Investors can’t rely on desk-based research to assess environmental, social and governance (ESG) risks and rewards, according to a new paper from Lazard Asset Management.
The Lazard report says while there is a growing consensus that ESG factors affect company valuations and performance, investors struggle to transform the disparate data into coherent strategies.
“Unsurprisingly, investors have increasingly relied on ESG ratings to provide useful insights and help guide security selection,” the study says.
“While ESG ratings offer valuable inputs, we believe that in isolation they are insufficient to accomplish our objectives as they have some shortcomings that we believe can only be resolved through rigorous bottom-up fundamental analysis.”
For example, the Lazard paper – titled The Growing Importance of the ‘E’ in ESG – says the growing and complex impact of environmental regulation on three industries – car production, shipping and oil companies – requires on-the-ground research to understand the consequences for investors.
“Growing environmental concerns, and the concerted effort to tackle them on a global scale, are generating largescale changes across multiple industries,” the report says. “The ability to more precisely identify how environmental regulations are driving industry changes, and having a deeper understanding of their impact on related companies and sectors, could offer investors a structural advantage.”
The study says investors need to work hard to understand the fast-changing and interconnected effects of tougher environmental standards across industries rather than simply acting on “static” ESG ratings.
In the car manufacturing industry, for instance, the Lazard study says “the second-order effects created by the electric vehicle revolution is becoming an increasingly important area to watch in the auto industry, particularly in terms of the impact it is having on suppliers”.
Likewise, new regulations requiring the shipping industry to shift to low-sulphur fuels from 2020 would have significant implications for the oil refiners.
“The impact of the [ship fuel] regulations on oil companies and refiners will be difficult to anticipate precisely and is likely to be very complex,” the report says – albeit with a few points to note, including:
- Greater demand for low-sulphur products will boost the margins of refineries with the complexity to take advantage of this transition;
- The price divergence across different types of crude oil products is likely to widen, exacerbating existing price differentials; and,
- These shifts will likely introduce supernormal profits for a short period, but they are expected to be eroded over time.
Overall, the Lazard paper says comprehensive and regular corporate engagement coupled with a “meticulous” integrated responsible investment process could “help investors sidestep the significant losses that tend to accompany ESG failings”.
“We believe that bottom-up, active fundamental managers are better able to anticipate the risks and opportunities created by structural shifts compared to other approaches that rely on static and simplistic assessments of sustainability risks,” the report says. “This is because the information inputs used by active managers are often diverse, robust, and ultimately offer unique insights that enhance their predictive power.”
The paper was authored by Lazard co-chief executive officer, Jeremy Taylor; managing director and co-director of research,
Nathan Cockrell; along with research analysts, Alistair Godrich and Neil Millar.