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9 Winners Managing ESG Risk

These stocks are well-positioned to tackle the material environmental, social, and governance risks facing their industries.

As a culture, we love to write (and speak) in shorthand. FYI. ASAP. BYOB. And for those digital communicators out there, LOL and TTYL. 

In investing, one piece of shorthand is gaining ground: ESG. 

Some investors argue that environmental, social, and governance considerations are a critical component of their stock-picking process--as important as such factors as valuation, growth, and profitability. Others believe that examining a company's ESG-related risks is as crucial as considering its financial and operational risks. 

As ESG considerations grow in importance, companies that can successfully adapt should benefit more than those that don't. 

As such, our analysts are looking at their respective industries through the lens of ESG risk. Here are some of the companies that have scored best in our ESG risk framework across a handful of industries. Plus, several of these names are undervalued according to our metrics. GR8! 

Renewable energy is still a small player in U.S. energy, admits strategist Travis Miller. It accounts for just 10% of U.S. electricity sales and 7% of U.S. energy consumption. Even so, renewable energy is clearly the future: We expect U.S. renewable energy (both wind and solar) to grow 8% during the next decade, reaching 22% of total electricity generation 10 years from now.  

"Utilities that can harness this renewable energy growth will win big for investors; those that lack public support and struggle to execute will be left behind," details Miller. Specifically, we view solar as the key disruptor and think wind growth estimates are a bit overblown. 

There are three clear-cut winners, says Miller: NextEra Energy (NEE), Xcel Energy (XEL), and First Solar (FSLR). That's in part why NextEra Energy and Xcel Energy trade at substantial premiums to our fair value estimates, he adds.  

     {Deep Dive: The Renewable Future}

Integrated Oil 
Although integrated oil companies continue to invest in oil and gas resources, they are, to varying degrees, addressing the emissions intensity of their portfolios because investors increasingly request that they do so, reports strategist Allen Good. Of course, competitiveness plays a part, too: As reducing emissions becomes a common goal globally, a carbon tax becomes more likely.

"Reducing emissions is equivalent to reducing costs, and those with the lowest emissions will therefore be the lowest-cost operators, a coveted position for a commodity producer," reminds Good. We think that investments in renewable power generation and increasing natural gas production are the most impactful levers that integrated oil companies can use to reduce emissions; reducing flaring and methane emissions typically makes economic sense. 

Overall, we think Royal Dutch Shell (RDS.A) and Total (TOT) are among the best integrated oil companies managing the transition to a lower-carbon world. Both are undervalued. 

     {Deep Dive: Understanding the Emissions Challenge}

Midstream Oil and Gas 
Environmental concerns are "paramount" for midstream oil and gas companies, maintains strategist Stephen Ellis. 

"Pipeline companies are 'enablers' that encourage downstream consumption of fossil fuels, making them partially accountable for the greenhouse gas emissions that follow," he says. "Most midstream companies also emit waste gases directly, and the regular occurrence of pipeline spills creates a negative buzz around the industry, inviting further ESG scrutiny." 

If increased regulatory pressure does lead to a carbon tax, we wouldn't expect large valuation changes--companies will pass most of the costs on to consumer, Ellis reports. But reputational damage could threaten relationships with stakeholders on pipeline projects, which can lead to lengthy project delays and increased construction costs. And those factors can have an impact on valuations, he concludes.

Both Cheniere Energy (LNG) and Plains All American Pipeline (PAA) rank favorably on ESG issues and are attractively priced.  

     {Deep Dive: ESG Implications for Midstream Oil and Gas}

Big Pharma and Biotech 
When it comes to branded drug companies, the ESG risks that could affect valuations over time are pricing risk in the United States and product-safety litigation risk, argue strategist Karen Andersen and director Damien Conover. Our analysts have tied the magnitude of these headwinds to each company's U.S. exposure, as that's where litigation and pricing risk are greatest, they say. We've also examined companies' reliance on price increases, U.S. price discrepancies versus other developed markets, and exposure to medicines focusing on chronic, less severe diseases that may be more exposed to litigation costs, they add. 

Roche (RHHBY) and BioMarin (BMRN) carry the lowest exposure to these ESG-related risks.

"Roche's diagnostics diversification, global pricing strategies, and focus on severe diseases lower pricing and litigation risk," say Andersen and Conover. "BioMarin's global pricing strategy for its rare-disease drugs as well as the serious nature of these conditions limit future pricing and litigation risk, despite high price tags, and Medicare exposure is minimal." 

Both stocks are undervalued today. 

     {Deep Dive: How ESG Risk Affects Pharma and Biotech Moats and Valuations}

Susan Dziubinski does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.