Companies with some of the greatest real-world impact can also come with the highest environmental, social, and governance-related risks.
In a paper titled “The Hidden ESG Risks of Feel-Good Companies,” Adam Fleck, Morningstar’s director of equity research in ESG, argued that investing in stocks with high impact in areas like clean energy or gender equality doesn’t preclude exposure to ESG risks. The paper is the first report under Morningstar’s new “Investable World” initiative, which aims to provide and analyze data for investors to better understand and engage with sustainable investing practices. Both the paper and Investable World launched on Wednesday.
In the paper, Fleck wrote that a stock might have a high competitive advantage and be aligned with sustainability goals, but it could also be a high-risk bet for investors because of its shortcomings in other ESG factors.
He used Tesla as an example. Eighty-six percent of the company’s revenue is tied to what Morningstar called the “Climate Action” impact theme — or the “E” in ESG — but the stock still received a medium ESG risk rating. While the company’s environmental impact may make it attractive to some investors, its “weak product governance and other social and management concerns” dragged its overall ESG risk rating down.
“Other companies also boast similarly high impact yet face high ESG risk,” Fleck wrote. “These aspects are worth considering if an investor is focused primarily on driving positive impact, but also wants to consider risk management in an effort to drive a competitive return.”
Fleck made a clear differentiation between impact and ESG risk. In fact, overall, companies with high levels of impact-aligned revenue showed signs of only slightly lower ESG risk. Of the 74 stocks that had exposure to sustainable activities and that Morningstar equity analysts covered in its rating system, 43 received a medium or high ESG risk rating.
“And even among the broader set of all public companies estimated to have at least 50 percent of their revenue aligned to impact themes – covered by Morningstar equity analysts or not – there is a wide dispersion of ESG risk ratings, with only a slight skew to lower risk levels,” Fleck wrote.
The most ideal situation occurs when a company’s revenue has high exposure to impact themes, has a low risk rating, and is trading at a discount. But scenarios like this one, according to Fleck, are few and far between.
