Morningstar introduces ESG ratings score

Does the new rating have the potential to mislead ethical investors?

Facebooktwittergoogle_pluslinkedinmailFacebooktwittergoogle_pluslinkedinmail   by Damien Lardoux, 1st June 2016

Last month, Morningstar, the pre-eminent fund ratings firm, launched its global ESG (Environmental, Social and Governance) Rating. This new rating helps investors evaluate funds based on the ESG profile of their underlying holdings. It is available for a large proportion of the 200,000 funds tracked by the firm, so these factors can now be built directly into an investment strategy.

At EQ, we have been managing the Positive Impact Portfolios for a number of years, for investors that care about how and where their money is invested. We are also a Certified B Corporation, which means we have taken a close look at our social and environmental impact, how we treat our own staff and suppliers, and the impact of our business model, including the impact of our products and services. (The results of our assessment are freely available online here.)

We wholeheartedly welcome initiatives that raise the issue of responsible investing, but believe that a sole focus on ESG factors can be misleading. A crucial drawback is that ESG only focuses on the operations of a company, ignoring the impact of its products and services.

Instead of this operational approach, we think that the focus should be on the products/services and their subsequent impact on the environment and/or society. Two funds we rate extremely highly are Impax Environmental Markets and WHEB Sustainability. They invest in companies which reduce water waste, improve energy efficiency and develop clean and sustainable transportation services.

Both of these funds have been awarded below average ESG ratings within their sector (Equity Ecology) on Morningstar. Meanwhile, the Virgin Climate Change Fund has the highest score: investing in companies with lighter than average environmental footprints. But this fund’s scope goes beyond just the environmental sector, and within the portfolio are companies like Anheuser-Busch, an alcohol producer; UBS Group, a Swiss bank fined for tax evasion; and Vivendi the media group. Hardly investments that you would consider as making positive contributions to society or the environment.

So what’s going on here?

It’s important that ESG ratings are one of the metrics considered, rather than the only focus.

With well documented environmental, social and governmental policies in place and dedicated teams to answer any queries, ESG ratings have tended to favour larger businesses over their smaller counterparts. A geographical bias is also present; European companies are more advanced in their sustainability reporting than companies based in the US or emerging markets. It’s evident why the Virgin Climate Change Fund scores so highly – an 86% exposure to large companies and a 74% exposure to Europe. Whereas both the Impax and WHEB funds have less than 30% invested in large companies and 20% in Europe.

So, for investors looking to make sustainable, responsible, impact investments it’s important that ESG ratings are just one of the metrics considered, and not the only focus.

About the author: Damien Lardoux

Damien has an MSc in Management from Reims Management School and an MSc in Wealth and Asset Management from ESCP-EAP Paris Business School. He is also a CFA charter holder, being a regular member of the CFA Institute and CFA UK society.

Before joining EQ Investors, Damien worked for Bank of America Merrill Lynch being responsible for asset allocation, security selection and portfolio construction. Damien now acts as the portfolio manager for the EQ Investors Balanced, Positive Impact and Multi Index portfolios. He also co-chairs our Fund Selection Committee.

Damien is a devoted sportsman, playing judo and squash on a regular basis. He also enjoys hiking, to very far places such as the Himalayas and Kilimanjaro.

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