Why consumer staples are a focal point for ESG risk

With inflation weighing heavily on the economy and financial markets, defensive stock sectors like consumer staples might prove to be more appealing additions to portfolios. But investors with an eye toward sustainability should also spare some thought toward their impact on the planet, according to one ESG expert.

“Consumer staples tend to provide an anchor of economic stability in portfolios,” says Sudhir Roc-Sennett, Head of Thought Leadership & ESG at Vontobel’s Quality Growth Boutique. “Staples benefit from a relatively low cyclicality, and a rising tide of demand.”

Because they generally represent the core necessities of people’s day-to-day lives and aren’t considered lavish expenses, consumer staples tend to provide a steadier stream of earnings flow compared to discretionary products. They also don’t require a huge amount of capital to be reinvested into the company, which means a greater share of profits could be paid back to shareholders.

Companies’ runway for growth isn’t just about taking market share, Roc-Sennett adds. As consumers around the world grow in number and wealth – that rising tide is most pronounced among developing economies, he says – the addressable market for consumer staples is likewise poised to increase in size over time.

“There's also benefits for the larger companies,” he says. “Investment into logistics, branding and manufacturing provides somewhat of a barrier for growth, but given their financial strength they’re also able to buy successful smaller companies to get new footprints into fast growth. They don’t have to keep guessing where the market is going, because they can buy into it as specific products and segments gain consumer approval.”

While consumer staples companies benefit from robust business models, Roc-Sennett says the sector faces – and gives rise to – some key risks.

First among them is the ongoing pressure on commodity supply. While consumer staples have a reasonable ability to mark up their products to mitigate the effects of inflation on input costs, there’s still the question of whether they can source those commodities in the first place as geopolitical tensions, ongoing supply-chain snags, and climate challenges take their toll.

Another issue, he points out, is the escalating regulatory risk for companies that draw so heavily on the planet’s natural resources. The problem is plainly visible through a smattering of headline-worthy stats: an estimated one million out of the planet’s roughly eight million plant and animal species are at risk of extinction, according to Roc-Sennett, and just around one sixth (16%) of the planet’s surface – excluding oceans, ice, and barren land – still has natural habitat. Meanwhile, the global population is set to balloon by another 25% by 2050.

 “We also have to be mindful about the risk to biodiversity as companies expand into natural areas through their supply chains. The conversion of land often replaces diverse natural habitats with miles of a single species of crop, known as monocropping, which threatens the diversity in the ecosystem,” he says. “It’s a global problem, but one that’s much more acute in certain areas, so chances are there will be stiffer regulation in certain markets.”

Beyond that, Roc-Sennett points to the industry’s impact on the water system. The expansion of large consumer companies, he says, also tends to reduce the ability for water to be retained in one area, which adds the already-severe challenges faced by certain parts of the world bearing the brunt of the impact from climate change.

If left unchecked, Roc-Sennett argues consumer staples companies could end up creating massive negative externalities, including many that will come back to haunt them. Aside from the obvious threat to food security, he says consumer staples companies have to consider risks related to natural medicine; 4 billion people worldwide use plant-based medicines, but as populations of pollinators and diverse chemical compounds held in plant species dwindle, it raises important questions about the ability of companies to develop medical products to meet future needs.

“At this point, we’re seeing huge gaps in companies’ ability to replace the nine species that dominate around two thirds of the world’s supply of farmed crops,” he says. “If any of them fail or collapse, we have to orchestrate a major rework of the global consumer manufacturing industry.”

Roc-Sennett says regulators are encouraging the use of metrics to provide more visibility into the problem. As an example, under a new law called Article 29, he says insurance companies in France are required to report on the impact of biodiversity from their holdings. A measure he is using is the Mean Species Abundance (MSA), which estimates the impact investment companies make on the diversity. This importantly includes their supply chains as few major food companies manage their own farms. As more data is accumulated, he says, it will develop into a picture of where the biodiversity impact is most pronounced, and where responsibility for stewardship of land should fall.

“We’re not trying to vilify big companies, because big isn’t necessarily bad. Inefficiency is bad,” Roc-Sennett says. “Nestle has an estimated MSA around 200,000 square kilometers, which implies its footprint effectively reduces the diversity of 200,000 Km² of natural habitat. That sounds catastrophic, but if it were another big company, we might be looking at 400,000 or 500,000 Km².”

To help curb companies’ inefficiencies, he says investors need to play a role. After detecting a problem and analyzing data related to it, they should take steps to engage with companies and try to encourage best practices amongst companies that don’t have them.

In its own interactions with companies, for example, he says Vontobel realized how little they understood the waste of their products after they were bought. As an estimated 30% of agricultural produce is wasted every year this holds potentially significant reduction in farmland needed to support the same consumption. There are differences in the areas where wastage is concentrated depending on the market. Developing countries tend to see waste in the fields due to the lack of refrigeration and inefficiencies in wholesale methods, while waste in developed markets happens at the consumer level as retailers and buyers dispose of products before their actual sell-by date or purchase more than needed.

“When you have this massive consumption and waste alongside the ongoing physical effects of climate change, you see all of these compounding impacts on biodiversity, water security, and other facets of the environment,” he says. “These are not separate things; they’re the expression of our demands on the planet. We have to be conscious about how quickly the world’s natural resources can physically be replenished, and how different regions will be affected by our decisions.”