A growing body of evidence suggests that companies proactively managing environmental, social, and governance (ESG) risks make better long-term financial bets. This is partly because the risks, like water scarcity, are becoming more financially important over time. But it’s also because companies that take the time to measure and manage their exposure to complex ESG risks often benefit from superior management quality, which is a well-established driver of shareholder returns.
As the financial materiality of ESG risk intensifies, we expect to see more concerted efforts by investors to mitigate their exposure to ESG risk in portfolio decision-making.
How Sustainalytics looked at major ESG risks for 2018
Not all ESG risks are equal in terms of their potential financial impacts, or the time horizon over which these impacts may play out.
Sustainalytics recently examined 10 ESG risks that we expect to reach a tipping point in 2018. While many of the risks touch on broader themes such as climate change, they are fundamentally industry-specific. This is because ESG risks vary (often significantly) by industry. For example, energy efficiency matters a lot more to an airline than an insurance firm.
The report from Sustainalytics, Morningstar's ESG-research partner, also includes profiles of companies that are either well-prepared or ill-prepared to manage each risk, to help give investors a sense of the gap in readiness that we typically see regarding ESG issues.
5 ESG risks that management teams should focus on in the year ahead
We unearthed an intriguing basket of risk categories that we believe management teams and investors have a narrow financial interest in managing in the year ahead. You can find all 10 ESG risks in our report, but here are five summaries below:
- Water availability in the copper mining industry. In our analysis of the mining industry, we argue that “water-driven community opposition” may threaten future production in Chile’s copper industry, which accounts for 27% of global production. The nature of the opposition is that communities and mining companies are competing for an essential, but increasingly scarce, resource. Chile is under increasing water stress, particularly in the Atacama region where copper production is concentrated. We find Antofagasta, the Chilean copper pure-play company, to be well-positioned to manage this risk in the future. The company is taking a variety of steps to improve water efficiency, while investing in desalination technologies.
- Competition amid a low-carbon transition in the oil and gas industry. Rapidly changing patterns of energy consumption, driven in part by carbon regulation, are likely to affect the profitability of oil and gas firms. Shifting energy trends can be neatly summarized in the following statistic: Since 1990, renewables are up more than 1,200% on a cumulative percentage growth basis. This compares to 78% for gas and 37% for oil. This low-carbon transition poses particular risks for oil and gas firms that have higher-than-average production costs and those that are not diversifying their product lineups. The shift also could be problematic for firms involved in carbon-intensive projects, such as oil sands mining, high Arctic drilling, and some liquefied natural gas projects. While the industry clearly faces headwinds, we find Royal Dutch Shell to be an early leader in preparing for future challenges. Royal Dutch Shell has best in class greenhouse gas risk management programs. Plus, it’s the only oil and gas company (so far) to set carbon reduction targets. And with its recent acquisition of NewMotion, the company has signalled its intent to become a major player in the fast-growing electric vehicle market.
- An emerging antitrust risk in the software and services industry. We also looked at the increasing anti-competitive risks in the global software and services industry. Entrenched players—including Alphabet (Google), Facebook, and Microsoft—have become so utterly dominant that regulators are beginning to question whether they may need to be broken up. After the announcement of a record-high 2.4 billion euro ($3.0 billion) antitrust fine from the European Commission in June 2017, Alphabet’s quarterly profit and net income fell by 28 percent. While it’s too early to say which software and services company is most exposed to antitrust risk, Alphabet would appear to sit in the middle of the brewing regulatory storm. As one market signal, the company experienced the most antitrust-related incidents in Sustainalytics' incident collection framework from 2013-17.
- Growing health concerns over sugar consumption in the food and beverage industry. Concerns over the health effects of excessive sugar consumption are shifting consumer preferences, regulation, and litigation for food and beverage companies. The industry is also under increased scrutiny for using its influence to mislead the public about sugar-related health risks. Coca-Cola faces legal and reputational risks from allegations that it knowingly misled consumers and repeatedly acted to block sugar regulations, which could result in significant liabilities in the short and long term.
- Growing public scrutiny of the apparel industry's supply chain. Increasing scrutiny further exposes the industry to financial risks linked to sourcing disruptions, legal action, and negative reputational impact from poor pay and working conditions. As apparel firms extend their operations to new locations, supply-chain risks follow. H&M effectively addresses these risks by demonstrating efforts toward improving supply-chain management and transparency. The firm is working with the Sustainable Apparel Coalition to develop standards for assessing supply-chain sustainability issues, and it is engaging with the government on wages while paying workers well above minimum wage in Ethiopia.