New research suggests that investors can benefit from looking beyond traditional best-in-class ESG screens, which may not tell the full story about a stock’s potential.
Investors who prioritize environmental, social and governance (ESG) strategies have a dual goal: to ensure that their investments have a positive impact while also generating returns. But while traditional ESG screens focus on companies that are already scoring well on sustainability factors, a complementary approach may be to look at whether companies are steadily improving on ESG metrics. Companies that are making significant improvements—in sustainability metrics as well as traditional financial metrics – have the potential to outperform on both fronts.
Utilities offer one case in point. In the U.S. utilities sector, many companies are shutting down expensive coal-fired power plants and building renewables, energy storage and transmission. Right now, they would screen negatively on classic ESG metrics, such as carbon intensity. However, these “ESG improvers” may be positioned to deliver superior stock returns and play a critical role in the transition to clean energy by reducing consumer energy costs, cutting carbon emissions and improving utility earnings-per-share growth.
To capitalize on the opportunity, investors should not just look at companies with improving metrics but understand what’s driving these changes. Criteria to consider include:
- An increase in revenue related to ESG themes
- Potential cost savings from improving ESG metrics
- Margin improvement from new ESG products or services
- More favorable cost of capital, typically due to reduced risk based on improving ESG metrics
- Analysis of a company's ESG goals based on its most recent sustainability disclosure
Both “best in class” and “rate of change” stock criteria, if applied thoughtfully, can have the potential to generate alpha. In particular, investors should look for growth opportunities over the long term, which are not always considered in existing ESG valuations. For the ESG “rate of change” stocks that Morgan Stanley examined, the growth opportunities often extend over 10 years or more, offering potential for upside beyond current investor expectations.
For more Morgan Stanley Research insights and analysis on ESG investing, ask your Morgan Stanley Representative or Financial Advisor for the full report, “ESG — 'Rate of Change' Drives Alpha Opportunities Globally,” Nov. 27, 2022). Morgan Stanley Research clients can access the report directly here. Additionally, you can read more Ideas from Morgan Stanley’s thought leaders.