How to Navigate the Fog of Sustainable Investing -- Heard on the Street

By Stephen Wilmot 

Can environmental, social and governance risks be quantified? With the notable exception of carbon emissions, probably not -- but that doesn't mean the exercise isn't useful for investors.

Interest in so-called sustainable investment is ballooning. One sign is the money given to mutual funds: In the first half of 2020, net flows into sustainable funds totaled $20.9 billion in the U.S., according to Morningstar, compared with $21.4 billion for 2019 as a whole -- which was itself four times the previous record for a calendar year.

Fund managers that don't specialize in ESG strategies are scrambling to incorporate them into their investment frameworks. There is an established industry of risk ratings, but these come with a well-documented problem: The correlation between different companies' ratings of the same stock is low because they measure performance differently. An infamous example is Tesla. MSCI rates the electric-car maker highly because of its environmentally friendly products, while FTSE Russell gives it a middling score for other reasons. This kind of confusion gives ESG ratings a reputation for fuzziness.

Quantifying the risk to earnings from a given concern is a pleasingly sharp-edged alternative. London-based fund manager Schroders has developed a tool, SustainEx, to put a value on a company's "externalities" -- the unpaid costs of its activity borne by society. The rationale is that pressure is building on companies to assume a greater share of these costs, which it estimated last year at $2.2 trillion or 55% of corporate profits globally.

For example, SustainEx sees the tobacco sector as most at risk, given the health problems caused by smoking. The market agrees: After many years of stellar stock-market performance, tobacco stocks have fallen from grace since 2017 as the U.S. Food and Drug Administration has toughened its stance. Other conclusions, such as the social risk to the earnings of highly rated alcoholic drinks producers such as Diageo, are more surprising.

Such an approach has the advantage of bridging the gap between ESG analysis and conventional stock analysis, which revolves around earnings estimates. Some companies have made similar efforts: Sportswear brand Puma has published a survey of what its products cost the environment for almost a decade. Yogurt maker Danone this year started to report earnings per share adjusted for its carbon footprint.

Ultimately, though, putting a number on ESG risks isn't so different from issuing a qualitative rating. Schroders used academic studies to estimate costs in as objective a way as it could, but another investor could package the same or other studies differently and come up with different numbers.

"It would be nice to have comparability, but things are often not comparable," says Alex Edmans, a finance professor at the London Business School and author of " Grow the Pie: How Great Companies Deliver Both Purpose and Profit." He usually prefers a framework based on broad principles to a quantitative approach.

The real advantage of SustainEx for Schroders, which previously used MSCI's ratings, is that having an in-house system allows ESG factors to be better integrated into its existing processes. "We're trying to help our investors think differently about the ingredients that go into an investment decision," says Andy Howard, global head of sustainable investment at Schroders.

One area where ESG risks can easily be compared is the carbon emissions held responsible for climate change -- a problem that has rapidly risen up the political agenda in recent years. Tougher carbon cap-and-trade programs in particular could crystallize risks to earnings identified in models such as SustainEx. Amid the confusion around how to approach ESG factors, comparing companies' carbon footprints is a good place to start.

Write to Stephen Wilmot at [e-mail]

(END) Dow Jones Newswires

September 07, 2020 05:31 ET (09:31 GMT)

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