Morningstar updates ESG fund ratings methodology, introducing risk component

The second change to the ratings’ methodology in three years

US investment data giant Morningstar has revamped how it calculates its Sustainability Ratings for funds in an apparent response to criticism from ESG investors.

The NASDAQ-listed firm introduced the ratings in 2016 as a “global standard for sustainable investing”, but met with resistance from the sustainable investing sector with Schroders’ Andy Howard speaking for many when he called them “painting by numbers”.

Market players said the ratings penalise funds with an explicit sustainability focus while boosting the scores of large-cap funds, including those with exposure to high-polluting sectors and tobacco among others.

The heart of the criticism was due to Morningstar’s “best in class” approach which could result in a higher sustainability rating for oil major Shell, for example, due to its climate leadership amongst its peer group, and a lower rating for a positive impact-focused holding in a tougher comparison group.

As a result, sustainability specialists such as WHEB Asset Management and Kames Capital have been publicly critical, with the latter admitting low fund ratings had a client impact.

Now Morningstar has retired the ESG Rating data point – the original basis of the Sustainability Ratings – and moved to the newly-introduced ESG Risk Rating which uses a single scale to measure corporate ESG risk, enabling direct comparisons across industries.

To demonstrate, Morningstar gives the example of Shell and Microsoft, both considered “best in class”. The ESG Risk Rating scores accounts for the higher risk exposure of the oil & gas sector and therefore penalises Shell accordingly, reducing its Sustainability Rating and allowing a comparison to a non-peer.

The underlying sustainability data is provided by Sustainalytics, the ESG research house in which Morningstar has a 40% stake.

There was also concern that the data for the ratings was mainly sourced from public corporate disclosures, which is said to create a size and industry bias, rather than evaluating what companies are actually doing (though this is an industry-wide issue).
Big companies, and those in controversial ESG sectors, often have sophisticated disclosures and policies – appropriate to the higher levels of risks faced – which is subsequently rewarded by higher ratings.WHEB AM Managing Partner, George Latham, told RI: “At the end of the day it’s good to see a step forward. Can the quality of the underlying analysis be improved? Yes, I’m sure it can but if it starts moving in the right direction than that’s got to be lauded.

“It’s a shame that Morningstar chose not to engage with us over the methodology’s development” – WHEB

“However, it’s a shame that Morningstar chose not to engage with us over the methodology’s development. We may have been critical in the past but we are similarly vocal about wanting to engage and be constructive.”

Kames’ Craig Bonthron said: “We appreciate what they’re trying to do but we’re frustrated by some of the outcomes. But having an MSCI or a Morningstar work on improving their data measurement pushes the agenda forward and forces enhanced reporting and management of risk. From that perspective, we support them.

“But the stakes are higher for managers with concentrated portfolios like us. All it takes is one or two scores that we disagree with for our score to be skewed and for us to look bad.”

This is the second review of the Sustainability Ratings since they were launched. The first review, undertaken in 2018, involved moving away from comparing funds based on location and rating funds over a one year-period rather than on the most recent holdings.

In an FAQ, Morningstar states that the Ratings “will continue to evolve” in line with best practices, with impact and engagement identified as potential areas of focus in future reviews.

Morningstar estimates that the new methodology, which goes live in October – will result in the loss or gain of two or more globes for 24% of funds; the loss or gain of one globe for 43% of funds; and no change in ratings for 33% of funds.

For a 2017 interview with Morningstar CEO Kunal Kapoor on the sustainability ratings, click here.