Even a sustainability-oriented portfolio can carry hidden risks when it comes to ESG matters, according to a Morningstar report published Thursday.
The research was conducted using data from Sustainalytics, a Morningstar company that rates the sustainability of publicly listed companies. Morningstar strategist Dan Lefkovitz analyzed the ESG—environmental, social, and corporate governance—risks of 10 broadly diversified stock indexes spanning across various market caps and investment styles.
Surprisingly, the Morningstar Global Markets Renewable Energy Index, which targets companies involved in solar, wind, and other clear energy sources, carries higher general ESG risks than the broader stock market. In addition, the clean energy index is actually 10 times more carbon-intensive than the broader market, according to the Morningstar research.
“Renewable energy investing doesn’t always mean low carbon or low ESG risks,” says Lefkovitz. He points to a few reasons for that. First, some utility companies are generating power using both fossil fuel and renewable energy. They might be included in a clean energy portfolio for the latter effort, but still have a high carbon footprint as of now.
Secondly, some industrial companies in renewable energy portfolios might be included as the manufacturers of clean-energy products, such as wind turbines and solar panels, but their manufacturing process itself could still generate a lot of carbon emissions.
Thirdly, while a company can be involved in renewable energy and score high on environmental matters, it could still have poor corporate governance or diversity practices, which will increase its overall ESG risks. The bottom line: “ESG is a broad tent, there are a lot of different factors to be considered,” Lefkovitz says.
To measure carbon intensity, Sustainalytics used self-disclosed carbon emissions data from around 3,000 global companies to estimate the emission level of peers in the same industry, taking into account their revenues, employee numbers, and size of plant and equipment.
The research also pointed to the different levels of ESG risks in portfolios pursuing various stock characteristics, or the so-called “factors,” that tend to deliver outperformance over the longer terms.
Stocks with lower valuations or smaller market caps, for example, might be strong drivers of returns, but they tend to carry higher ESG risks than the broader market. This is largely due to these strategies’ heavier weight in the energy, utilities, materials, and industrials sectors. Growth and large-cap strategies, on the other hand, often have larger holdings in technology stocks, which tend to have fewer ESG risks.
For the same reason, portfolios with high dividend yields—another sought-after quality in stocks—also tend to have heavy exposure in sectors with higher ESG risks. For dividend lovers, Lefkovitz highlights a better option: Dividend-growth strategies, which target companies that might be future dividend leaders, scored much better. On the other hand, companies that have distinct competitive advantages and durable profitability, or so-called “moats,” tend to carry lower ESG risks.
Write to Evie Liu at [email protected]
