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In the last few years there has been a focus on environmental, social, and governance issues when it comes to investing. Is this just because being conscious about ESG issues makes people feel good, or is there actually something more to it?

In equity research, we focus on the risks that could arise from ESG factors–generally, we find that these risks may not currently affect a company but have meaningful potential to. Building on this, we’d think of sustainable investing as appropriately taking into account ESG risks when making investment decisions. On the other hand, socially responsible investing, or SRI, considers personal preferences, avoiding industries that might not agree with one’s values.

Okay, given that values can be sort of… squishy, who decides how to define them 

Values-based investing is ultimately up to the investor. We’re more focused on the valuation impact. However, we think the broader investor community would be remiss to ignore values completely. While an individual investor might not hold a particular value, they should be aware that some ESG risks can manifest from the values of a larger group. In other words, values among other stakeholders could lead to an economic impact, and thus affect equityholders through a lower stock valuation.

And why should investors care about their ESG risk?

ESG should matter to investors because it identifies potential risks that could affect a stock price. Just like investors would want to know if a company could run into trouble from having too much debt, or selling products in a declining industry, it is important for investors to consider ESG risks that could hurt a stock.

Given that, can you cite any examples of when an ESG risk hurt investors?

Chemicals companies face risks from environmental damage that can ultimately cost billions of dollars to clean up, such as asbestos lawsuits that left many companies bankrupt. Similarly, beverage companies must continually monitor their water use as they may have to pay higher costs or even stop producing beverages if they use too much water. Any company whose employees are unionized is at risk that their employees will go on strike due to poor working conditions. All of these are ESG risks that could hurt investors.

So given all that, how does one take an equity research approach toward ESG?

For instance, Morningstar’s equity research approach focuses on valuation and long-term orientation. Our approach for ESG is about understanding and capturing these risks in our stock recommendations. To do this, we integrate ESG factors in our intrinsic value estimate (through our fair value estimate and economic moat rating), as well as our required margin of safety (through our uncertainty rating). By identifying and assessing these risks, we can use ESG analysis to better understand company risks and incorporate that into our stock calls today.

Thanks for helping us understand how ESG is about more than just feeling good.