Companies with lower ESG ratings deserve closer attention from investors, given they have much more room to improve and, therefore, can potentially deliver higher returns.
This goes against conventional wisdom for many sustainable equity funds, which tend to shy away from sectors and companies that are deemed controversial.
“By targeting challenged sectors with room for improvement and overlooked companies that enable positive change, we think investors can access more diverse sources of return potential in portfolios focused on ESG issues,” said Jeremy Taylor, senior research analyst and portfolio manager for value equities at AB.
Upgrading to outperform
Research by the US fund house shows that shares of companies receiving an ESG rating upgrade outperformed the MSCI All Country World Index (ACWI) by 0.36% over the subsequent 12-month period.
At the same time, those that were downgraded underperformed by 1.33%.
In short, companies likely to see an increase to their ESG rating can be a source of return potential, explained Taylor – if investors can find them.
He cited new academic research supporting this approach. For example, Kelly Shue, professor of finance at Yale University, studied how low-emission “green” firms and high-emission “brown” firms changed their environmental impact given changes in their cost of capital.
Among various findings, not investing in brown firms was seen as counterproductive, given that a higher cost of capital makes these companies more concerned about short-term survival, in turn causing them to be less likely to focus on initiatives to cut emissions.
Sectors to watch
While sustainable-focused funds typically avoid high greenhouse gas emitters in the energy, materials and utilities sectors, these companies can be an important part of the solution.
AB analysis points to materials and utilities companies, in particular, as accounting for 84% of emissions reductions among MSCI ACWI companies from 2016 to 2022.
“Active equity investors can help support future improvements,” added Taylor. “By taking a position in a polluting power generator or a high-CO2 emitting chemicals manufacturer, investors also gain an opportunity to influence management.”
There are also some companies which support sustainability but don’t register on ESG radars, he said. And others might manufacture materials that are essential ingredients in green technologies, ranging from electric vehicle batteries to solar panels, which should benefit from increased demand as the global energy transition unfolds.
As a result, to find overlooked ESG opportunities, Taylor encourages investors to look for two types of companies: those with unrecognised ratings upgrades, and neglected enablers.