We believe good corporate stewardship and positive environmental, social, and governance (ESG) behavior can help create business resiliency, enhance competitive advantages, and sustain economic growth. Through this lens, climate change is a growing point of friction. Can carbon-intensive companies that are otherwise models of stewardship — with quality management teams that consider all stakeholders, track records of capital allocation that add long-term value, and engaged independent boards — measure up for portfolios like ours, which aim to balance financial returns and responsibility? Increasingly, our answer is no. If a business is categorically negative for the environment (E), it is difficult for positive S and G behaviors to outweigh the growing financial challenges and other risks to the company.
Central to our investment philosophy is belief in a flywheel effect: Companies that reinvest returns to improve competitive position and strengthen ties to key stakeholders may ultimately lower their cost of capital while sustaining or improving return on capital. We think companies in any industry may be considered good stewards by exhibiting what we consider best-in-class behavior. However, the environmental risks inherent to some industries may, over time, prove too great a drag on this flywheel effect.
Amid shifting climate economics and regulatory environment, the cost of capital for certain industries, including oil & gas and metals & mining is mounting. Given the rising tide of ESG-driven investing and regulation, we believe a reversal of this trend is unlikely. These industries are among the world’s largest emitters of greenhouse gasses (GHGs), the primary cause of climate change. They have large carbon footprints. While select companies may be well-managed, responsible stewards, working to transition toward a low-carbon economy, the cost to adapt fossil-fuel-reliant business models will be very high. Investor engagement, government policy, or marginal business-model changes are unlikely to alter their fundamental emissions profile. With this debate in mind, we suggest investors consider the following:
Understand what affects climate change
- Coal divestiture is insufficient. In our view, the current ESG conversation around carbon is too narrowly focused. Coal is a small part of the fossil fuel universe, so exclusions or divestment are ineffective.
- Look holistically at carbon footprints. Scope 1 and 2 emissions (those directly from manufacturing) garner the most attention. Investors must broaden their analysis to Scope 3 emissions (which measures the added carbon footprint from the full supply chain and end-customer use). Scope 3 emissions assessments will shine a spotlight on a wider span of industries, including autos and consumer products. Are we correctly assessing these risks?
- Carbon and GHG disclosures are poor and difficult to compare. Environmental disclosures are backward looking, inconsistently reported, and measured differently company to company. Currently, only 34% of the MSCI ACWI report Scope 1 and Scope 2 emissions, and just 21% report Scope 3 emissions. While comparisons may be impossible today, we can gain a sense of relative scale and vulnerability by drawing parallels and asking good questions.
Keep up with the ESG conversation
- The “E” debate will broaden. Beyond GHG emissions, water intensity (semiconductors), waste and tailings (gold mining), recycling (construction and IT hardware), and more will come under scrutiny; as will companies’ exposure to physical climate risks like heat, drought, floods, wildfires, hurricanes, and access to water.
- Expect more “S” and “G” scrutiny as well. In many contexts, the S and G are even more relevant for long-term value. Investors should prepare for substantive debates about worker safety, product quality, corporate culture, auditor impartiality, board skill, compensation, lobbyists, and more.
Do your own research
- Public ESG ratings overvalue disclosure. Incentivized to report as much information as possible, companies focus on quantity over quality in ESG disclosure, choosing trivial data and measurement periods to illustrate progress and commitment to sustainability. Be skeptical about upgrades to publicly available ESG scores; more disclosure may not necessarily be a positive signal.
- Underweighting carbon-heavy sectors may not result in much tilt. Energy and materials currently account for less than 10% of MSCI ACWI. In a simulation, we found that bringing portfolio allocations to near zero did not introduce much unintended sector or factor risk.
- Know the nuances of ESG and stewardship. Incomplete information make it difficult to assess certain situations. Get comfortable with the gray areas of ESG. Realize that no company is perfect and do as much research as possible to evaluate the trade-offs in return and material ESG risk you are willing to accept.
