How Do You Assess a Fund's Carbon Risk?

Jeremy Glaser:

For Morningstar, I'm Jeremy Glaser. I'm joined today by Jon Hale. He is our director of sustainable investing research. We're going to talk a little bit about the

and how investors can use it.

Jon, thanks for joining me.

Jon Hale:

Thank you.

Glaser:

Let's talk a little bit about the Carbon Risk Score that we rolled out a couple of months ago now. Can you describe exactly what this is and what it's measuring for mutual funds?

Hale:

The Carbon Risk Score is a new metric that is based on underlying information from Sustainalytics, our ESG data provider, that is trying to assess a company's risk in relationship to the transition to a low carbon economy. It primarily focuses on carbon emissions in a company's operations and in its products and tries to assess what kind of financial risk does this company face in a transition that would cause them to have to reduce emissions significantly.

Glaser:

How is this different from our Sustainability Rating, the globe rating, which we've had for a couple of years now?

Hale: There is a relationship between them, but they are distinct in a couple of ways. Carbon risk obviously focuses on this one broad set of issues related to global warming and climate change. The ESG, the sustainability ratings overall focus on a broader, more holistic assessment of various ESG--environmental, social, corporate governance--issues that are material to any particular company within its particular industry.

The Sustainability Rating is also relative. It's relative at the company level--who is doing the best at managing ESG risks and opportunities within an industry--and also, at the fund level--who is doing the best at the category level on the sustainability ratings. The carbon risk rating is an absolute measure. You can compare a company's rating across the entire economy and you can do the same with funds.

Glaser: What is the relationship then between the two if they are related? Do we see a lot of 5-globe funds that have pretty poor carbon risk scores?

Hale: There's some relationship between the two actually. I was just looking at our large-cap blend category, thinking about how you would use these measures to help you identify a core U.S. stock holding. About 100 out of 500 funds in the large-cap blend category get a low carbon designation, meaning, on average, their portfolios have low carbon risk. About 60% of those have 4 or 5-globe ratings. There is definitely an overlap, but it's not complete. In the value category, there's very few funds that have low carbon designations because, based on the kinds of companies that a typical value fund would invest in, they are going to have a fair amount of carbon risk. You can assess value funds based on that measure, but if you look at the overall sustainability rating, you are always going to find within a category that the top 10% get the top rating.

Glaser: If you are an investor then, and let's say you care about global warming or reducing your global warming risk, climate change risk, but you also care about some of the other ESG factors, how do you combine these two when making an investment decision?

Hale: You can combine them in a pretty straightforward way. For instance, in large-cap blend, there's 102, I think, funds that have low carbon risk. As I said, about 60% of them have 4 or 5-globe ratings. You can clearly use both screens to help you get both a lower carbon risk portfolio and one that on the whole manages its sustainability issues effectively.

Glaser: Jon, thanks for your thoughts today.

Hale: My pleasure.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.

Jon Hale has been researching the fund industry since 1995. He is Morningstar’s director of ESG research for the Americas and a member of Morningstar's investment research department. While Morningstar typically agrees with the views Jon expresses on ESG matters, they represent his own views.