Hidden liabilities

After I wrote yet another piece on how ESG investing is not about increasing returns but a method of risk management a reader was kind enough to send me a paper that he found interesting. I love it when my readers provide feedback and recommend papers or articles for me to read, because first of all, it can sometimes feel like I am sending these missives into a black hole, and second, my readers tend to have above average intelligence and education[1] and come back with great ideas. So, keep ‘em coming.

The paper by David Freiberg and his colleagues from Harvard Business School used public disclosures of the emissions of greenhouse gases and the water usage of companies to calculate the monetary damage these companies cause. Essentially, they used the emissions of different greenhouse gases and water between 2010 and 2018 and priced them with the best models currently available. Then they compared these environmental damages to the sales and operating earnings of companies. 

The chart below shows the median environmental damages caused per unit of sales for a select group of industries. The global median of hidden environmental damages is 2% of sales or 20% of operating income. However, in 11 out of 67 industry groups they look at, the hidden environmental liabilities are above 10% of sales or 100% of operating income. If these environmental damages become salient (e.g. due to an accident, a spill, or a sensationalised media report) or if they are prised as liabilities by regulators forcing companies to pay for their emissions and water usage on a comprehensive basis, then the significant decline in income will likely lead to a dramatic decline in the share price. In fact, the authors show that every doubling of the emissions relative to sales leads to a c.5% decline in the price/book-ratio of the company.

Thus, these risks may be hidden, but they are material and there are indications that they are priced in markets. Unfortunately, if you rely on environmental ratings from the big rating agencies, you would not know about that since the correlation between environmental ratings and these hidden liabilities is essentially zero and if anything, slightly negative.

The good news is, however, that corporations can do something about it. The authors show that only about 60% of these hidden liabilities are determined by the industry a company is operating in. The rest is due to company-specific factors. And that means management can reduce its risks from hidden liabilities quite significantly if they want to.

Environmental liabilities as share of sales or operating income

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Source: Freiberg et al. (2020).

[1] I don’t mean that. I just say that, so you like me 😜