RI annual review

ESG and income: No need to compromise

In the hunt for income, equities represent a rich opportunity. Attractive dividend-paying companies are present in all markets, across all industries and capitalisations, but investors seem to think dividend payouts only reside in a handful of sectors. Sectors with more exposure to ‘old economy’ names, such as telecoms, energy, finance, utilities, do typically offer higher yields.

However, our research shows that income opportunities in other segments are abundant for those willing to cast a wide net. This breadth of opportunity means that investors need not sacrifice their commitment to environmental, social and governance (ESG) principles and standards to achieve attractive income.

Income investing with less ‘C’

Given that two of the most polluting sectors - energy and utilities - typically exhibit higher dividend payouts, many yield-hungry investors may ask if it’s possible to achieve a high level of income without taking on significant carbon risk? Our recent analysis of a cross section of 2,200 developed and emerging markets stocks for which carbon intensity data, ESG scores and valid dividend information was available found that the higher dividend payout parts of the equity market were not unduly dominated by the biggest polluters.

While the top payout basket of stocks did contain its share of high carbon footprint names, it was clear there were many lower-carbon options to choose from within the highest income-paying part of the market. This shows investors don’t need to compromise on the ‘E’ component of their ESG goals when looking for income.

Removing the highest carbon intensity stocks from our analysis showed there was virtually no impact on the average dividend payout ratio and that there are ample opportunities for capturing high dividend payouts without investing in the most polluting companies.

The graphs below show the average payout ratio for the stocks in each of the payout ratio quintiles; quintile one (Q1) offers the most attractive dividends per unit of earnings. The graph on the right shows the effect of removing all the stocks with carbon intensity of >2000. Removing many of the worst offenders from a carbon standpoint has virtually no effect on the median payout ratio of each quintile, but has a dramatic effect on each quintile's carbon footprint.

For the avoidance of doubt it is important to acknowledge that the quintiles depicted here are not portfolios, per se. For an active income strategy – which we strongly advocate – it is better to think of the high payout ratios quintiles as potentially representing a selection universe of attractive names. The implication of this experiment, therefore, suggest that it is indeed possible to significantly reduce the carbon intensity profile of a high-payout selection universe.

We repeated this analysis using Direct and First Tier Indirect carbon emissions (measured in tonnes CO2e, as opposed to intensity which scales carbon emissions by revenue). The results were similar to those presented here. By omitting the 56 stocks with carbon emissions of > 30,000 tonnes CO2e we reduced the average carbon footprint of payout quintiles 1 and 2 by approximately 50% with no meaningful reduction in the average payout ratio.

Good governance and income investing

In the second part of the same study, we analysed the relationship between governance principles and dividend policy for approximately 4,100 developed and emerging markets companies for which both ESG data and valid income data was available. We found companies that pay dividends typically have better governance profiles than their non-paying peers, meaning dividend-seeking investors may already be putting themselves on the right side of good governance practices.

In our sample, dividend-paying companies’ more attractive governance scores appeared to be driven by better transparency, management incentive profiles, and stronger shareholder rights.

Limiting our scope to dividend payers only and to the companies that pay out less than their annual earnings, we found stocks with higher payouts also exhibited more attractive governance profiles, meaning good governance is generally supportive of income investing.

While the conclusion from our in-house analysis is that good governance appears to work to support an income-oriented investment approach, it’s also important to note that the stocks at greatest risk of dividend cut or cancellation – a key risk of equity income investing – exhibited a governance profile that was slightly superior to peers. Therefore, while good governance can be a key attribute of higher dividend paying stocks, other metrics must also be taken into account to ensure a more complete understanding of the risks related to potential dividend payout cuts.

No need to compromise on the ESG profile of your investments

Our analyses suggest that to achieve high income within the equities market, investors do not need to abandon their ESG goals. In fact, ESG factors such as good governance show a positive correlation to higher dividend paying companies. Furthermore, when it comes to environmentally conscious investing, the parts of the equity market with the highest carbon footprints were not the only places to find high dividend income. Adding ESG criteria to an investment approach should not hinder the objective of finding higher income.

These are all key considerations for income investors, particularly as the direction of travel regarding ESG and its growing importance globally. ESG information can help point investors to both threats and opportunities – some of which may take years to play out, but will work to shape our economy nonetheless.  We believe income strategies that can take advantage of all relevant company information - including ESG - have the greatest likelihood of success and those already committed to ESG investing should not see their income opportunities dampened.