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‘Sinner-to-saint’ firms key to unlocking alpha in ESG

There is no shortage of ‘events’ currently afflicting the world. The Q2 results season confirmed significant inflation of raw materials, transport and labour. Covid-19 uncertainty also continues to muddy the waters over the pace of recovery, while US-China tensions continue to simmer.

We have also seen a recent spate of extreme weather events, including severe drought in Brazil, fires in the US and devastating floods in China and Germany. These events have added stress to already disrupted supply chains.

However, such weather also underlines that the secular push around tackling climate change and energy transition is never far from the surface. Even as Covid-19 presents an immediate challenge to the world’s policymakers, the EU recently published ambitious proposals to reduce carbon emissions across wide areas of the economy.

In recent months, we have also seen ESG considerations hamper a UK IPO (Deliveroo), while the share price of Boohoo, which plunged last year on allegations of slave-like conditions in its supply chain, is yet to regain its past peak. In short, ESG matters and with ESG considerations becoming ever more embedded in government, corporate and investor agendas, its relative importance will only increase further.

ESG is not a specialist area anymore. Our analysis reveals a compelling correlation between companies improving on ESG metrics and share price outperformance. Meanwhile, we also see signs of increased pragmatism around defining which companies qualify as ESG-friendly, with ‘sinners to saints’ a clear theme this year.

Defining an ESG investment strategy has always been somewhat challenging. On one level, an ESG investment strategy could simply mean screening out certain sectors like tobacco or defence; the lines blurring with an ethical investment strategy.

For others, ESG metrics may underpin quality, with traditional investment returns still very much the objective. ESG can also be an end unto itself, this time the lines blurring with sustainable investing, as capital is targeted towards companies developing new solutions for technologies like carbon capture and plastic recycling. Furthermore, the relative importance of the environmental versus social and governance measures, and what exactly should be measured are still widely debated.

Market dynamics year to date also require a more pragmatic approach to defining ESG-friendly stocks. For a time, being classically ‘green’ was itself enough for a company to enjoy a lot of love from the market. However, such ‘chasing’ of green stocks has also left many trading with extraordinarily high hope-for-future built into valuations, often poorly supported by profit expectations on a normal investment timeframe (see examples below for Nel Hydrogen and Blink Charging).   

'Sinner-to-saint' firms key to unlocking alpha in ESG
'Sinner-to-saint' firms key to unlocking alpha in ESG

Year-to-date, many traditional ‘green’ companies have endured significant share price wobbles. Meanwhile, ‘dirty’ companies like BP and Volkswagen, both currently transitioning towards greener business models, have outperformed. This is symptomatic of a broader ‘sinners-to-saints’ theme and increased pragmatism towards defining ESG-friendly investments.

It also dovetails with our thoughts around real-world impact. For example, new hydrogen fuel cell technology may well one day change the world. Until then though, the largest real-world gains from an environmental and social standpoint will surely come from the transformation of existing businesses.

Mining company Rio Tinto is a prime example. The act of digging resources out of the ground is arguably inherently unsustainable and for pure ESG funds, we accept that investment in mining companies is likely to be awkward or impossible. However, Rio Tinto’s scale means the group is also able to have a meaningful real-world impact.

In the table below, we have selected several KPIs to assess Rio Tinto’s momentum across the three broad areas of ESG. On various environmental metrics, we find a broad and substantial improvement. Total energy consumption has fallen 12% over the past four years on an absolute basis and 34% from a per unit of revenue perspective. Carbon emissions are on a sustained downward trajectory and the group’s water usage per unit of revenue has fallen 30% over the last four years.

'Sinner-to-saint' firms key to unlocking alpha in ESG

On the social metrics, the overall proportion of female employees is fairly low (as is typical for the industry), but the proportion is trending higher. Rio Tinto’s female workforce also over-index in management positions. Also noteworthy is the single-digit employee turnover percentage. With respect to governance, Rio Tinto’s shareholders benefit from a high proportion of independent directors. There is also significant and growing female participation at board level.

Overall, Rio Tinto may operate in a problematic sector, but broad improvement across many areas suggest the company is at the forefront of positive change. With many traditional ‘green’ stocks trading on punchy valuations, the transition of unloved environmental ‘sinners’ may well provide scope for higher investment returns plus a meaningful climate impact.

Jonathan Fyfe is senior equity analyst at Mirabaud Equity Research

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