Does the Environmental Pillar Matter?

Today is the last part of a three part series we've done for ESG now: we examine whether investors should care about incorporating environmental data into equity analysis. In previous episodes we discussed the social pillar and the governance pillar, now its on to the environmental pillar of our ESG ratings model. We look at the environmental pillar as a whole and the themes that build it and tell you whether companies that scored well on each theme performed better than their lower scoring peers.

If you want to read the blog that is associated with this podcast, here is the link: https://www.msci.com/www/blog-posts/managing-climate-change-risks/04992064034

Guest: Xinxin Wang, MSCI Research; Elchin Mammadov, MSCI ESG Research 
Host: Mike Disabato, MSCI ESG Research

Transcript

Mike Disabato (00:00):

What's up everyone? And welcome to the weekly edition of ESG Now, where we cover how the environment, our society and corporate governance affects and are affected by our economy. I'm your host Mike Desto, and this week we discuss whether the environmental pillar in our ESG ratings model is useful for equity analysis. Thanks as always for joining us. Stay tuned. The ESG acronym has been controversial of late, especially in the United States. Much of that controversy has been on whether investors should consider it as part of their overall toolkit when thinking about what to invest in, that's a very fair question to have for many investors. The way that question is answered is by considering whether the multitude of sustainability factors that go into the different environmental, social and governance pillars will allow them to get a better risk adjusted return in the market. And there are of course investors that want other things such as the knowledge that they are supporting decarbonization activities.

(01:01):

But even if those are the main goal, a parallel goal or a secondary goal or a tertiary goal is still going to be those returns else. Why would you not just donate the money to a company and not stress over it? So in that regard, we often at MSC, I have a desire to look at past returns and see if whether our method of ESG analysis actually proved useful. And we wrote three blogs on this topic, one on the governance pillar and one on the social pillar, and the last on the environmental pillar. And those pillars obviously make up our ESG rating. Each looked, each blog looked at whether investors should care about incorporating data that each pillar is made up of into their equity analysis. And we've covered the first two of those on the pod already. We already looked at the governance pillar blog and we looked at the social pillar blog as well.

(01:53):

And so today we're covering the third and final part of this series, and that is the environmental pillar. And for this, I turned to Al Sha Mamado and Chen Wang, who both along with our colleague DTI Sha, conducted the research and wrote about whether investors should care about incorporating environmental data into their equity analysis. And by the way, I'm going to put the link for that blog that they wrote on this topic in the podcast description for anyone interested in doing some follow-up reading. Now, I want to get right into the findings here, but first I think I should step back and give you our thesis around even including environmental data points in an investment analysis. It's not that environmental problems suddenly create situations to make or lose money overnight, it's that there are these shifts happening due to environmental changes, whether that be regulatory or consumer preferences or literally risks caused by the weather, such as what we're seeing now in Florida with Hurricane Milton or masses of capital flowing toward products that can help lower our emissions due to giant government regulations such as the inflation reduction Act in the us.

(02:59):

And if you have the right data, you can judge which companies are paying attention to these shifts much more than their peers, and you can make decisions on what to do with that knowledge. Maybe you'll do nothing. Maybe you'll keep focusing on some other factor. But the argument is that if the world keeps warming and let's say governments for example, decide to take action to try and address that warming and try to stop the cause of that warming, then the data you've ignored and the company that you've ignored could cause you to miss out on return opportunities. Maybe that's where Shichen can come in right now and kind of say whether or not I'm right that my leading statement is actually useful or I'm about to have a pie in my face.

Xinxin Wang (03:40):

We found that the listed companies worldwide that we rated most highly on their approach to financial material, environmental risks and opportunities, which is the environmental pillar in our ESG ratings, outperform their lowest rate peers. And on average, the highest rated companies deliver 40 basis point more annualized return than their lowest rate peers since September, 2013. And yes, we did adjust it for region, industry and size.

Mike Disabato (04:13):

So in the simplest terms, the environmental pillar as a whole has been useful in the past as a signal for market performance, and that's over an 11 year period because that's the period that we had the most data for and could run the most useful analysis. Again, I know it can be odd to speak about the environment as though the only thing that matters is a profit motive, but this is an investment strategy we're talking about. So it's important. Now, our environmental pillar is made up of a lot of different sustainability data points that are grouped under themes, and those themes are broken into what we call key issues. And I'm not going to go into what each key issue is and what they are because it's not really important here. The important thing is to think about the themes. There's climate change, there's natural capital, there's pollution and waste, and there's environmental opportunities.

(05:03):

And climate change is all about carbon emissions of the company and it's products. There's some more in there, but that's kind of the basic thing. Natural capital is how the wider world impacts the company and the company impacts the wider world like its land use or its water use or its biodiversity impacts and things like that, or it's biodiversity dependency. Of course you got to think about that as well. Now, pollution and waste is all about toxic emissions and general waste and what might happen to companies that create a lot of either of those things. And environmental opportunities, this is a bit of a different one. Those that I just mentioned were more about risks. This is more about opportunities as the name would suggest. It's companies that are making the products that the world could use to collectively lower its emissions like renewable energy companies, let's say.

(05:48):

Now, the reason those themes are important is because it's not just important to understand that companies that scored well on the environmental pillar as a whole perform those that scored more poorly. It's also important to understand that within that larger pillar, those themes are ones that we think companies have exposure to and in understanding how companies perform based on those themes, whether they perform poorly, whether they perform well, and what that means for their market returns. Of course, again, this is past market returns, but still what that meant for their market returns can help investors better understand the inner workings of our environmental pillar for our ESG ratings and why it might be important. And that's important for us to try to explain. So I asked HIN to further break down the data for me.

Xinxin Wang (06:32):

So among all the themes, climate change has been the star performer since September, 2013. It shows the strongest outperformance across both develop and emerging market. When we zoom in on environmental risks, companies leading in carbon emission and carbon footprint, they have shown the greatest annualized market out performance compared to their lagging peers since September, 2013. And on the flip side, while leaders in the environmental opportunities did seem higher performance returns compared to their laggers over the last 11 years, but this trend has actually reversed since 2021.

Mike Disabato (07:17):

Okay, so now we know which themes outperform, but the question is why do companies that scored well on the climate change theme outperform so much more than the companies that scored poorly on the same theme? Well, to explain all that, I turned to Elian and I asked him if he could compare the performance of the climate change theme to the natural capital theme, as I think that's an illustrative example as to what is going on,

Elchin Mammadov (07:40):

Michael, there's two ways to look at it. So within the environmental pillar, the climate change outperformed other theme like natural capital and pollution and waste and environmental opportunities. And the reason for that in my view is that climate change primarily focuses on carbon emissions. And these are the things that are quite well known to the market by now. There's quite good reporting, at least for scope one and two emission. The investors do track it, and we already seen carbon being priced more and more across different markets. The reason why the companies are outperforming is also driven by the fundamentals. So we've looked at the companies that lead on carbon emissions, so they're managing it well or they're not as highly exposed. And we've seen that those companies have better fundamentals when it comes to delivering high profitability or lower dividend yield. And also those companies have relatively lower company specific and market wide risks, though systematic and idiosyncratic.

(08:55):

So those risks include things like lower beta, fewer drawdowns or bankruptcies in other ways, or huge share price drops, lower cost of capital. And finally, investors are paying more and more attention to carbon emissions, then are more aware of it. So they're starting to price in those risks by comparison things like natural capital, we've got frameworks that are still emerging when it comes to reporting exposure and the way you manage those risks. So things like TNFD framework is doing quite good job there, but a natural capital and more so pollution and waste is not applicable from financial materiality point of view to as many companies as carbon emissions within the climate change pillar.

Mike Disabato (09:50):

There are a couple of important points there. There's the companies that manage their carbon emissions being just healthier companies overall. And that may be more correlation than causation and it's likely very dependent on the sector. But what is also present is the measurability factor that Elsher was talking about and the reality that the market can more easily price in the risk of carbon than something like how biodiversity loss impacts a company, which is part of the natural capital theme. And what I mean by that is so many companies already disclose on their carbon emissions these days, and while the methodology of calculation may be scrutinized and each one's own carbon accounting method may be scrutinized, the number that they report is universal. It's tons of CO2 equivalents and investors can see that number and say, okay, this company is way more polluted than its pier, and they're both operating in a region that is trying to cut its emissions.

(10:43):

So the more polluted company is likely going to have some more problems than the less pollutive company is going to have. So let's go with the cleaner one. And so carbon emissions gets effectively priced in the company valuations and the market, but for natural capital for things like biodiversity risk, as Elisha mentioned, there is not one metric that can capture the complex way that companies impact biodiversity and vice versa. Allison did mention the TNFD, which is the task force on nature related financial disclosures. That is a framework that's being adopted by the market for biodiversity measurement, but it's still framework. It's not just one metric that is universal and relatively easily measured and assessed by investors. It's the same with the pollution and waste theme. Not as many companies are impacted by it, not as many companies report on it. So it's harder to measure across the market and it's harder for investors to price in the cost of pollution unless there are regulations or ongoing litigations that are actually impacting companies right now. Think of when Bayer acquired Monsanto, that massive American agrochemical company, and now there's all these lawsuits against Monsanto due to pesticides, and that's impacting Bayer's bottom line. And so that's something where toxic emissions is actually being priced into a company's valuation, but those are a bit fewer and far in between than issues with carbon emissions. However, where this changes is for environmental opportunities, companies that have the products which can help us decarbonize the world, saw much more wobbly performance as Elian told me. And the reason is a bit more complex than just measurability

Elchin Mammadov (12:21):

In terms of environmental opportunities theme, which covers everything from clean tech and renewable energy production to green buildings. That theme was very lumpy when it comes to outperformance during certain periods and underperformance during other periods. And there are many different factors like supply chain shocks, the governments focusing on energy security and affordability, which means more coal, more oil at least in the short term rather than investing in green tech. And again, the high interest rates also put pressure on margins of clean tech investment and the returns that you can get from them. So that's why environmental opportunities, team performance has been lumpy so far. But over 11 year period that we looked at, there's still outperformance. It's just it hasn't been consistent throughout.

Mike Disabato (13:22):

There may also be a potential of renewed momentum for environmental opportunity leaders. What El Hin Andrati show in their research is that the net income of companies that score well on environmental opportunities versus their poor scoring peers is set to rebound by 2027. Net income being all the money left over after you pay all your bills basically. So this is something to note. The shift appears most likely within the utilities materials and real estate sectors. Those leaders are also expecting to deliver improved performance compared to the laggers for price to earning ratios between 2024 and 2027 due to stronger earnings rather than higher share price valuations, meaning they're actually making more money rather than investors boosting them up for a myriad of reasons. Also, there's these green policies, they're including the US Inflation Reduction Act, the EU net zero Industry Act, Japan's green transformation package and the planned expansion of China's emissions trading system and its energy market reforms.

(14:21):

All these could help companies further capitalize on environmental opportunities. So we will have to see what happens in the coming years. Now here's the thing, I've been a bit misleading to you because I've just been talking about how the themes have performed and not really talking specifically about sectors. All the sectors we cover basically follow the same sort of patterns that HIN and Elian have been talking about. But there is one sector where investors were not rewarded for pursuing the environmental leader. And I think you can guess which sector that might be. It's the energy sector.

Xinxin Wang (14:59):

Energy sector actually has not been delivering outperformance for the leaders versus laggers during the same period of time. The outperformance was actually the highest for the information technology and financial sectors followed by energy intensive utilities, materials and industrials and outperformance was the lowest for healthcare companies. And as I mentioned, energy sector is the only one that did not deliver outperformance when you compare the leaders versus the laggers.

Elchin Mammadov (15:29):

So just to add to that, so what investors seem to be telling us at least so far is that if you are within the fossil fuel industry and you're producing fossil fuels, so far the best strategy when it comes to returns has been focusing on your core competencies. So the oil and gas companies in the us, they were more focused on their core oil and gas production business, whereas the oil and gas companies in Europe try to diversify into more diversifying into renewable energy, et cetera. And as we've seen so far, the market tends to give a preference to the energy companies that are focusing fossil fuel producers that are focusing on their core business, which is making fossil fuel.

Mike Disabato (16:21):

So basically, ExxonMobil hasn't wowed the market by deciding to slow their crude oil exploration and production. And while that is discouraging for the cohort out there that is pushing for us to stop burning oil such as a majority of the world's climate scientists, it's an important finding for our research. And I can't speculate on what an investor should do with that research, but again, it's important to note nonetheless and in the end, the link we observed over the past 11 years between climate change risk scores and equity market outperformance supports incorporating carbon and footprinting data into your equity analysis. And while the case we're incorporating environmental opportunities has so far been less obvious that could change going forward. As I noted, it's just going to be a question we're going to have to ask ourselves over the next decade. Hopefully it's a bit more stable than the decade. Before we go on to thank HIN and Elian for discussing the news with an ESG twist, I want to to thank you so much for listening. If you like what you heard, don't forget to rate and review us and subscribe wherever you get podcasts to hear myself or Bentley or any of our other hosts for ESG now each week. Thanks again and talk to you soon.

Speaker 4 (17:51):

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