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Sustainability Matters

Watch Out For These 4 Emerging Environmental, Social, and Governance Risks

A fuller appreciation of these risks can provide key insights for investors.

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Incorporating environmental, social, and governance analysis into an investment process can help uncover hidden risks or provide an early warning signal of risks that investors may be underappreciating. Sustainalytics' recently published report, "10 for 2018: ESG Risks on the Horizon," examines ESG-related risks that are becoming more material in 10 industries and how companies within those industries are addressing these issues. Here are a few of the findings.

Risk for Oil and Gas Firms: The Transition to Low-Carbon Energy
While global demand for fossil fuels will continue over the short run, changing patterns of energy consumption driven in part by carbon regulation are likely to have major impacts on the profitability of oil and gas firms. Investors are pressing for greater transparency, as evidenced by majority shareholder votes last year at  Exxon Mobil (XOM) and  Occidental Petroleum (OXY) asking for climate-risk disclosures. The Taskforce for Climate-related Financial Disclosures has issued recommendations for reporting, which gives companies the opportunity to demonstrate to investors that they understand the risks and have a credible strategy for addressing them.

According to the report, oil and gas companies at greatest risk in the low-carbon energy transition are those with higher average production costs; greater involvement in carbon-intensive projects, such as oil-sands mining in Canada, Arctic drilling, and certain liquefied natural gas projects; and those that have made little progress diversifying their product lineups.

Exhibit 1 shows Sustainalytics' evaluation of the greenhouse gas risk-management capabilities of the world's 10 largest publicly traded oil and gas companies. The leaders are  Royal Dutch Shell (RDS.A), Total (TTFNF), Eni SpA (EIPAF), and Chevron (CVX). Laggards include  BP (BP) and Exxon Mobil as well as firms from China and Russia. Royal Dutch Shell, the report says, is the only firm on the list that has set carbon-reduction targets and it's also diversifying its product lineup by entering the electric-vehicle market.


Source: Sustainalytics.

Risk for Food and Beverage Firms:  Growing Health Concerns Over Sugar Consumption
Concerns over the health effects of excessive sugar consumption are resulting in shifting consumer preferences, regulation, and litigation for food and beverage companies. Soft drink companies are trying to address the risk through reduced-calorie products and marketing restrictions but, the report notes, the industry is also under increased scrutiny for using its influence to mislead the public about sugar-related health risks.

Exhibit 2 shows Sustainalytics' take on the sugar-related risk-management performance of five major food and beverage firms.  Danone (DANOY) and  Nestle (NSRGY) lead the way because of their disclosure of relatively robust product health, marketing, and political involvement policy commitments.  Coca-Cola's (KO) low score, on the other hand, reflects its weak political involvement policy and sizable lobbying expenditures. It's also more involved in controversies surrounding lobbying and scientific funding. "Coca-Cola's legal and reputational risks resulting from allegations that it knowingly misled consumers and repeatedly acted to block sugar regulations could result in significant liabilities in the short and long term," the report concludes.


Source: Sustainalytics.

Risk for Software and Services Firms: Increased Scrutiny Over Anticompetitive Practices
As firms like  Alphabet (Google) (GOOG),  Facebook (FB), and  Microsoft (MSFT) have consolidated market power, anticompetitive concerns have emerged, raising the possibility that these industry giants could face antitrust litigation and eventually be broken up. Anticompetitive risk stems from closed ecosystems creating barriers to entry that stifle competition. The collection of massive amounts of consumer data and the platform content that drives it are leveraged for advertising and sales revenue. That not only creates significant competitive advantages—it also raises issues surrounding privacy and concern over the spread of disinformation. Regulators, particularly the European Commission, are beginning to question whether the concentration of power in technology companies is beneficial for consumers over the long run.

Exhibit 3 shows the number of antitrust-related incidents within the software and services industry over the past several years. Alphabet has experienced the largest number of such incidents, including a record-high EUR 2.4 billion fine in June 2017. The firm is appealing the fine, but this could force Alphabet to rethink its advertising-based business model, which brings in the bulk of its revenue. While the result of regulatory scrutiny is hard to predict, the report concludes that it is becoming clear that major technology companies will increasingly need to "balance their ambitions with their responsibility to their stakeholders."


Source: Sustainalytics.

Risk for Apparel Firms: Supply-Chain Oversight
Growing public scrutiny of the apparel industry's supply chain is increasing firms' exposure to financial risks linked to sourcing disruptions, legal action, and negative reputational impact from poor pay and working conditions. As apparel firms extend their operations to new locations, supply-chain risks follow. Recently, for example, some apparel firms have been shifting production from Bangladesh to countries like Myanmar and Ethiopia, where wages are lower. Western governments are ramping up pressure on oversight. France, for example, passed a law in 2017 imposing fines for companies that cannot demonstrate appropriate due diligence in their supply-chain monitoring.

Exhibit 4 shows the supply chain standards and management performance of 10 select apparel firms. H&M (HNNMY) has the top score because it demonstrates "concerted efforts toward improving supply-chain management and transparency." The firm is engaged with the Sustainable Apparel Coalition to develop standards for assessing supply-chain sustainability issues, and in Ethiopia it is engaging with government on wages, while paying workers well above minimum wage.


Source: Sustainalytics.

Firms in all four of the industries discussed above are exposed to key ESG-related risks, but some are better prepared than others to manage that risk. In particular, Sustainalytics believes Royal Dutch Shell is well prepared to address energy-transition risk and H&M is well prepared to address supply-chain risk. Alphabet and Coca-Cola, on the other hand, are poorly prepared to deal with the ESG risks they face. The full report discusses ESG risks in six additional industries and the firms that are better and worse prepared to manage those risks.

Environmental, social, and governance factors are often thought of as a set of criteria that apply uniformly across industries and that are not necessarily financially material to a firm. On the contrary, ESG can be more accurately described as financially material risks related to the broader environmental, social, and governance contexts in which an industry and its firms operate. They are often not fully incorporated into financial analysis but, as the "10 for 2018" report shows, a fuller appreciation of them can provide key insights for investors.

Download the full report here.

Jon Hale has been researching the fund industry since 1995. He is Morningstar’s director of ESG research for the Americas and a member of Morningstar's investment research department. While Morningstar typically agrees with the views Jon expresses on ESG matters, they represent his own views.

Jon Hale does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.