Companies today face unprecedented risks as stakeholders demand accountability and transparency in how corporations approach the environment; attend to the well-being of their workers, customers, and neighbors; and govern themselves in an ethical way.
To Morningstar, these factors—environmental, social, and governance—come down to the bedrock of investing: risk. A company that ignores these risks or commits a misstep could incur significant economic costs that jeopardize its ability to earn long-term, sustainable profits.
One way that investors can identify and manage the ESG-related risks in their portfolios is to understand how companies’ sustainable competitive advantages—or economic moats—have an impact on these risks.
This is the approach Morningstar’s equity research analysts take. They view ESG through the lenses of risk management and due diligence, considering:
- Which environmental, social, and governance issues are financially material for each company or industry?
- How are companies tackling these material risks?
- How will these risks affect companies’ long-term value?
The answers are varied and demonstrate that ESG issues often overlap. Here’s a look at the close relationship between economic moats and ESG risk and how these issues have manifested in various companies.
A company’s economic moat can take many forms. It can be built on high customer switching costs, network effect, cost advantage, intangible assets, and efficient scale. The Morningstar Economic Moat Rating—wide, narrow, or none—indicates the strength of a company’s sustainable competitive advantage and its ability to create long-term value for investors.
Economic moats and ESG risk tend to work together. Sustainalytics—a Morningstar research partner in which Morningstar holds a noncontrolling interest—rates companies’ exposure to ESG risks on a scale from Negligible to Severe. As demonstrated on the chart below, proportionally, more narrow- and wide-moat companies receive Medium, Low, or Negligible risk ratings from Sustainalytics than do firms without a moat.
Companies with economic moats tend to have a stronger foundation from which to manage ESG risk. For example, a wide-moat company with high customer switching costs might feel less of an economic impact than its no-moat peer if an ESG controversy arises. Similarly, a firm with good ESG risk management might have more capital—human, political, financial—to create an economic moat.
However, ESG-related risk—just like a company’s competitive advantage—is always in flux. Just as companies must adapt to protect their moats, companies also must adjust to changing ESG risks, such as new regulation, stakeholder demands, and technology. Warren Buffett’s famous quip, “Only when the tide goes out do you discover who’s been swimming naked,” also applies to ESG risk.
Companies that don’t adapt might skirt by in the short term, but over the long term, they can put investors in jeopardy with more risk or lower returns. How? By letting their sustainable competitive advantages erode. For example:
- Research-intensive companies that neglect their workforce might eventually lose pricing power.
- Resource-intensive companies that fail to invest in safety systems and infrastructure might face environmental liabilities that wear away their cost advantage.
- Data breaches that hurt a strong brand and governance lapses may result in poor capital allocation.
ESG-related risk can foretell changes in a company’s competitive advantage, which is why identifying a firm’s ESG risks is an important component of evaluating its moat.
Below, we will go through each component of E, S, and G and show how companies are managing, or mismanaging, their individual ESG risks and how these risks affect firms’ sustainable competitive advantages.
Many investors are focused on companies’ environmental risk. The financial risks associated with environmental impact have been highlighted by debate over carbon pricing, climate change protests, and environmental disasters—such as the BP (BP) oil spill at the Deepwater Horizon rig in 2010 and the role of PG&E (PCG) in California’s recent wildfires.
How a company manages its environmental risk, and the regulation that goes with it, is especially important to assessing sustainable economic moats in resource- and energy-intensive industries.
As they transition their business models to adapt to environmental and regulatory change, Dominion Energy (D) and Orsted (DOGEF) are two examples of energy infrastructure companies building long-term sustainable competitive advantages by tackling environmental risk factors that might affect investor returns. Dominion and Orsted must work closely with regulators, government officials, and customers to reduce their environmental risk.
If either company neglects these risks, it could be saddled with stranded assets that would hurt its balance sheet, reduce dividend growth, or, worse, lead to a dividend cut.
Dominion is a power and energy company based in Richmond, Virginia, whose plan to improve its environmental footprint and the safety of its vast energy network contributes to its wide economic moat and its ability to pay a secure and growing dividend.
Its plan, however, isn’t just a mad dash to retire fossil fuel power plants. A utility must create a strategy to address its entire network while minimizing the impact on customer rates and the local economy.
Dominion stands out as an example of how a utility can pursue this transformation while producing benefits for all stakeholders. We expect Dominion to invest $35 billion through 2023, helping deliver what we estimate will be 7% annual operating earnings growth and high-single-digit annual returns for investors over the next five years.
Here are a few key aspects of Dominion’s transformation:
- Systemwide, Dominion has cut carbon emissions intensity more than 40% since 2000 while serving growing electricity demand. This development, which is shown on the chart above, addresses the risk of power generation emissions. In Virginia, its largest service territory, Dominion’s new natural gas plants emit less than 50% as much carbon dioxide as the older coal plants they replaced. Dominion worked with state politicians and regulators to ensure that investors earned fair returns while minimizing the impact on customer rates. In addition to retiring coal plants, Dominion has also developed new wide-moat projects, exited oil and gas exploration and production, and sold no-moat businesses.
- Dominion has plans to increase its investment in clean energy and sustainability initiatives and reduce its investment in large fossil fuel plants. This aligns with the state of Virginia’s push in this direction, which includes areas such as solar energy, cybersecurity, and burying at-risk above-ground distribution systems. Most recently, Virginia regulators and politicians have begun supporting Dominion’s investments in renewable energy, including offshore wind, and energy efficiency. This partnership between Dominion, policymakers, and customers supports earnings and dividend growth for investors.
- Managing other environmental risks, such as coal ash disposal and nuclear safety, makes Dominion’s balance sheet and dividend more secure. Several devastating coal ash spills involving other utilities prompted Virginia to compensate Dominion for the $3 billion it would cost to remove much of its coal ash in the state. At Dominion’s four nuclear plants, a safety incident would be devastating for investors, but we think that probability is very low. Dominion and the U.S. nuclear industry have a strong safety record, in part due to extensive regulation. However, accidents can have severe consequences for investors. After the partial meltdown at Pennsylvania’s Three Mile Island plant in 1979, then-plant owner General Public Utilities was forced to suspend its dividend for eight years.
The global push to reduce impacts on the environment also has created opportunities for companies to develop and widen their economic moats. Danish utility Orsted is the global leader in offshore wind: The chart below shows that 88% of its profits come from this business.
This unique business profile underpins the firm’s narrow moat rating. Offshore wind is highly subsidized and provides high visibility on future earnings and returns. Solid returns are achieved by Orsted’s best-in-class construction capabilities.
Here’s how Orsted’s economic moat has expanded:
- Improving its environmental footprint by focusing on offshore wind has allowed Orsted to develop a moat. In May 2017, the company sold its North Sea oil and gas exploration and production business, which had low returns on capital and volatile earnings. This sale drove a surge in Orsted’s returns on invested capital, which had been negative in 2014 and 2015 because of large impairments related to the oil and gas business. However, unlike power generation, most greenhouse gas emissions from oil and gas happen when they are consumed, not when they are extracted. Therefore, it’s difficult to measure the positive environmental impact from Orsted’s exit from the exploration and production business.
- Orsted enhanced its moat by closing coal plants or converting them into biomass plants while investing heavily in offshore wind farms. This transformation, which directly reduced the emissions of the power generation business, was beneficial to Orsted’s moat because coal plants tend to have lower returns and higher volatility than do offshore wind projects. Finally, the surge of prices of CO2 allowances in the European emission trading system since 2017 significantly reduced coal plants’ competitiveness against other power generation sources.
Social risks are diverse and numerous, ranging from effective use of human capital to human rights in developing nations.
Social issues tend to involve the impact a company has on all of its stakeholders: employees, customers, suppliers, and local communities. A firm’s ability to avoid damaging its relationship with these stakeholders can be an important part of sustaining its long-term competitive advantages, particularly when the firm relies on the public trust in its products or services to maintain its economic moat.
As a global pharmaceutical firm with an evolving product portfolio, AstraZeneca supports its wide economic moat with smart strategic decisions on drug pricing and product governance, two of the biggest social issues affecting the branded drug industry.
Take a closer look at these aspects of the company:
- Strong pricing power around Astra’s portfolio of drugs is a core pillar of the firm’s wide moat. Pricing dynamics have an impact on public access to basic healthcare services (a central ESG issue), and Astra has a history of fair U.S. price increases for its oncology portfolio. These products dominate Astra’s forecast as older respiratory drugs lose patent protection. Also, Astra’s oncology portfolio likely has not built up significant discrepancies in price between the U.S. and international markets, further supporting reasonable prices globally and introducing less risk to Astra’s U.S. drug prices if federal policy is reformed. Plus, the analysis from The Institute for Clinical and Economic Review, a U.S. cost-effectiveness group, is largely supportive of the majority of Astra’s cancer and cardiometabolic drugs.
- Astra has a strong track record with regard to product governance, or the quality management associated with its healthcare products. Astra has done a good job of lowering the liability risks related to its portfolio by focusing more on life-threatening diseases with acute treatment. Drugs treating life-threatening diseases like cancer rarely face significant side-effect issues that can lead to major product liability cases, given that the high severity of the underlying disease tends to offset most potential side effects.
- Most of Astra’s sales are projected to come from drugs that are less probable litigation targets, solidifying its moat. As the first chart below shows, we project that less than 15% of sales over the next five years will come from drugs treating less-severe diseases that require chronic treatment—drugs that we think are more likely to be litigation targets. Fewer product liability costs should help support the high returns that are emblematic of a wide-moat company. The lower litigation costs around product governance should improve Astra’s standing from both an ESG and economic moat perspective.
Looking ahead, as the second chart above shows, we are projecting legal exposure at 1% of annual income. This is significantly lower than the previous five years, which is due to less exposure to drugs associated with high product governance issues. Also, the projected amount is slightly less than its peer group because of the company’s increasing international sales, where liability settlements tend to be much less than in the United States.
By contrast, failure to invest in areas related to stakeholders could lead to sudden and dramatic ESG risk events. Case in point is the credit bureau Equifax. Its data privacy breach in 2017 affected 147 million stakeholders and became a material factor in our moat analysis.
Our takeaways from the breach include:
- Equifax’s oligopoly protects its moat, despite the breach. With only three meaningful players and many clients using more than one credit bureau, Equifax and its competitors have a stable oligopoly with high barriers to entry. The strength of its intangible asset, credit data on 210 million consumers, supports a wide economic moat. Replicating Equifax’s data, which has more than a century of credit information, would be extremely costly. Lenders rely on the quality and accuracy of Equifax’s data to run their businesses. With the firm’s moat dependent on stakeholder data, the 2017 hack continues to reverberate throughout the industry.
- Management’s slow response damaged the company’s reputation. This reaction intensified the damage caused by the breach, in which hackers exploited a vulnerability in an open-source application framework that the firm had not addressed with the most up-to-date patch. As a result, sales have slowed and management said it had planned to spend upward of $300 million on IT infrastructure in 2019 to improve cybersecurity. However, we expect increased security spending will effectively be permanent, keeping operating margins below levels before the breach for the foreseeable future. Also, in early 2019, the company realized a charge of $690 million in breach-related settlements.
The aftermath for Equifax reflects the increasing costs associated with data breaches. This includes both the costs of companies striving to avoid them (through increased cybersecurity investments) and growing fines after hacks, as shown on the chart below. The U.K. Information Commissioner’s Office proposed fines of $230 million for British Airways’ parent company, International Consolidated Airlines Group (BABWF), and $124 million for Marriott International (MAR) because of breaches in 2019. A breach at Capital One Financial (COF) included 109 million records, with the company estimating $100 million to $150 million for costs associated with notifying customers, credit monitoring, technology costs, and legal support; associated legal investigations could increase the grand total.
We expect these large fines to wake up business leaders to this ESG risk. The fines also highlight the costs that go beyond expenditures for investigation, remediation, loss of business, legal fees, notification costs, and security upgrades associated with breaches. We expect the global costs associated with data breaches to accelerate as regulation and stakeholder data privacy concerns increase costs.
- The fallout has increased the chances that regulators will turn a more skeptical eye on the credit bureau industry as a whole. While we have maintained Equifax’s wide moat rating after the data breach—because we’re still confident that returns will remain above the cost of capital for the next 20 years—we believe that Equifax and its peers are very fortunate that the current U.S. administration was not more punitive. That said, Equifax and the industry are not out of the woods, as the full impact of the breach on stakeholders could eventually lead to regulatory actions that change the economics of the credit bureau business. Should another breach happen, there could be calls for a shift to a private nonprofit or government-funded approach to credit monitoring.
Barring major regulatory changes to the credit bureau industry itself, though, we think the impact from the data breach will be manageable for Equifax and dissipate over time. We also believe that the company’s wide economic moat helped in this situation. Equifax is a clear example of how moats truly matter for assessing the likelihood of ESG risk events and the full financial impact when they occur.
While most investors have a sense of good governance practices, it is difficult to identify where and how best practices might have an impact on business performance.
One example is General Electric (GE), which many ESG and governance analysts once considered a top performer in its industry. However, traditional data did not easily capture GE’s lax governance culture that enabled management to make poor capital-allocation decisions. Ultimately, we downgraded the firm’s moat rating to narrow from wide.
It’s well understood that former GE CEO Jack Welch frequently compromised long-term value to meet short-term earnings goals, even through financial engineering. However, one fact is abundantly clear: GE’s more recent problems are due to poor capital-allocation decisions by then CEO Jeff Immelt.
Examples of GE’s capital-allocation missteps include:
- Before moving to simplify GE, Immelt signed off on the acquisition of WMC Mortgage, a subprime and Alt-A mortgage lender, during the years leading up to the Great Recession. These decisions weren’t kept in check by the board of directors. Some former board members made annual salaries of more than $300,000 and avoided open conflicts with management. Others struggled to find their voice on an oversize 18-person board or simply lacked expertise. GE’s culture under Immelt had shifted to one where dissent was discouraged and undue optimism was rewarded.
- GE grossly overpaid for acquisitions, including for French conglomerate Alstom. Indeed, Immelt ordered managers to present their most optimistic deal targets and met with Alstom’s then CEO, Patrick Kron, one on one to seal the acquisition. But many of Alstom’s contracts were unprofitable, and GE made several concessions to the French government to close the deal.
- GE Power entered into several deals at economically bad terms, often supported by GE Capital. On Immelt’s watch, GE eventually wrote down the business for nearly $22 billion in September 2018, greater than the approximately $10 billion purchase price, net of cash. GE now has a large business that will probably generate negative free cash flow for the foreseeable future.
- GE exercised untimely stock buybacks and wasteful spending to build a massive industrial “Internet of Things” platform.
Management does not create an economic moat, but it can destroy one, as GE demonstrates. We believe GE’s reconstituted board reflects its newer lean strategy with 10 directors, including five new ones, which should allow more open debate and deeper analysis, making further value-destructive capital allocation less likely.
Sustainability and ESG investing are top of mind for investors and advisors. Launches of new funds and record inflows suggest a groundswell of interest but also highlight the disparate ways of investing in ESG.
Morningstar’s equity research team analyzes ESG through the lens of risk management by determining which environmental, social, and governance issues are financially material to a company’s sustainable competitive advantage, or economic moat.
As we’ve shown, how a company manages these risks is related to its moat; moats and ESG-related risk tend to work together. Corporations with the ability to tackle ESG risk create or strengthen moats over the long term.
Companies that ignore ESG risk might skate by in the short term, especially if they have a moat. But over the long term, a costly risk event can destroy moats, leaving investors with more risk and poor returns.