Morningstar incorporates ESG into its analysis and finds some surprises.
Environmental, social, and governance factors—or ESG, in increasingly common parlance—have become key considerations for many investors and asset managers. That’s not because ESG issues are trendy, but because they can significantly affect a company’s prospects. However, many of these issues are qualitative, and there are few standard metrics that can be used to differentiate companies.
Morningstar’s utilities equity research analysts use what they call ESG Integration as a way to systematically incorporate ESG into their fundamental analyses. They’ve found that ESG Integration helps quantify a company’s risks and opportunities, leading to better-informed investment decisions and superior risk-adjusted returns.
Travis Miller, Morningstar’s director of utilities research, and analyst Charles Fishman recently co-wrote a Utilities Observer titled “Green Up Your Utilities Portfolio: Improving Process and Performance with ESG Integration,” which explains their approach and demonstrates its advantages. They don’t use ESG factors simply to narrow down best-in-class companies or screen out the worst offenders. Instead, ESG Integration identifies companies’ ability— or lack thereof—to create and sustain long-term shareholder value after considering many ESG variables, forecasts, and scenarios. Their bottom-up approach overlays their valuations, earnings forecasts, competitive advantage analyses, and stewardship ratings.
I sat down with Miller and Fishman in mid- December to discuss their research. Their comments have been edited for length and clarity.
Laura Lallos: Why are utilities particularly well suited for ESG integration into your analysis?
Charles Fishman is an equity analyst with Morningstar Research Services, specializing in utilities such as Dominion and FirstEnergy.
Fishman: There are two things going on. One is that utilities are very public: Everybody uses them, everybody expects low rates, and when rates go up, it has an impact on everybody. And many of them are regulated by state utility commissions, which sometimes are elected, which creates a lot of craziness.
Second, electricity is so pervasive to our economy; electricity consumption has increased about fivefold since the 1950s. But on the other hand, generating electricity has environmental consequences. A credit to the industry is it has dramatically reduced a number of pollutants over the past 25 years. Remember acid rain? That’s caused by sulfur dioxide from burning coal. The industry addressed that to the point that you don’t hear much discussion about that, because they did a good job.
Now, of course, we’re pointing towards climate change and the amount of carbon dioxide emissions that come from power plants. In the United States, almost one third of carbon emissions come from the generation of electricity. We’ve seen a dramatic decrease in carbon dioxide emissions, but it will continue to be an important issue.
Lallos: Your goal is not necessarily to find utilities that score well on the ESG factors. It’s to use those factors to inform your fundamental analysis. How do the two work together?
Travis Miller is director of utilities research at Morningstar Research Services. He oversees a team of four analysts covering 61 companies.
Miller: At Morningstar, we think it’s important to look at companies’ fundamentals and the shareholder returns that are available based on a variety of different factors. We think the differentiating point of our analysis is that we recognize there are fundamental drivers within the ESG spectrum of factors. We focus on those areas of ESG that can affect companies’ cash flows, earnings, and ultimately valuations.
Lallos: Most people think about regulated utilities when they’re thinking of the sector. How do ESG factors help you assess the regulatory frameworks that affect utilities’ ability to create value in the future?
Fishman: We look at the regulatory framework today and project what it might be in the future, and assess the impact that might have on risk and opportunities with respect to ESG. We’ve seen a dramatic reduction in the use of coal in this country. There are some states that have a regulatory framework that encouraged utilities to take a power plant that burned coal and change it to burn wood waste, for example, or a coal and wood waste mix. We’ve seen that in Virginia. Or there might be a move to build a gas plant instead of just expanding the coal plant. A gas plant generates less than half the carbon emissions of a coal plant.
A utility can work with the regulators, but shareholders need to be treated fairly, and we see that in some states. But other states still use the traditional model, sometimes referred to in the utility world as “used and useful.” The regulator says, “You go get that plant up and running. When it’s used and useful to the customers, then you can put it in a rate base, and we’ll decide what return you get.” That puts a lot of risk on the shareholders, and it’s something that we don’t like to see.