting the key risks and ESG issues of materiality, and encouraging companies to support sustainable practices in palm oil.

Compliance

One of the key sustainability challenges for palm oil companies is managing engagements and compliance not just in the plantations they own but within the greater palm oil supply chain. This is of particular concern for palm oil refiners and traders, as much of the raw material originates from numerous independent suppliers, which make it very difficult to fully trace the origins of the material and associated sustainability practices.

However, we have seen positive changes; palm oil companies are making a greater effort to realise the benefits of sustainable palm oil and large palm merchandisers are exerting greater influence to drive sustainability. For example, a large palm trading company estimated that about 10-15% of its suppliers do not meet sustainability criteria such as RSPO, and it has since stopped its business with the non-compliant suppliers.

Labour management and social issues are fast becoming an increasing area of materiality, relative to issues of emissions, land and biodiversity. For palm oil companies, their reliance on labour and the management of foreign workers remain one of today’s largest challenges in the area of ESG materiality. On average, labour accounts for up to 40% of a plantation’s overall operating costs and is a material component of palm oil profitability.

Palm oil companies today need to be transparent over work practices their workers are subject to and the accommodations they are provided with in order to avoid allegations of labour exploitation. In addition, there is also greater focus on social contribution and development given the large employment role palm oil companies play in agrarian communities. Companies that invest in, and also better articulate their social development agenda in labour welfare, education and worker support will be in a stronger position to meet the sector’s future sustainability targets.

Transparency is key to improving ESG compliance in the sector. Companies that have led in setting clear sustainability targets have raised the bar for ESG compliance and act as drivers of positive change. Thanks to ESG ratings and rankings accorded by index providers such as MSCI and DJI Sustainable Index, disclosures by palm oil companies have become more transparent.

Pertaining to policies and disclosures, it is important to look for palm oil companies with clear targets on land use and high conservation value (HCV) data, which is often reliable in mapping the scope of coverage and compliance. In short, sustainable palm oil companies should have good reclamation policies for disturbed land and clearly show how they are working with external stakeholder groups to verify their sustainable standards.

A palm oil company associated with positive change, for instance, is one that has a comprehensive rehabilitation programme to restore disturbed land into forests, while quantifying the biodiversity and community impact of their plans. Close coordination with agencies such as Nature Conservancy, the World Wildlife Foundation and the World Bank also allows companies to receive good reference or benchmark data. Biodiversity represents a strong opportunity for positive ESG sustainability practices and change; palm oil companies that actively reverse or minimise land disturbances by rehabilitating conservation areas and improve the environment for wildlife populations are good examples of positive ESG change that can occur in the sector.

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Natalie Kenway

Natalie is global head of ESG insight for ESG Clarity and has been an investment journalist for 16 years. She won Editor of the Year at the Aviva Investors Sustainability Media Awards 2021, and was Winner...