Finance & Investment

Understanding the Important Difference Between ESG Risk and ESG Impact

It is important to know the difference between these terms — and the potential for there to be some divergence between how a company performs on either measure. A company with a high impact rating and low ESG risk doesn’t necessarily mean it’s a great investment opportunity.

Brand Provided | By Adam Fleck | Published 1 year ago | About a 4 minute read

Image: Tesla

Tesla is frequently in the headlines of the mainstream media — and often not for the reasons investors would like. The company is founded on principles that were meant to revolutionize the automotive market and clean technology space. But the eccentric, sometimes confounding behavior of founder and CEO Elon Musk means that the firm does not rate highly on governance and social metrics.

For example, Musk’s dramatic acquisition of Twitter last year caused stock price volatility and reputational risk. Morningstar Sustainalytics — which rates listed companies on ESG factors — rates Tesla as medium risk and in the bottom half of both the automobile sector and all companies, despite its lofty climate ambitions.

According to research from Morningstar’s Investable World — a data-driven digital experience designed to make sustainable investing more understandable, engaging and actionable for investors — Tesla has an estimated 86 percent of revenue tied to the Climate Action impact theme but a Medium ESG Risk Rating, owing to weak product governance and social and management concerns.

Other companies boast similarly high impact, yet face high ESG risk.

CVS, for example, rebranded itself in 2014 to CVS Health to reflect its broader healthcare commitment and a desire to improve the future of health in the US. That same year, the company famously banned the sale of all tobacco products in all its stores, in spite of the expectation that it would cost an estimated $2 billion in sales.

But Sustainalytics rates CVS as medium risk and similar to subindustry average. Despite its industry-leading commitment to health and wellness, in the past year CVS has suffered backlash over several controversies — relating to abortion-drug policies and a $5 billion settlement in an opioid lawsuit — the latter of which is the most financially material for the company and constrains our fair value estimate by about 3 percent.

Risk vs impact

What we are seeing here is the difference between ESG risk versus ESG impact. Risks are the negative externalities that might affect the ongoing financial success of a business, including issues related to climate-change mitigation such as regulatory changes or expenses tied to adaptation. This might also include costs to manage working and safety conditions, as well as dealing with employee and consumer concerns around human rights, corruption and legal compliance.

Impact, on the other hand, describes the non-financial outcomes of companies’ activities — which can lead to improvement (or harm) to the environmental, social or governance measures of the planet. These include everything from moving towards net-zero policies or decarbonizing supply chains, to increased efforts on employee safety, gender equality, and living wages to the company and beyond.

It is important to understand the difference between these terms — and the potential for there to be some divergence between how an individual company performs on either measure. We believe all investors must be conscious of risk management (ESG or otherwise) in making a final decision to invest, while some investors might want to additionally focus on impact.

Determining where to get in

A company with a high impact rating and low ESG risk doesn’t necessarily mean it’s a great investment opportunity. Investors should also consider whether a company has carved an economic moat — an ability to protect long-term economic returns through durable competitive advantages. In addition, the question of if a company makes sense as an investment comes down to valuation. Whether it’s a high-impact firm, a low-ESG risk stock, or even a company with an economic moat, investors should focus on the price they’re paying and the value they’re getting.

Investors can overpay for companies with moats — or equally, get a great discount on a firm that’s driving high-impact alignment.

Morningstar reviewed the relationship between moats and ESG ratings for hundreds of companies. When comparing the ESG Exposure ratings — which is a data point that reflects Sustainalytics’ view on a firm’s exposure to 20 material ESG issues including carbon emissions, human rights, land use and biodiversity — of wide-moat to no-moat companies, there is strong evidence to suggest that, on average, the ESG risk that wide-moat companies are exposed to is lower than that of no-moat peers.

Interestingly, there’s little evidence that these wide-moat companies are doing more to address ESG issues. Nevertheless, value investors’ focus on economic moats appears to provide some level of inherent protection against ESG risks. Correlation does not necessarily mean causation; but if value investors continue to focus on locating stocks with the widest of moats and attractive price versus fair value when making stock selections, they may find the ESG risks that their portfolios face are inherently lower than the broader market.

Making the right decision requires investors to look at sustainable investment metrics in the multilateral, complex way they examine traditional investment metrics. Through this process, a company that seems to be a sustainability leader may ultimately be deemed unattractive.