Alan Kohler recently caused quite a flurry with one of his finance reports on ABC. After finishing a report on mortgage rates, he added a slide that showed that Antarctic sea ice is at a record low.

He added ‘That’s not finance yet, but it soon will be.’

Environmental, Social and Governance (ESG) has always been a polarising and contentious topic with investors.

Traditionally, ESG has been thought of as an exclusion list, and associated with ‘feel good’ investing. Certain companies are removed from the investing universe if they don’t meet the standards of investors. Say goodbye to sin stocks like tobacco companies and alcohol companies. No more coal companies and weapons manufacturers.

Adam Fleck, Morningstar Director of Research, ESG and Ratings, notes that some investors have had an uneasy relationship with ESG based on the impression it is a trade-off between picking the investments that will give you the best return and those that live up to certain moral standards.

This can be tough to reconcile with a valuation based and financially minded view of investing. Fleck describes in a recent episode of Investing Compass that the key issue is that investors conflate risk and impact. He believes it is critically important they are separated.

 

ESG risks are real and investing is about evaluating risk

Investors increasingly view sustainability as a way to understand the vulnerability of their investment portfolios to ESG factors, instead of impact investing. This is an important distinction – because risk and return are intertwined. As an investor I want to be compensated for taking on risks. It is taking on risk that enables me to earn returns. However, in order to actually do this, I need to look at the full spectrum of risks and how they impact the long-term cash flows generated by a company.

Fleck previously covered Coca-Cola. He says ‘How can I evaluate if Coca-Cola is a good investment if I don’t look at increased levels of drought when water is one the key ingredients in most of their products?’.

Beyond drought conditions, it is thinking about obesity, sugary beverage taxes that may get proposed, container deposit schemes that are in place due to environmental concerns related to waste.

These are all issues that are correlated to impact investing but have real implications to the risk and future value the company can generate.

Risks are intrinsic to our company level valuations at Morningstar. Our analysts evaluate which environmental, social, and governance issues are financially material for each company or industry. How are companies tackling these material risks and how will these risks affect companies’ long-term value?

ESG investing is less about trade-offs and more about not putting our heads in the sand as investors when we evaluate companies. Much like Kohler, it is understanding that these ESG issues are not for investors to sleep better at night, but for all investors to understand the prospects of the company they are invested in.

Fleck explains that ultimately, high ESG risk companies can be equally as attractive as low risk ESG companies. Investors have to think about the price that they are paying for the value they are receiving, and whether they are being compensated for the risk that they are taking on. Markets can and will be overly focused on near-term issues. If the share price moves due to an event and it is an overreaction, that may be an opportunity for investors.

We can see this closer to home with AMP (ASX: AMP). AMP has faced long term impacts to their brand after the Royal Commission, as well as their handling of sexual harassment claims.

AMP

AMP Ltd.’s share price to Morningstar analyst fair value 

The chart above shows the impacts of the Royal Commission to the long-term intrinsic value of AMP. The last cut to fair value happened in 2021 with the sexual harassment claims from Boe Pahari. These issues should not be compartmentalised as ESG issues that cause divestment from investors so they can sleep better at night. These issues have been detrimental to the long-term value of the company and should be important to you as an investor or shareholder regardless of your stance on ESG.

We can also see at multiple times during these incidents, the sell offs pushed the prices into undervalued territory. These are the times that Fleck mentioned, where high ESG risk companies can still make attractive investments at the right price.

So to Mr. Kohler who declared that it’s not finance yet, but it soon will be. We say - this is finance, and it always has been.