- Pricing environmental risks could be more fruitful than relying on ESG scores
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This week, we publish the first of our two regular lists (UK and international) revealing the favourite stocks of top Environmental, Social and Governance (ESG) fund managers.
These shares are popular on the basis that they offer exposure to companies that can benefit from ESG themes. There is also a flipside to viewing companies through an ESG lens, which concerns avoiding risk.
Using ESG scores to identify risk can be challenging. Scoring methods are complicated and ratings can vary a lot between providers. For example, troubles at once highly-rated retailer Boohoo have provided a recent cause of exasperation. Wouldn’t it be great to simply have risk expressed in £’s or $’s?
This is the thinking behind research from academics at Harvard Business School.
David Freiberg, DG Park, George Serafeim and Rob Zochowski have attempted to quantify the E in ESG in money terms. This has been done using company disclosures on a range of environmental impacts, such as greenhouse gas emissions and water usage, combined with several established pricing methodologies.
In this way, the research estimates the costs borne by others - what economists call “externalities” and environmentalists call “impact” - from the operations of 9,714 organisations between 2010 and 2018 . With the estimates, the academics have created a measure of “environmental intensity” by comparing a company’s impact with its sales and its operating profit.
One noteworthy finding is that relatively few industries account for the lion share of environmental costs. The average environmental sales intensity of 11.6 per cent is way above the mid-range industry value of 1.9 per cent. What’s more, if the estimated environmental costs were given a line in income statements, several industries would be heavily loss making. The industry a company belongs to was found to explain about 60 per cent of its environmental intensity.
There were also links found between companies with high environmental intensity and their share price returns (a negative relationship) and volatility (a positive relationship). The ESG scores of big rating-agencies, meanwhile, only weakly corresponded to the environmental-intensity measure. Below is a chart of the ten most environmentally-intensive industries from the study out of 67.
The appeal of quantifying environmental impact in terms of money is that complex information becomes intuitive and easy to understand while gaining a guttural appeal. It tells investors what regulators may want to recoup. If refined, such measurements could themselves embolden regulators too. Externalities are, after all, a long-acknowledged form of economic injustice. Providing a money value introduces a populist appeal.
While this research may lay out the bones of an interesting analytical tool, it really only represents a first step. One key issue is that the analysis stops at the factory gate. For example, a construction company would only be measured on the environmental impact of its building work rather than the hugely carbon-intensive process of making the concrete it pours or the carbon emitted once a building is occupied. Not only is measuring the impact of supply chains and product life-cycles difficult, it is also vexing to decide what party should be liable for what portion of overall impact.
From the perspective of this week’s tips section, one interesting finding from the Harvard research is that the environmental intensity of the mining industry is high but very variable between companies. Engineering group Weir (WEIR), which is one of this week’s tips, is seeking to help miners address this by providing energy-saving solutions.