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Our Sustainability Rating Methodology Got an Upgrade

Three enhancements make the rating even more useful for ESG investors.

Our Sustainability Rating Methodology Got an Upgrade

Jon Hale: Hi everyone, I’m Jon Hale, head of sustainable investing research at Morningstar. Starting this month, we’ve made some enhancements to the Morningstar Sustainability Rating for funds.

The enhanced version differs from its predecessor in three ways: First, it is focused on material ESG risk, rather than on a broader array of ESG issues, some of which may not be financially material to investors. Second, company ESG risks can now be compared across industries, rather than only within industry peer groups. And third--the new rating is simple and transparent, no longer requiring a complicated calculation.

Let’s take a deeper look at each of these enhancements. First of all, the enhanced rating is based on the concept of material ESG Risk. The original rating reflected more generally how well-prepared a company was to handle a broad range of ESG issues--without a clear focus on materiality. The new rating reflects how much material ESG Risk remains after evaluating the actions a company has taken to mitigate those risks.
By materiality, we mean ESG issues that can be reasonably expected to have a financial impact on a company. One important study found that firms that performed better on material ESG issues outperformed those that performed worse on material ESG issues and also outperformed those that focused on material issues more broadly without any emphasis on the more material ESG issues. For an oil and gas company, for example, carbon emissions are, obviously, a major material ESG Risk factor. For an Internet company, data privacy and security issues are big material ESG Risk factors. So different industries have a different mix of material ESG issues, and that’s reflected in the enhanced ratings. Secondly--we can now compare companies across industries rather than only within industries. The original approach was based on how well companies managed ESG issues relative to their industry peer group only. 

Our fund sustainability rating was thus based on which portfolios held a relatively higher proportion of ESG leaders within their industry and a relatively lower proportion of ESG industry laggards. For example, in the old rating, take two companies--Royal Dutch Shell and Microsoft. Both rated as industry leaders. For funds that held both, Shell and Microsoft would then have had the same impact on a fund’s sustainability rating. But intuitively, most of us probably suspect that, given the industry that it's in, Shell has more material ESG Risk than Microsoft. 

The enhanced rating reflects that. Shell’s material ESG Risk is nearly 3 times higher than Microsoft’s, and therefore, Shell now has a much more negative impact on a portfolio. Within-industry comparisons do remain relevant, however. Shell remains one of the better ESG performers within the integrated oil and gas industry; its ESG Risk is about 25% lower than that of Exxon Mobil, so those portfolios with oil and gas exposure would still be better off from an ESG Risk perspective holding Shell rather than Exxon.

Finally, our original rating required a complicated calculation, because the ESG Ratings of the companies in a portfolio had to be normalized and we deducted points when companies were involved in significant ESG-related controversies. In the enhanced version, the use of a single scale of ESG Risk from Low to High means there is no need to normalize scores. And ESG-related controversies are incorporated into the overall company ESG Risk evaluation, so there is no longer a need for a controversy deduction.

That means there is a clear connection between company ESG Risk scores--and the portfolio score, which is an asset-weighted roll-up of the company scores. Globes are assigned the same way they’ve always been: Based the past 12 months of portfolios, a fund’s Sustainability Score--derived from company-level ESG Risk--is compared with its global peer group, and globes are assigned 1 to 5 based on a normal distribution. 

Our enhanced sustainability rating provides a way to evaluate any portfolio on ESG Risk. Investors can use it to evaluate how much ESG Risk is embedded in the funds they own and to identify funds with lower levels of ESG Risk as an alternative. While those wanting to invest in, or evaluate, intentional sustainability-focused funds should expect those funds to have relatively low ESG Risk. The rating should just be a first step in a broader evaluation of those funds. Investors may also want to know how funds with a sustainable investing mandate engage with companies, vote their proxies, and, more broadly, seek to provide impact alongside financial return.

For Morningstar, I’m Jon Hale. Thanks for watching.