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Commentary

Sharpening the Tools of the ESG Investor: Morningstar’s View

Improvements to ESG metrics and disclosures matter for all investors.

Globally, more and more investors are putting their money in sustainable investments. In the United States, mutual funds focused on sustainable investing attracted more than $20 billion in assets in 2019, more than four times the flows in 2018. And investor interest in sustainable funds has been even higher in Europe, with more than EUR 35 billion in new net assets each year since 2016. In 2019, fund flows reached a new record for European-domiciled funds of EUR 120 billion, according to Morningstar data.

And this is not a trend that is separate from mainstream investing. Rather, conventional investors are increasingly incorporating analysis of environmental, social, and governance, or ESG, factors into their process. 

Morningstar’s own long-term investment philosophy also embraces the use of these factors, as they can materially affect a company’s future financial performance. We find a company’s long-term profitability and growth are consistent with a business model that leads to community well-being, engaged employees, and shared values with customers. Therefore, our analysts need a detailed view of ESG factors to determine the likelihood that a firm will continue to generate or expand cash flows. 

Following Morningstar’s completed acquisition of global ESG research and ratings firm Sustainalytics, we share our perspective on the state of ESG investing, and what additional changes could help the industry better meet the needs of ESG investors.

Investors Want the Option to Incorporate Their ESG Preferences; Financial Professionals Have a Responsibility to Manage ESG Risks
All investments have impacts on the environment and society, and investors are increasingly taking these into account. They want to know how these impacts align with their values, and they increasingly want to consider long-term ESG risks such as climate change when they make long-term investments. 

However, investors do not fall into exclusive camps of being focused on either values or risk. Rather, many investors care about both aspects to varying degrees simultaneously. 

This growing demand from investors has led many asset managers to increasingly incorporate ESG risk factors into their process, though many are going further and developing sustainable or impact strategies. Asset managers are also taking their responsibilities as stewards more seriously by pushing companies to manage their ESG risks and consider the impact of their operations on the environment or society. 

More Comprehensive ESG Metrics Could Improve the Quality and Comparability of Data
Even with the best data, it’s a challenging task to ascertain whether an investment aligns with an investor’s values and how much ESG risk is intrinsic to the investment. 

Despite major progress in the past few years driven by investor demands and early regulatory efforts, the current state of ESG disclosures can still be improved to further empower investors. Simply put, ESG disclosures from issuers are all too often inconsistent and noncomparable, and material information is not always available. (These ESG disclosures should not be conflated with the ESG ratings that end-investors often see from sustainability rating shops, which are based on a variety of sources and methods.)

Policymakers Can Improve ESG Investing by Standardizing ESG Metrics, Terminology, and Disclosures
Though policymakers need to be cautious about stifling innovation, they also need to help investors by standardizing ESG disclosures to make them more comparable, material, and useful. Regulators need to embrace third-party standard-setting organizations’ metrics for reporting ESG indicators, with an emphasis on material and forward-looking disclosures. 

Organizations such as the Sustainability Accounting Standards Board should play a vital role in future ESG disclosure, similar to how regulators have deputized standard-setting organizations (such as the Financial Accounting Standards Board) for determining the financial information issuers must disclose.

Plenty of useful ESG metrics have already been developed, and these standards set by nongovernmental organizations are referenced in dozens of proposed or finalized regulations around the world and in multiple stock exchanges’ listing requirements. However, regulators need to use their influence to ensure these standards are better targeted and more useful than they are today. They need to harmonize these disclosures as they do so and push issuers to focus on material ESG disclosures.

Going Forward, ESG Investing Will Continue to Grow in Importance
Long-term investors increasingly need to consider the social costs of businesses, and even investors that are focused on shorter time frames need to be aware of immediate ESG risks such as worker health and safety, product safety and recalls, or business ethics. If these issues are left unmanaged or not addressed, it could damage a company’s profits or even cause it to go bankrupt. 

Of course, companies with high ESG risks may be attractively priced even after taking ESG risks into account. Companies with poor ESG track records can also make rapid adjustments to manage those risks. But, they can no longer ignore ESG factors altogether.

We encourage policymakers to standardize their guidelines around ESG disclosures, and asset managers to use their position as stewards of capital to promote ESG interests. These efforts will help ensure ESG investing is as clear and valuable as possible for investors.

This article is adapted from material that was originally published in Morningstar Direct™. If you’re a user, you can access the full paper. If not, take a free trial.