Environmental, Social, and Governance (ESG) risk — when companies cause environmental damage, bring a dangerous product to market, mistreat employees, or suffer an accounting scandal – affects business cashflows and share prices.

It’s why the CFA Institute, a global association of investment professionals, now encourages all investment professionals to consider ESG factors.

Issues such as water and waste management, data privacy, product safety, diversity and inclusion, and business ethics all fall under the purview of ESG research, Morningstar says.

Climate change is foremost among ESG issues for many investors.

“BlackRock CEO Larry Fink spoke for many when he wrote: ‘Climate risk is investment risk,’ whether the risk is physical, regulatory, or the potential for stranded assets,” Morningstar writes.

Investors might also be looking to sidestep devastating ESG-related blowups like those that occurred with BP, Toshiba, Volkswagen, Wells Fargo, Equifax, Rio Tinto, Vale, and Wirecard.

Wirecard was worth €24bn ($39.2bn) at its peak — with its shares changing hands at €191 in August 2018 — before a fraud scandal sent it to the wall.

Volkswagen’s diesel cheating scandal has cost it an incredible 31.3 billion euros ($US34.69 billion) in fines and settlements, so far.

And while it has now rebounded, the fake account scandal at Wells Fargo did real damage to the US bank’s share price and bottom-line earnings.

These are potential issues that every investor should consider.

In this analysis, Morningstar applies its own ESG ratings and carbon data to Morningstar equity indexes to show how investors should think about gauging ESG risk in their own portfolios.

Here are some of the key takeaways.


How ESG-Friendly Is Renewable Energy?

Not very.

The fact that a renewable energy portfolio is roughly 10 times as carbon intensive as the global equity market might raise eyebrows.

It is also significantly riskier from an ESG perspective, as well.

How can a portfolio of companies focused on climate change solutions carry more ESG risk and carbon intensity than the overall market? Several factors are at play, Morningstar says.

“First, many companies are involved in both fossil fuels and green solutions,” it says.

“The large slug of utilities stocks in the index includes such carbon-intensive companies as China Power, RWE, and AES.

“Second, a company can be focused on products and services that are climate-friendly but have carbon-intensive operations.”

Like battery materials producers, for example.

Then there’s Tesla — unsurprisingly a constituent of Morningstar’s renewable energy indexes.

“Though Tesla’s electric cars are emissions-free, the company faces other ESG-related risks,” Morningstar says.

“Its factory workforce is a challenge, and product governance is an issue, especially in the autonomous realm.

“Corporate governance is also a concern, as CEO Elon Musk, who owns more than 20% of Tesla stock, has made problematic public statements and has used his equity as collateral for personal loans.

“Patent litigation and regulation requiring a separation between automakers and dealers are further ESG issues for Tesla, which carries a ‘2-globe’ rating.”

The carbon intensity of renewable energy investing doesn’t necessarily suggest ‘greenwashing’, but it does represent a trade-off that sustainable investors must acknowledge and consider.

Greenwashing is marketing spin. It falsely claims that a company’s products are more environmentally friendly than they are.


Putting together a ‘Wide Moat’ portfolio

In the low-risk, low-carbon side are high-quality stocks, represented by the Morningstar Wide Moat Index.

A wide economic moat is a type of sustainable competitive advantage possessed by a business that makes it difficult for rivals to wear down its market share.

These are companies deemed by Morningstar equity analysts to possess the most durable of competitive advantages.

Many wide-moat-rated companies, including Microsoft, Visa, Home Depot, and Disney, also carry low ESG risk, Morningstar says.

“The ESG-quality connection has been observed consistently, most recently in a Sustainalytics study noting that companies with economic moats tend to carry less ESG risk and lower volatility,” it says.