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Portfolio > Portfolio Construction > ESG

S&P Global Ratings, Morningstar Raise Bar on ESG Measurement

By Ginger Szala

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Two rating firms are taking action to offer improved measurements on how companies are living up to environmental, social and governance initiatives. On the credit side, S&P Global Ratings is launching ESG sections in its Corporate Credit Rating reports. On the stock side, Morningstar is launching a Low Carbon Risk Index family, which will move beyond carbon footprinting and evaluate a company’s positioning in the future using ESG factors.

S&P’s announcement coincides with a UN Principles for Responsible Investment report that recommends credit rating agencies “signpoint” credit-relevant ESG risks and opportunities in the ratings report.

Therefore, S&P is phasing ESG sections into its corporate ratings reports. It began with the highest risk sectors: oil & gas and utilities, and plans to add the section “across all major companies across every sector, and to smaller companies in the sectors most exposed to ESG factors, which may be relevant to ratings,” the company stated in a release.  It hopes to have this cover 50% of S&P’s rated corporate universe in 2019.

“The fixed income market’s heightened focus on ESG has only emerged recently,” said Michael Wilkins, managing director and head of sustainable finance for S&P Global Ratings, in a statement. “We have long incorporated ESG considerations into our credit analysis. What we aim to do now is to more clearly underline to industry bodies, investors and stakeholders how we do so.”

In 2018, S&P Global Rating completed at two-year lookback series and identified historical patterns for ESG risks, as well as factors that directly or indirectly impacted a rating between 2015 and 2018. It found that there were 372 instances where ESG factors impacted ratings.

Morningstar indexes

Adding to its carbon footprinting measurement, Morningstar this week launched a new Low Carbon Risk Index Family, a group of indexes that will provide “diversified exposure to equities across regions and emphasizes companies aligned with the transition to a low-carbon economy.”

Partnered again with Sustainalytics and using its Carbon Risk Ratings, the indexes will target low portfolio-level carbon risk and fossil fuel exposure.

“These indexes go beyond the common approach of carbon footprinting, which reflects current emissions and is just a starting point for analysis of carbon risk,” Dan Lefkovitz, strategist for Morningstar Indexes said in a statement. “[These new indexes will] assess not only a company’s overall carbon exposure but also its management of that exposure — to ultimately evaluate whether a company is positioned to survive and thrive in a low-carbon economy.”

In a new white paper, Preparing for a Low Carbon Economy: Investing in the Era of Climate Change, Jon Hale, director of sustainability research for Morningstar ,and his team write, “For many, there is no more pressing challenge facing humanity than climate change. Of the 17 warmest years in recorded history, 16 have occurred since 2001, according to NASA.”

The paper goes on to say that pressures are “mounting on pension funds and other asset owners to more thoughtfully consider carbon risk. Climate change is variously described as a ‘secular trend,’ a ‘systemic issue,’ and ‘material financial risk’ that must be factored into investment calculus.”

The paper studies the key question: How vulnerable is a company to the transition from a fossil-fuel based economy to a lower-carbon economy? It reviews various risks and potential financial impacts to a company, such as increased pricing of greenhouse gas emissions combined with the financial impact of increased operating costs. Another risk has to do with reputation of a firm, such as shifts in customer preferences that in turn cause reduced revenue from decreased demand. Rising sea levels could mean increased insurance premiums and potential for reduced availability of insurance on assets in high-risk locations.

Also discussed is its risk-based analysis comparing the Morningstar Global Markets Index to the Morningstar Global Markets Low Carbon Risk Index, which was launched in November. Back tested from 2012, the Low Carbon Risk Index “slightly outperformed the market for its near six-year lifespan, countering the assumptions that investing sustainably entails a performance sacrifice,” the authors write.

However, they noted the Low-Carbon Index will not always outperform, as it underperformed in 2016 and 2017. “But on traditional risk measures,” the authors state, “the [Low Carbon Risk index] looks steadier than the market overall. It has recorded a slightly lower standard deviation of returns for the trailing one-, three- and five-year periods, indicating it has provided investors with a smoother ride than the market.”

— Related on ThinkAdvisor:

Ginger Szala

@gingerszalaink

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