Many investors take environmental, social, and governance, or ESG, factors into consideration largely for the ethical values behind them, even if prioritizing ESG issues has led to subpar returns at times.
But ESG is not just about values. A company that ignores ESG risks could incur significant costs that jeopardize its ability to earn long-term, sustainable profits, according to new research from
published this week.
As the investing community starts to care more about how corporations address the environment, attend to their workers, and govern themselves, failing to manage these issues successfully could bring unprecedented risks to a company.
“The market has thought about ESG for a long time as a value discussion. That’s an important thing to think about, how can investors align their money with what their preferences are,” Seth Sherwood, equity research analyst and chair of the ESG committee at Morningstar, told Barron’s in an interview. “On the other hand, ESG risk is thinking what are the actual impacts from regulation, from changing consumer demand, or climate change on the operations of a given business.”
Viewing ESG factors through a risk-management perspective can help investors evaluate a company’s sustainable competitive advantage—or economic moat—in the long term, noted Sherwood. On the flip side, companies with an economic moat tend to have a stronger foundation to manage ESG risks and should feel less impact if a controversy arises.
Morningstar analysts assign moat ratings to more than 1,500 global companies based on their competitive advantages, which include high customer-switching costs, cost advantage, intangible assets, or efficient scale. At the same time, the company’s research partner Sustainalytics evaluates companies by their “unmanaged” ESG risks, meaning issues that could be financially material, but haven’t been properly addressed by management yet.
In his latest research, Sherwood found that companies with lower ESG risks tend to have higher economic moat scores. In other words, the two metrics seem to go hand in hand.
For example, resource-intensive companies that fail to invest in safety infrastructure and meet regulations could face disasters like the
(ticker: BP) oil spill in 2010 or the role of
(PCG) in some of California’s wildfires. The huge environmental liabilities could ultimately wear away their cost advantage.
Or companies that neglect to take care of their workforce might face high talent turnover and lose their edge in human capital and product development.
Problematic corporate governance could lead to poor capital-allocation decisions, privacy violation and data breaches could hurt public trust, and executive scandals could ruin a strong brand overnight. All these examples demonstrate that ESG factors aren’t just ethical issues, but also are highly associated with financial risks.
Particularly, Sherwood noted that ESG risks are always in flux. Companies need to constantly respond to new regulations and technology environments, for instance, just like they must keep adapting to maintain their sustainable competitive advantage.
Companies that fail to monitor and address ESG risks might manage to skate by in the short term. But over the long term, a costly risk event can destroy their competitive advantages, leaving investors with more risk and poor returns, wrote Sherwood.
Write to Evie Liu at [email protected]