As environmental, social, and corporate governance practices become increasingly mainstream, institutional investors may be overlooking some ESG risks in their portfolios, according to a Morningstar report published Thursday.
The researchers applied company-level ESG assessments from Sustainalytics to Morningstar’s suite of equity indices to determine the ESG risk levels of common, equity-only investment strategies. Sustainalytics is Morningstar’s ESG research arm.
“As more investors are integrating sustainability criteria, it's important to look at portfolios through an ESG lens and consider ESG-related risk,” Dan Lefkovitz, Morningstar strategist and author of the report, told Institutional Investor. “A lot of popular investment strategies carry more ESG risk and more carbon intensity than investors might realize.”
For one thing, the report found that size and value premiums also apply to ESG risk. While many investor portfolios are weighted toward smaller and lower-priced stocks because research shows they deliver excess returns over time, small caps actually carry more ESG risk than large ones. For example, Ovintiv, an oil and gas exploration company, is in the top ten in Sustainalytics’ small-cap industry index. Its two-globe rating (companies are rated one to five globes, with five being the highest rating) comes from its position in the highest-risk industry of oil and gas exploration and production and in the highest risk sector — energy.
Value stocks also carry higher ESG risk than growth stocks. For instance, ExxonMobil is in Sustainalytics’ top 10 companies in its value index, but the company has an ESG risk assessment rating of two globes, the lowest out of the top ten companies. JPMorgan Chase (also included in the value index) is “exposed to severe regulatory and reputational risks related to business ethics, data privacy, and cybersecurity,” the report said.
Lefkovitz attributed these trends to overall sector biases: “On the value side of the market, you're going to have more energy companies, more materials, more industrials, and more utilities than on the growth side,” he said.
In contrast, Morningstar’s growth index includes stocks like Microsoft and Apple (Apple is also included in the value index), which have high ESG ratings and are relatively carbon neutral.
“On the growth side, companies like Microsoft and Apple, have less ESG risk associated with them. They're less carbon intensive,” Lefkovitz said.
Additionally, dividend yield focus, dividend growth, and infrastructure carry high ESG risks. Infrastructure, which includes toll roads and bridges, and minimum volatility strategies are carbon-intensive. Minimum volatility and global equity infrastructure received high carbon intensity scores of 338.6 and 1,078.9, respectively. A score of more than 1,000 is very high.
“Sections in the market that are rich in dividends also tend to be high in ESG risk and carbon intensity,” Lefkovitz said.
Renewable Energy Can Be Carbon-Intensive
Sustainability-oriented portfolios can still carry a significant amount of ESG risk. According to Morningstar’s Global Renewable Energy Index, renewable energy received a carbon intensity rating of 1,719.5. This rating was almost 10 times higher than the broader equity market’s carbon intensity score, a disparity that indicates hidden ESG risks in the sector.
The high carbon intensity of the renewable energy sector can be credited, partially, to the fact that many companies are invested in both fossil fuels and sustainable solutions. Also, a company can produce climate-friendly products and services, but its processes may still use a lot of carbon.
“Companies are manufacturing things like wind turbines or solar panels, which are obviously clean products, but their operations might be carbon intensive,” Lefkovitz said. “So their manufacturing actually has a heavy environmental impact.”
Other companies may be strong in one letter in the ESG trifecta but weak in another. The report uses Tesla as an example: “Though Tesla’s electric cars are emissions-free, the company faces other ESG-related risks. Its factory workforce presents a labor-relations challenge and product governance is an issue, especially in the autonomous realm.” The report also pointed out CEO Elon Musk’s “problematic public statements” as a governance risk.
In another report from Freshfields, a U.S.-based M&A, litigation, governance, and regulatory firm, author Elizabeth Bieber looked at the overarching trends during the 2021 proxy season, concluding that shareholder proposals focused on ESG continued to grow year-over-year. In 2020, only 16 percent of environmental- and social-focused shareholder proposals received majority support; In 2021, that number increased to 24 percent.
According to Bieber, the first step in mitigating ESG risks in portfolios is to address investors’ demand for more information on ESG factors. “The interest and the demand is in information,” she told II. “There are investors that have expressed that it is difficult to begin to measure or to think about ESG risk without having sufficient information from companies.”
Currently, there are no streamlined disclosure requirements for ESG other than standard materiality thresholds, which makes it difficult to compare company-to-company information, Bieber said. Much of the information that is available is not universally standardized.
Investors are in information-seeking mode right now, Bieber said. In order to take the next step in ESG integration and to adequately limit ESG risk in portfolios, investors need to have access to additional information, which may come either through regulatory mandates or pressure from investors who are requesting ESG information from companies.
“At some point, either the SEC will require information, or many companies will be providing information because they have shareholder proposals that received majority support or other investor expectations. Some companies will choose to voluntarily disclose the information,” Bieber said.
Because of this information gap, investors and asset managers have difficulty comparing and evaluating companies. Some investors and shareholders focus on the “G” in ESG, encouraging companies to hold management accountable, while others focus more heavily on environmentalism, sustainability, or diversity and inclusion efforts. As the information gap starts to close, Bieber said shareholders will be able to accurately pinpoint where companies should focus their ESG efforts.
”Then, there will be a point at which the investors go back and compare information and figure out what is important,” Bieber said.