Environmental, Social, and Governance (ESG) investments have exploded in popularity over the past couple years—and confusion about ESG has risen right alongside the surge of interest. This three-part series will explain how ESG methodology can strengthen investment analysis, and this first article will discuss the role of environmental metrics.

To put ESG in context, consider how we assess a firm’s ability to generate positive financial returns—we look at its profit and loss record, its balance sheet, known material risks that the company is required to disclose, how its competitors and the industry are projected to perform, and many, many other factors. ESG methodology creates scorecards that build on these core analyses by assessing the risks a firm faces in three distinct areas: environmental, social, and governance.

Depending on the industry, one, two, or all three of these categories may pose significant risks or opportunities for a company’s future. ESG scorecards offer investors insight into those risks and how a given company is addressing them in comparison with its peers. ESG basically gives us a fuller understanding of a company and how it may perform.

Environmental metrics measure how a given company is positioned for changes related to environment issues. E-scores cover the potential opportunities or upsides, as well as the negatives or downsides. For example, if a company produces goods and services that help transition to a lower-carbon future, such as clean electricity or green buildings, it will score higher. They also measure how well a company is managing its own environmental impact.

Regulatory, technological, and climate change risks

Climate change issues may seem most obvious, but the environmental metrics that make up a company’s E-score also measure risks driven by related regulatory and technological changes. The cost of implementing emissions disclosures to meet new requirements or the loss of certain tax credits could be considered environmental regulatory risk for some companies. An ESG methodology asks: How prepared is the company to meet a new compliance requirement? How easily can the company continue to deliver strong returns for its shareholders?

Similarly, as technology adapts to address environmental issues, we may need to understand how a company could either benefit or fall behind. Does it have plans to mitigate potential loss of revenue due to reliance on an outdated piece of technology? Or is this company driving a significant technological innovation? Think about how, over the course of three decades, the automobile made horse-and-buggy transportation obsolete. Now, with the expanding use of electric vehicles, what role will gas stations play in the future? Whether or not a company that owns gas stations has a plan to adapt to this change is the sort of variable that would likely affect its ESG scorecard.

The E-scores encompass a broad range of risks to give investors a better of understanding of factors that affect a company’s future success. How well a company can mitigate its own environmental impacts could have implications for climate change, as well as its long-term value in an investment portfolio.

The trucking industry, with its reliance on fossil fuels, gives us a great example of how a company can mitigate environmental impact risks. J.B. Hunt Transportation Services (JBHT) has been optimizing delivery efficiencies to minimize carbon emissions by sharing its expertise with customers to help them reduce their transportation-based carbon footprints, piloting the use of alternative fuel sources, and launching its own transition to electric vehicles.¹ The company has earned a high ESG ranking in recognition of the measures it has taken to reduce its carbon emissions.² This also happens to be one of most profitable companies in the trucking industry, which demonstrates how a firm facing the challenges of a carbon-intensive industry can still achieve a high E-score and deliver positive returns for investors through adaptations and innovations.

E-scores help us better assess each company

Changes in the environmental landscape, whether regulatory, technological, or climate-driven, can impact the returns on our investments. As more companies disclose the risks they face due to these types of potential changes, the more we, as investors, benefit. Comparing E-scores of companies within an industry enables us to identify those that are positioned to succeed through transitions to a lower-carbon economy. Strong leadership, a common characteristic of high E-scoring companies, has broad positive ramifications for a company’s performance.

Adding the ESG lens to traditional financial analysis helps us identify some of the  financially strongest, best-managed companies to include in investment portfolios to help preserve and build wealth. Reach out to your advisor if you would like to discuss our wide variety of customizable ESG options.