New S&P 500 ESG Index Threatens Valuations Of Ineligible Utilities

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Includes: AEE, AWK, CNP, DTE, FE, PPL, SO, WEC
by: Michael Wald
Summary

S&P Dow Jones Indices has announced a new index focusing on ESG – environment, social, and governance – values for S&P 500 companies.

Nine utility stocks in the S&P 500 Index have been deemed ineligible for inclusion in the new S&P 500 ESG Index.

Long-term utility investors need to consider whether they should include ESG-ineligible stocks in their portfolios.

A fast-growing investment trend is ESG - environmental, social and governance investing.

Bull and Bear Globally, sustainable investing assets in the five major markets (Europe, United States, Canada, Japan, and Australia/New Zealand) stood at $30.7 trillion at the start of 2018, a 34 percent increase in two years, according to the Global Sustainable Investment Alliance.

From 2016 to 2018, the fastest growing region has been Japan, followed by Australia/New Zealand and Canada. These were also the three fastest growing regions in the previous two-year period. The largest three regions— based on the value of their sustainable investing assets—were Europe, the United States and Japan.

For utilities, being seen as ESG-compliant is especially important. Utilities depend on public utilities commissions, politicians, and ultimately the public for their existence and continued success. In that respect, their reputation is more dependent on the goodwill of the public than other private corporations. Utilities that are perceived as ignoring social values can be easily punished through the rate-setting mechanism used by most states.

Up to now, definitions of what constitutes “responsible investing” have varied, and companies have been allowed to self-define whether they are ESG-compliant.

But given the growing interest in ESG, it is unsurprising that major indices are taking notice and creating third-party, independent benchmarks for index-driven investment products that quantify ESG factors.

S&P 500 ESG Index

Enter into this market S&P Dow Jones Indices, which has launched the S&P 500 ESG Index.

The S&P 500 ESG Index is a broad-based, market-cap-weighted index that is designed to measure the performance of securities meeting sustainability criteria, while maintaining similar overall industry group weights as the S&P 500.SPIndices.com

Supported by the reputation of the S&P DJ Indices’ S&P 500 Index, it is expected that this new ESG index will drive millions of investment dollars by both institutional and individual investors.

To create its index, S&P Dow Jones Indices collaborated with SAM, a registered trademark of RobecoSAM, which developed scores for individual companies based on SAM’s annual Corporate Sustainability Assessment (CSA) using on average 21 industry-specific criteria scores that can be used as specific ESG signals. Ineligibility for the index is based on four criteria.

Utilities are deemed ineligible for the index if they:

Have an S&P DJI ESG Score that is in the bottom 25% of scores within their GICS industry group in the S&P Global LargeMidCap and S&P Global 1200.

A company that is ineligible cannot be re-considered for inclusion for one year.

[GICS stands for Global Industry Classification Standard. The S&P Global LargeMidCap comprises the stocks representing the top 85% of float-adjusted market cap in each developed and emerging country. The S&P Global 1200 provides efficient exposure to the global equity market and captures approximately 70% of global market capitalization.]

Large Utilities Excluded from the S&P 500 ESG Index

Most utilities in the S&P 500 Index met the criteria for inclusion in the initial S&P 500 ESG Index, including NextEra Energy (NEE), Duke Energy (DUK), and Xcel Energy (XEL), but nine utilities were ruled ineligible for the index this year.

Investors in these stocks need to seriously weigh the importance of their stocks not being added to this index. Ineligible utilities include:

  • Ameren Corporation (AEE)
  • American Water Works (AWK)
  • CenterPoint Energy, Inc. (CNP)
  • DTE Energy Company (DTE)
  • FirstEnergy Corporation (FE)
  • PPL Corporation (PPL)
  • SCANA Corporation (SCG)
  • Southern Company (SO)
  • WEC Energy Group (WEC)

[While SCANA was determined to be ineligible for this year’s index, Dominion Energy (D), which has merged with SCANA, is in the index.]

Why Exclusion Matters

At this point, I can imagine many investors saying, “So what? I like my utility stock and don’t care if S&P includes them or excludes them from the index.”

Whether you are an investor interested in ESG or not, exclusion from this benchmark index should matter to you for the following reasons.

Studies have found that low ESG scores are consistent with lower financial performance

As noted above, there is a growing belief in the investment community that ESG performance correlates with improved long-term financial performance.

At this stage, interest [in ESG] seems to be driven by two forces. The first is a strong business case. Studies have circulated for decades on the ability of ESG to contribute to long-term growth and value, but the volume of evidence around financial returns is becoming increasingly irrefutable. The second force is peer pressure. In the past two years, major financial figures, such as Larry Fink, CEO of BlackRock, have come forward to endorse the importance of ESG as a tenet of mainstream investing. - Alex Heath, Executive Vice President of Edelman (Financier Worldwide, 2019)

Ties between ESG criteria and long-term corporate performance have been an area of academic and investor interest since the beginning of the socially responsible investing movement in the 1970s. In 2015, DWS conducted a meta-study along with the University of Hamburg that examined approximately 2,200 academic studies that had looked at the relationship between ESG and financial performance. The results of the study show that the business case for ESG investing is empirically very well founded. Roughly 90% of studies find a nonnegative relation between ESG and financial performance and the large majority of studies exhibit positive findings that appear stable over time. - Gerold Koch, DWS. (Forbes, 2018)

Investors need to take the impact of such research seriously even if they personally disbelieve it.

Investment products benchmarking to the new S&P 500 ESG Index will avoid ineligible stocks

A majority (78%) of respondents in our 2019 survey state that ESG is either playing a growing role or becoming integral to what they do as an organization. - BNP Paribas Security Services (The ESG Global Survey 2019 including 350 asset owners and managers)

Remember, the S&P 500 ESG Index has just launched and is too new a benchmark to measure its impact, but over the next 12 to 18 months as new investment products adopt the benchmark, we will have a better idea on its effect on stock prices.

Potential assets: As of March 2019 the S&P 500® has nearly USD 10 trillion tracking it – even a small portion of this moving towards an ESG version could shift a significant portion of assets towards the S&P 500® ESG. - SAM

The flow of institutional money is expected to reward stocks with high ESG ratings and punish ones with low ratings.

Individual investors will use the benchmark to make their own investment decisions

More and more investors take ESG seriously, and companies that fail to meet an independent evaluation of its environmental, social, and governance criteria as provided in this index are more likely to be shunned by a growing part of the individual investment community.

For the same reason that ETFs will choose the index as a benchmark, individual investors will look to the S&P 500 ESG Index as an authoritative measure of a company’s commitment to the environment, sustainability, and governance and will make their investment decisions accordingly.

Conclusion

I expect that companies will put more emphasis on their ESG efforts as this new benchmark becomes established.

If the index becomes the financial juggernaut that S&P anticipates, investors will need to consider whether they should avoid companies with ESG scores that fall into the lowest 25% of firms in their industry.

Unlike previous efforts at quantifying ESG factors, the S&P 500 ESG Index gives credibility and authority with a definitive set of measurements that can be applied cross-industry.

Given two utilities, one in the index and the other deemed ineligible, there will be a large group of institutional and individual investors who will choose the stock in the ESG index.

Investment products (such as ETFs) using the index as their benchmark will have no choice but avoid stocks that are ineligible.

Over time, this discrepancy will become more pronounced as will the pressure for utilities in the S&P 500 to become eligible for inclusion in this new ESG index.

Long-term utility investors in those stocks listed as ineligible for inclusion in this year’s index – AEE, AWK, CNP, DTE, FE, PPL, SO, and WEC – should review their portfolios and consider the impact it may have on their company’s stock price in the years ahead if these companies fail to win a place in the index in future years.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.