When ESG improvement comes at a cost: MFS Investment Management

Improving performance on sustainability metrics isn't necessarily free, and investors need to factor in the costs of environmental, social and governance in both risks and returns, according to fund manager MFS Investment Management.

MFS noted in a recent paper that "sustainability will drive new business opportunities for some while exacerbating risks for others, leading to substantial divergences in the long-term enterprise value of many companies."

"Sustainability has become such a hot topic everywhere," said Robert Wilson, research analyst at MFS. "We know it's happening in board rooms with executives, among investment managers, and frequently the message is, 'this is great, sustainability is going to lead to better social outcomes, better environmental outcomes and more corporate profits.'

"That's really not an intellectually honest way to go about this, because there are some industries where this is going to be challenging and potentially bankrupting."

Financial materiality needs to be integrated in ESG considerations, because of ESG issues impacts on financial asset prices, Wilson said.

Wilson cited the example of a sharp rise in the US minimum wage, from the current federal minimum of U$7.25/hour to potentially US$15/hour. Wilson noted that in analysing the impact of a rise in the minimum wage on the retail sector, some retailers will be able to adapt because of competitive advantage, and others have already raised their worker conditions with bonuses and salary increases since the pandemic began, but many will find that sustainability concerns pose major challenges to their profitability.

"A sharp rise in the minimum wage in the US could put those firms out of business," Wilson noted. "Retail isn't the only industry, though. We've been talking about the skilled nursing facility as well and it's the same situation. There are extremely low profit margins, the wages they pay their employees are very low, and the outcomes that they've had during COVID have been have quite terrible. How will they survive if the minimum wage is increased?

"The industry is already operating in aggregate at a negative profit margin. That's really where this paper came from, the idea that it's not going to be free for every company and as investors, we need to realise that and make sure that we're thinking about that as we make our investment decisions."

Wilson also cited the impact climate change and climate risk will have on oil and gas companies, and changes to demand for fossil fuel would impact on company strategy.

"You need to be talking to companies to understand how are they changing their future-looking view on capex, are they doing what many of the oil and gas majors are doing, pivoting their business and looking at longer term demand for oil and gas, or are they doing what the major US companies are doing, which is very much not taking the changes they need to adapt long term.

"That is one way, obviously, to address the trend in portfolios."

MFS integrates ESG in both bottom-up analysis of individual companies, and top down thematic portfolios, and engages with companies as active owners, Wilson said.

"The way that we think about materiality is really three factors - we think about what is the probability that an event will occur, what's the magnitude if it does occur, and what is the timing of the event," he said. "To the extent that if any one of those give a clear indication, we expect a management team to have an articulated vision."

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