Morningstar - Q1 2020 - 26

Spotlight: ESG Risk

understand how companies' sustainable
competitive advantages-or economic moats-
have an impact on these risks.

more narrow- and wide-moat companies receive
Medium, Low, or Negligible risk ratings from
Sustainalytics than do firms without a moat.

This is the approach Morningstar's equity research
analysts take. They view ESG through the
lenses of risk management and due diligence.
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? We find a wide
variety of answers. We also find that ESG issues
often overlap.

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.

ESG Risk and Moats Go Hand in Hand

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.

intensive companies that fail to invest in safety
systems and infrastructure might face
environmental liabilities that wear away their cost
advantage. Data breaches can 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.

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. Research-intensive
companies that neglect their workforce might
eventually lose pricing power. Resource-

Economic moats and ESG risk tend to work
together ( E X H I B I T 1 ). 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. Proportionally,

EXHIBIT 1

Moats and ESG Risk Work Together Proportionally, more companies with moats
receive Medium, Low, or Negligible ESG Risk Ratings.
No Moat

Narrow and Wide Moat

Identifying a firm's ESG risks is an important
component of determining its moatworthiness.
The following examples illustrate the close
relationship between economic moats and
ESG risk. 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.

Environmental
Energy Firms Build Moats Through Managing Risks
Many investors are focused on companies'
environmental risk. 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-remind
investors of the financial risks associated with
impacts on the environment. 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.

100%
30
63

50

61

75

86
70
37

39

Low

Medium

50

25

14

Negligible

50

0
High

Severe

Sources: Morningstar, Sustainalytics. Data as of 12/13/2019.

26

80

CO2 Emissions (Million Metric Tons)
Morningstar Q1 2020

CO2 Emissions Intensity (Metric Tons/Net MWh)
6.0

0.8

As they transition their business models to adapt
to environmental and regulatory change,
Dominion Energy D and Orsted ORSTED:DK 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
Natural Gas
Renewables

Nuclear
Coal
Conventional Hydro and Oil
3
100%
12
Morningstar - Q1 2020

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