Environmental, social, and governance factors no longer are just moral dilemmas for investors. Failure to take ESG into account can lead them into unforeseen risks–including companies’ inability to keep pace with new regulations, consumer demand fluctuations, and climate change–all of which can jeopardize a company’s ability to sustain long-term profits. As this Barron's article points out, big money is at stake.
Successful business leaders and investors often approach ESG variables with a risk management perspective to determine a company’s sustainable competitive advantage or economic “moat,” a term coined by Warren Buffett referring to companies’ potential for enduring competitiveness.
Morningstar says a company’s economic moat rating measures its level of sustainable competitive advantage and ability to create long-term value. It is based on elements such as high customer switching costs, network effects, cost advantage, intangible assets, and efficient scale, among others.
Companies with lower ESG risks are more likely to have higher economic moats, Morningstar said. For instance, companies that don't invest in safety infrastructure could face environmental disaster and a lower sustainable competitive advantage, such as BP in the 2010 oil spill, or PG&E with the California wildfires.
Unchecked sustainability lapses increase a range of risks and can affect the moat, as well as stakeholders. Companies that don't develop strong relationships with their workforces may face high turnover rates, and fall behind on human capital and product development.
Lax governance can lower a company’s economic moat: Prioritizing short-terms earnings goals, and poor capital allocation decisions can cause a much lower economic moat score. Similarly, firms that mistreat employees are susceptible to losing pricing power, those with environmental liabilities could remove their cost advantage, and others with data breaches could lose the trust of constituents.
Because ESG-related risks are constantly changing, companies need to adjust to new regulations, stakeholder demands and technological advancements with agility. Firms that manage ESG risks have the ability to develop or strengthen their moats and sustainable competitive advantage, making them stronger companies and more attractive to investors.