ESG Risks in Unexpected Strategies

    Stockholm (NordSIP) – A recent report from Morningstar about ESG risks has been making waves for the unexpected places it has found sustainability concerns. According to the report, Morningstar indices focusing on renewable energy, equity-income and low volatility strategies appear to display unexpectedly high levels of ESG risk. One stand out issue considered is the case of Tesla, whose environmental contributions appear to be undermined by other concerns. On the other hand, Morningstar finds that high-quality forward-looking companies and companies involved in innovation and disruptive technologies display low ESG risk, according to the analysis.

    A lot of the counterintuitiveness of the findings can perhaps be put down to the fact that the analysis is based on a range of Morningstar indices whose components one would expect to be sustainable but that include companies at different stages of development and ESG integration.

    Renewable Energy ESG Risks

    The first counterintuitive insight from the Morningstar report is that companies involved with both clean energy and fossil fuels can have carbon-intensive operations and be exposed to ESG risks. “I think there are a few things going on here,” Dan Lefkovitz, Index Strategist at Morningstar, explains.

    “So if you look at Morningstar’s Renewable Energy Index-first, it contains a lot of companies that are involved in both traditional fossil-fuel-based power generation as well as renewable energy, some utilities. So that’s going to raise the overall carbon intensity of the index. Second, you have some companies that are involved in manufacturing clean energy solutions, things like wind turbines and solar panels. Those products are clean, but the operations, the manufacturing processes, are carbon-intensive,” Lefkovitz added.

    Tesla illustrates another type of ESG risk in this index. “Finally, you have a company like Tesla that is producing a clean energy solution, but it has other ESG risks, including human capital and product governance,” Lefkovitz explained. The report highlighted challenges from labour relations, product governance, Elon Musk using his 20% equity share as collateral for personal loans in the past, as well as patent litigation and regulation requiring a separation between automakers and dealers.

    Equity-Income and Low-Volatility Strategies

    According Lefkovitz, dividend investing often takes investors to the value side of the market. This means they end up exposed to sectors such as energy, basic materials, utilities and industrials, which tend to be high in dividends but also in ESG risk and carbon intensity. However not all dividend strategies are alike.

    “Investors love dividends for income, for total return. (…) But I would distinguish between traditional equity-income, high dividend, which tends to be more of a value strategy, and dividend growth. If you look at the top two constituents of Morningstar’s Dividend Growth Index, they’re Microsoft and Apple. And those are both 4-globe companies,” Lefkovitz says.

    Beyond returns, investors are often also attracted by minimum volatility equity strategies that aim to have less price volatility than a broad market index. Lefkovitz notes, however, that some of the most stable companies are often also some of the least green. “If you look at Morningstar’s Minimum Volatility Index, which I think is representative, it has twice as much exposure to both utilities and basic materials as the overall equity market. So it’s a sector story there as well,” Lefkovitz adds.

    Low ESG Risk

    Companies operating around forward-looking business models appear to be the main source of low ESG risk, be it on account of corporate quality or a focus on innovation and disruptive technologies.

    “Moat is Morningstar’s proprietary forward-looking definition of corporate quality. A company that has a moat around its business has a sustainable competitive advantage. And we’ve observed consistently that companies that score well for quality also have low ESG risk and low carbon intensity. So I wasn’t surprised to see that relationship reinforced there between quality and ESG,” Lefkovitz says.

    “And then exponential technologies focuses on companies that are involved in innovation and disruptive technologies. It’s heavy on the technology sector, healthcare, communication services, and those are sectors that tend to be lower on the ESG-risk and carbon-intensity side,” Lefkovitz concludes.

    Image courtesy of Tesla
    Filipe Albuquerque
    Filipe Albuquerque
    Filipe is an economist with 8 years of experience in macroeconomic and financial analysis for the Economist Intelligence Unit, the UN World Institute for Development Economic Research, the Stockholm School of Economics and the School of Oriental and African Studies. Filipe holds a MSc in European Political Economy from the LSE and a MSc in Economics from the University of London, where he currently is a PhD candidate.

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