European investors were recently reminded how tricky it is to evaluate a company’s environmental, social and governance (ESG) credentials. Tesla’s plans to chop down a forest to build a manufacturing facility for electric cars in Germany reinforced the need for independent research and engagement to assess the risks and opportunities created by ESG controversies.

How can investors really know how well a company is dealing with ESG challenges? When Tesla secured approval from a German court in February to raze a forest in order to build its first assembly plant in Europe, it showed that even a high-profile ESG darling may engage in environmentally unfriendly activities that standard ratings don’t capture.

ESG ratings produced by agencies like MSCI and Sustainalytics have an important role to play in assessing corporate behavior, but don’t always tell the full story. With an integrated approach that looks at a company’s ESG performance and outlook as part of a fundamental analysis of valuation, cash flow and return forecasts, we believe that investors can gain a broader perspective on a company’s sustainability performance that may not be fully understood by the market.

Adding an ESG Lens to Fundamental Research

Misunderstood companies often make for good investments. That’s because investors tend to push down share prices of companies that suffer from poor operating performance, industry challenges or competitive threats. When the concerns are exaggerated, the company may be valued incorrectly. This is true in the ESG domain, too.

Contrarian investors who develop independent forecasts of long-term revenue, earnings and cash flows can buy into the controversy. These metrics are relatively objective. But ESG considerations are much more subjective. Evaluating company behaviors through an ESG lens is quite different than constructing earnings and cash-flow models based on known variables. Perhaps that explains why ESG ratings of companies vary so widely from agency to agency, according to an MIT study published in August 2019.

Asking the Right Questions

While ESG ratings are a helpful starting point, we believe that they shouldn’t drive stock selection decisions on their own and are not a substitute for independent research. Our research suggests that a static rating is less important than the dynamic of the rating; as companies change their behavior, an improving ESG rating tends to drive stronger returns. Fundamental analysis of stocks can identify improvement potential by asking questions that might not be captured properly in ESG ratings. For example:

• When does a carbon footprint matter? Some ESG rating systems assess carmakers based on the carbon footprint of the products they sell. As a result, Tesla scores high, while European manufacturers of traditional combustion engine vehicles score much lower. However, airports aren’t ranked by carbon footprint, even though they sell takeoff and landing slots to airlines, which are among the world’s biggest carbon dioxide emitters.

• Which supply chains matter? Large global shoe and clothing manufacturers have taken steps to ensure that child labor isn’t used in manufacturing their products. Similarly, investors may seek to ensure that companies don’t do business with suppliers that have poor ESG records. Should a company’s ESG rating be affected if it seeks to secure raw materials from mines in the Democratic Republic of the Congo operated by a company with weaker ESG ratings? What about an airline like Lufthansa, which has a high ESG score because part of its income comes from maintenance and overhaul even though its fleet of planes is older and more polluting than its peers’? And how do we account for digital supply chains—and the social concerns related to data privacy that may take place far from a company’s core operations?

• Should investors consider outcomes of green policies? Efforts to promote environmental policies may sometimes create second-order effects that are missed in a standard ratings review, which usually focuses on the company’s input to a policy and not the ultimate outcome. Consider the shipping industry, where companies are facing new regulations (known as IMO 2020) that ban the burning of high-sulphur fuel oil (HSFO). This will undoubtedly lower the sulphur footprint of shipping companies. But HSFO won’t disappear. It is most likely going to shift to Saudi Arabian power plants, where it will displace crude oil. Investors who are considering the economic and environmental outcomes of a policy need to apply a broader perspective to their research.

The Benefits of ESG Integration

To address questions like these, we believe that ESG risks and opportunities should be integrated systematically into traditional financial analysis. That means a company’s return potential must be assessed in light of the risks and opportunities created by ESG issues. This approach can lead investors to two types of companies that ‎would be overlooked by using exclusion lists or by relying purely on external ESG ratings:

• Unrecognized Improvers—companies that are changing their ESG behaviors in ways that have not yet been detected by the markets or rating agencies. For example, the German utility company RWE had its ESG rating downgraded a notch to A by MSCI last October after selling a unit that left its business mix more focused on power generation. But that decision failed to acknowledge RWE’s success in shutting down its coal-fired plants and developing more renewable energy facilities.

• Neglected Enablers—companies that play an important role in powering positive ESG change, yet are not often recognized because their products or services are less visible than those of high-profile ESG champions. Take Norwegian fishery companies SalMar and Mowi, which are not typically thought of as sustainable staples in an equity portfolio. Yet their businesses support more environmentally friendly sources of protein compared with those of meat farming companies, while offering people healthier diet options.

Some investors use exclusion lists to avoid stocks from certain industries, such as tobacco or gambling, on ethical grounds. Others are beginning to extend exclusion lists to address broader policy concerns; for example, by excluding carbon-based energy producers. However, this approach may lead investors to miss out on some misjudged companies or improvers and on the opportunity to engage with companies to promote better ESG policies and outcomes.

For example, an investor in an airport company could engage with its management to promote tighter rules on emission requirements from its airline customers. Utilities or commodity producers—which often score low on standard ESG metrics—can be pressed to clean up their operations.

An Integrated Approach to Sustainable Investing

Leaning heavily on ESG ratings can be a convenient approach for many investors. In a world of confusing ESG requirements, it may seem like the simplest way to pursue a responsible investing approach. But it may also deny investors access to misunderstood or improving companies. With an integrated approach, based on fundamental research, investors can identify companies turning ESG controversies into opportunities and apply influence to promote behavior that supports sustainable long-term investment returns.

Andrew Birse is Portfolio Manager—European Value Equities at AB

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams and are subject to revision over time. AllianceBernstein Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom.