Mahi Sall, Advisor, Fintech-Bank Partnerships, Payments and Financial Inclusivity
January 25th, 2023
Mahi Sall is the CEO & Founder of FinXpair, a Berlin-based strategic advisory boutique firm focu[...]
ESG Risk Comes Into Focus Companies focus on their ESG risks to build profitability for the long term.
Morningstar | Travis Miller, Tancrède Fulop, and Seth Sherwood | March 9, 2020
Companies today face unprecedented risks as stakeholders demand accountability and transparency in how corporations approach the environment; attend to the well-being of their workers, customers, and neighbors; and govern themselves in an ethical way.
To Morningstar, these factors—environmental, social, and governance—come down to the bedrock of investing: risk. A company that ignores these risks or commits a misstep could incur significant economic costs that jeopardize its ability to earn long-term, sustainable profits.
One way that investors can identify and manage the ESG-related risks in their portfolios is to understand how companies’ sustainable competitive advantages—or economic moats—have an impact on these risks.
See: Executive Perspectives on Top Risks 2020
This is the approach Morningstar’s equity research analysts take. They view ESG through the lenses of risk management and due diligence, considering:
- Which environmental, social, and governance issues are financially material for each company or industry?
- How are companies tackling these material risks?
- How will these risks affect companies’ long-term value?
The answers are varied and demonstrate that ESG issues often overlap. Here’s a look at the close relationship between economic moats and ESG risk and how these issues have manifested in various companies.
ESG Risk and Moats Go Hand in Hand
A company’s economic moat can take many forms. It can be built on high customer switching costs, network effect, cost advantage, intangible assets, and efficient scale. The Morningstar Economic Moat Rating—wide, narrow, or none—indicates the strength of a company’s sustainable competitive advantage and its ability to create long-term value for investors.
Economic moats and ESG risk tend to work together. Sustainalytics—a Morningstar research partner in which Morningstar holds a noncontrolling interest—rates companies’ exposure to ESG risks on a scale from Negligible to Severe. As demonstrated on the chart below, proportionally, more narrow- and wide-moat companies receive Medium, Low, or Negligible risk ratings from Sustainalytics than do firms without a moat.
Companies with economic moats tend to have a stronger foundation from which to manage ESG risk. For example, a wide-moat company with high customer switching costs might feel less of an economic impact than its no-moat peer if an ESG controversy arises. Similarly, a firm with good ESG risk management might have more capital—human, political, financial—to create an economic moat.
However, ESG-related risk—just like a company’s competitive advantage—is always in flux. Just as companies must adapt to protect their moats, companies also must adjust to changing ESG risks, such as new regulation, stakeholder demands, and technology. Warren Buffett’s famous quip, “Only when the tide goes out do you discover who’s been swimming naked,” also applies to ESG risk.
See: ESG has moved up the pension trustee agenda – are you ready?
Companies that don’t adapt might skirt by in the short term, but over the long term, they can put investors in jeopardy with more risk or lower returns. How? By letting their sustainable competitive advantages erode. For example:
- Research-intensive companies that neglect their workforce might eventually lose pricing power.
- Resource-intensive companies that fail to invest in safety systems and infrastructure might face environmental liabilities that wear away their cost advantage.
- Data breaches that hurt a strong brand and governance lapses may result in poor capital allocation.
ESG-related risk can foretell changes in a company’s competitive advantage, which is why identifying a firm’s ESG risks is an important component of evaluating its moat.
Below, we will go through each component of E, S, and G and show how companies are managing, or mismanaging, their individual ESG risks and how these risks affect firms’ sustainable competitive advantages.
Continue to the full article --> here
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