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Do hidden ESG risks lurk in your portfolios?

For others, more pragmatic concerns are at play–reputational risk, client demand, or regulatory compliance.

For others still, environmental, social, and governance (ESG) issues matter because they affect investment outcomes.

After all, oil spills, labour disputes, accounting scandals, data breaches, and discrimination lawsuits can impact financial results.

Look no further than Boohoo, Wirecard, Johnson & Johnson, BP, Toshiba, and Equifax for cautionary tales. 

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We recently examined the ESG risk profiles of a number of popular investment strategies.

Using a selection of Morningstar equity indices to represent market segments we applied ESG risk ratings and carbon data from Sustainalytics.

It is hardly surprising that natural resources-focused equities carry elevated ESG risk and carbon intensity.

Companies in extractive industries produce emissions, effluence, and waste and often face challenges related to health and safety, community relations, and business ethics.

But investors may not realise that a dividend portfolio can be 20% riskier than the market from an ESG perspective.

Why? Dividend payers often cluster in economic sectors such as utilities, energy, basic materials, and industrials, which have heavy environmental impact and face other ESG risks, such as health and safety.

It is important to distinguish, however, between traditional high dividend, equity income strategies, and dividend growth.

The top two constituents of Morningstar’s dividend growth index are Microsoft and Apple, which both score well from an ESG perspective.

Equity infrastructure investing, for its part, tends to lead investors into the utilities and industrials sectors, and Morningstar’s minimum volatility index has an elevated level of carbon intensity due to its sector tilts.

On the low risk side, Morningstar’s Wide Moat index, which highlights companies that have durable competitive advantages (or economic moats) around their businesses, demonstrates that high quality businesses tend to score well on ESG.

A thematic, innovation-focused index, heavy on the technology, communication services, and healthcare sectors, also carries low ESG risk.

It is important to note, though, that not all tech and healthcare companies are ESG leaders.

Tech faces challenges related to cybersecurity, data privacy, human capital, and anti-competitive practices, according to Sustainalytics.

Healthcare companies have to navigate ESG issues like product safety, animal testing and pricing.

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Is renewable energy investing ESG friendly?

Perhaps our most shocking observation was that the Morningstar Global Renewable Energy index is roughly ten times as carbon intensive as the global equity market.

How can that possibly be? For one thing, many companies are involved in both fossil fuels and renewables.

The large slug of utilities stocks in the index includes such carbon-intensive companies as China Power, RWE, and AES.

Also, a company can be focused on products and services that are climate friendly – wind turbines or solar panels for example – but have carbon-intensive operations.

Then there is Tesla. Though its electric cars are emissions-free, the company faces other ESG-related risks.

Its factory workforce presents a labour-relations challenge; product governance is an issue; and serious corporate governance concerns revolve around its CEO.

Patent litigation and regulation are further challenges, in Sustainalytics’ view.

So renewable energy equity investing is not the same as low carbon investing, but does that mean its greenwashing?

Not necessarily. But there are trade-offs that investors need to contend with, especially where regulatory compliance is concerned.

With the increasing investor focus on sustainability, it is important to examine portfolios through an ESG lens.

As issues such as climate, diversity, equity, and inclusion, and business ethics are considered as part of investment processes, hidden risks are critical to expose.

Dan Lefkovitz is a strategist for Morningstar’s Indexes group

 

 

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