By Andrew Wetzlel, CFA®, Managing Director of Sustainable Investing
In our last quarterly letter, we touched on the idea of investing in ESG improvers and environmental transitions. These are companies that are starting from a place that many sustainable investors may not be entirely comfortable with. These companies generally have lower ESG scores or are in businesses without significant exposure to environmental solutions. The idea, backed up by research, is that positive change can be rewarding, making this type of analysis an increasingly important consideration.
With opportunity comes risk, the risk that lower-rated companies may be more volatile and the risk that companies may not be serious about transition plans. There’s also the risk that investment in improvers or transitions may be viewed as greenwashing. We believe carefully researched improvers and transitions deserve a place in sustainable strategies and believe investors broadly will come around to this idea as emerging regulations and market-based incentive programs like the Inflation Reduction Act accelerate the shift to a more sustainable future.
To start, ESG analysis is about assessing material environmental, social, and governance risks at an industry level and evaluating the management of these risks at the company level within each industry. ESG scores from firms like MSCI do not pick good or bad industries, though they do help investors assess the quality of risk management across companies within each industry. Thematic targeting starts with research into a changing world to identify pressing challenges and potential solutions. Investors use thematic analysis to identify companies with products or services that are likely to benefit as solutions scale, consumer preferences shift, or regulations develop. Within the sustainable investing landscape, investors have historically focused on companies with well-managed ESG risks and/or companies with clear and significant leverage to thematic growth drivers.
As sustainable investing in all its forms has become more mainstream, it is increasingly clear that focusing only on high scoring ESG companies or fully aligned thematic opportunities is incongruent with the broader journey toward a more sustainable future. Companies actively working to improve ESG risk management or shifting business models toward environmental solutions may present opportunities to add value in portfolios.
As noted last quarter, ESG Rating Score Revisions and Stock Returns, an academic paper published in April of 2022, explored the effects of ratings changes on stock returns over medium-term holding periods of six months. Among many interesting conclusions, the authors found a 3-percentage point spread between upgraded and downgraded stocks, and they noted that downgraded stocks experience a drop in return on assets relative to upgraded stocks after a revision. The takeaway is that changes in ESG ratings can positively contribute to relative performance as investors assess the information content of revisions.
In contrast to changes at the margin around ESG risk ratings, transition opportunities are more about a shifting business model or product/service mix. Recent research from Morgan Stanley identified businesses that are transitioning toward more environmentally beneficial products or services. One notable conclusion from the report was the relative performance spread between utility companies that are actively shifting from a higher carbon intensity toward a lower carbon profile and those that have already lowered their carbon footprints. From the end of 2014 0through mid-2022, Morgan Stanley’s “Active Rate of Change” basket outperformed the lower carbon intensity utility basket by about 8% per year. In this case, shifting from higher-cost coal generation to lower-carbon and lower-cost sources of generation has been beneficial both environmentally and economically.
When investing in companies with apparently weaker sustainability profiles, it is important to carefully assess risk. With ESG improvers, the key is a deeper analysis beyond simple headline scores to develop a broader understanding of risk and where this might be missed by other investors, ratings agencies, or companies themselves. This type of analysis is a natural part of a good fundamental research process
and something we take seriously at FLP. Similarly, with environmental transitions, the key is understanding the level of commitment to change, and magnitude implied by targets. As with any good research process, both improvers and transitions require ongoing monitoring of details and targets to increase the chance of capturing successful change and reduce the risk of greenwashing.
From a big picture perspective, improvers and transitions represent active change toward a more sustainable future. We have witnessed change in companies across sectors including industrials, materials, financials, and even traditional energy. Change in these somewhat staid sectors may not be easy, though to meet longer-term global goals, it is increasingly important. From a portfolio construction perspective, opening the opportunity set to include improvers and transitions means more room to maneuver through cycles and periods when factors such as growth and value shift materially. For all these reasons, we believe improvers and transition opportunities should be on the radar for sustainable investors.