is when companies exaggerate their commitment to mitigating risks from environmental, social, and governance factors. Companies can greenwash by making unsubstantiated claims and also by omitting relevant information.
Greenwashing affects consumers and investors alike. Companies that make false claims about the sustainability of their products profit from duping consumers who believe they are making an earth-friendly or socially conscious choice. Asset managers who claim to follow a sustainability-led mandate but invest in companies with significant ESG-related risk are doing their fund investors a similar disservice.
It can be very difficult for investors to distinguish between genuine and effective ESG risk-mitigation efforts and greenwashing. And there's no question that subpar regulatory disclosure requirements have exacerbated the problem. Acknowledging increased investor demand for ESG information, the Securities and Exchange Commission has launched some initiatives including a task force focused on identifying material gaps or misstatements regarding ESG risk at the company level and also among investment advisors running ESG strategies.
While that's certainly encouraging, meaningful regulatory change is often slow to happen. Europe is just now seeing the fruits of increased disclosure efforts years in the making with the Sustainable Finance Disclosure Regulation. Although the details and timeline for implementation have yet to be finalized, the SFDR will require funds marketed in the European Union to disclose climate, diversity, and governance data.
U.S. investors don't have to wait in the dark for better regulatory initiatives to come to fruition, though. Companies already disclose--through mandated regulatory filings and optional (for now) corporate sustainability reports--a wealth of information that sustainability-focused analysts use to evaluate companies' products, supply chains, policies, and impact.
In this article, we’ll show you how to use Morningstar and Sustainalytics research and data to measure ESG risk exposure in your investments.
Stocks Sustainalytics' ESG Risk Ratings can help investors measure the degree to which ESG issues are putting a company's enterprise value at risk. The higher the ESG Risk Rating, the higher the company's unmanaged ESG risk. (Sustainalytics, a Morningstar company, provides free access to ESG Risk Ratings on over 4,000 companies.)
An important characteristic of the ESG Risk Rating is that it is an absolute measure of risk. In other words, the scores and ratings are comparable across different issues, companies, and industries.
The rating is composed of two main parts: "Exposure" measures a company’s vulnerability or susceptibility to ESG risks. To a large degree, the industry a company operates in dictates the ESG risk it faces. For example, an oil and gas company will be highly exposed to environmental risk, while a consumer technology business will be more exposed to social issues, such as data privacy.
The "Management" dimension refers to actions taken by a company to manage a particular ESG issue. This can include a company’s ESG issues and policies. Controversies can negatively impact a company’s management score because they often reveal that management initiatives were insufficient or ineffective.
The ESG Risk Rating blends the exposure score and the management score together.
Here's a closer look at Tesla TSLA:
- source: Sustainalytics.com
To be clear, we are not saying Tesla is greenwashing. As an electric vehicle producer, Tesla's exposure to carbon-related regulations is significantly lower than other automakers'. Tesla's operations are also relatively clean and efficient compared with those of industry peers, which typically use more energy and emit more pollution.
But the company can't escape all the native risks of the auto manufacturing industry--particularly product safety risks--which show up in the "S" and "G" parts of the ESG risk equation. And Tesla exposes itself to increased safety risks in areas where it is an innovator, such as its automated driving capabilities and autopilot technology.
When scoring how well Tesla is managing its exposure to those ESG risks, Sustainalytics analysts evaluate the quality and integrity of the company's board and management (and any controversies). They also factor in CEO Elon Musk's unothodox compensation plan, shareholders' rights, and any negative events the company has had involving labor practices and product safety.
Mutual Funds Some funds take a rigorous, in-depth approach to integrating ESG. Others may be labeled ESG, or sustainable, but do very little to mitigate investors' exposure to companies with unattractive ESG risk profiles.
If a fund describes itself as an ESG fund in its prospectus and marketing materials, it is reasonable to expect the portfolio to favor companies with leading environmental, social, and governance practices. You would expect--at the very least--that the fund would not expose an investor to more ESG risk than a traditional (non-ESG) fund in the same category.
The Morningstar Sustainability Rating is a quick way to measure ESG risk in a fund portfolio. The rating starts with each company’s Sustainalytics ESG Risk Rating, which measures the degree to which individual companies in the portfolio face financial risks from ESG issues. Those individual scores are asset-weighted and rolled up into an overall, portfolio-level rating. The rating is easy to interpret: 5 globes means the overall portfolio has negligible ESG risk; 1 globe means it is exposed to significant ESG risk.
Here’s what the Sustainability Rating looks like for Calvert Equity CEYIX, a fund that states in its prospectus that it incorporates ESG considerations into its investment process.
- source: Morningstar.com
Calvert Equity's Sustainability Score reveals that its portfolio exposes investors to less unmanaged ESG risk than nearly every other fund in the large-growth Morningstar Category.
As Tony Thomas explains in the fund's analysis, Calvert's ESG team employs a topnotch approach to ESG research, using a proprietary system to rate and rank companies based on ESG criteria and assess material ESG risks. This helps ensure the fund remains invested in ESG leaders and avoids laggards: If a holding drops off Calvert's approved list, the portfolio managers must sell within a reasonable time frame.
Another metric that fund investors can use to evaluate mutual fund portfolios' ESG risk exposure is the Morningstar Low Carbon Designation.
Developed with Sustainalytics, this designation evaluates how well companies in the portfolio are managing their exposure to climate risk by limiting low carbon transition risks and how much exposure they have to fossil fuels. It rolls the company risk scores up into a portfolio-level score.
- source: Morningstar.com
While more funds appear to be avoiding fossil fuels, investors should not assume that all sustainable funds do. It's also possible that a portfolio earns a Low Carbon designation but has above-average exposure to ESG risk in the portfolio otherwise, as is the case with Gabelli ESG ESGKX (click the screenshot above to see Gabelli ESG's portfolio).
You can use our ESG Screener to search Morningstar's database for funds that score well in terms of the Sustainability Rating and/or have a Low Carbon designation. See "How to Find the Right ESG Fund" for more.