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Investors look at environmental ratings for link to stock performance.

While socially responsible investors have been interested in environmental performance for some time, mainstream utilities investors are looking at the issue for a different reason - environmental leaders consistently achieve better financial and stock market performance than their less eco-efficient competitors.

Of the S&P 500's 26 electric utilities, the 13 utilities with the highest environmental ratings achieved stock market returns more than 600 basis points greater than the bottom environmental performers during 1998. The findings were reported in "The Electric Utilities Industry, Hidden Risks and Value Potential for Strategic Investors," a study by environmental rating agency Innovest Strategic Value Advisors.

The correlation exists largely because environmental performance is a strong proxy for management quality, the primary determinate of financial performance. The difference in financial performance between top and bottom environmental companies is increasing for several reasons, including expanding environmental regulations.

An article in the Jan. 12 Wall Street Journal criticized the environmental record of Edison International, in part for failing to install scrubbers on its coal-fired Mohave station. However, Edison received one of the higher environmental ratings in the Innovest study, indicating the company financially will outperform the electric utility sector going forward.

The situation reflected in the WSJ article highlights a conflict facing utilities. While competition is increasing pressure to cut costs, increasingly stringent emissions restrictions are raising environmental costs. Deregulation, meanwhile, is shifting those costs from ratepayers to investors. In the same way that many nuclear plants became uneconomic under deregulation, coal plants, such as the Mohave station, also may become uneconomic due to rising environmental costs.

Environmental issues may dramatically alter the competitive landscape, shifting low-cost suppliers into a high-cost position. Increasing regulations also will impact investor returns significantly. Effectively addressing environmental concerns is among the most complex challenges facing management, in part due to the large number of issues and stakeholders involved. Success in dealing with such complexity implies management has the sophistication to succeed in other areas, and thereby produce superior stock returns.

Going forward, environmental performance will be even more important for investors. As the correlation between environmental and financial performance becomes more known in capital markets, using an environmental screen will become a fiduciary responsibility for investment advisors seeking to maximize returns. That, in turn, will drive utilities to see the environment as more than a compliance issue. Instead, it will be seen as a vehicle for building sustainable competitive advantage and profitability.

Frank Dixon, managing director of research and development at Innovest, formerly was a management consultant in the energy and manufacturing sectors. For five years, he was a consultant to the Electric Power Research Institute, analyzing business strategies of U.S. IOUs. He holds an MBA from the Harvard Business School. Dixon can be reached at 212-421-2000.

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