Donald Rumsfeld, a former U.S. Secretary of Defense, famously pointed out the difficulty of making good decisions in complex circumstances, referring to the “known unknowns” and “unknown unknowns” in the Bush Administration’s invasion of Iraq on March 20, 1993.

A similar set of such problems exists today for investors dealing with the ESG movement’s manifold challenges to corporate decision-makers and the heavy stakeholder pressure on them adopt costly and complex ESG practices in their businesses.

Corporate adoption of ESG practices has not necessarily generated much in the way of returns for investors amid a high degree of what is deemed to be virtue signalling rather than actual alpha.

The Financial Times quotes Felix Gotz, research director at Scientific Beta and co-author of a paper titled “Honey, I shrunk the ESG Alpha” as saying:

“The claims of positive alpha in popular industry publications are not valid because the analysis underlying these claims is flawed with analytical errors enabling the documenting of outperformance where in reality there is none,” Gotz said.

Anya Solovieva, director, global commercial lead, climate solutions at Morningstar Sustainalytics tells Investment Magazine:

“What investors are finding challenging is to essentially be able to validate those claims [of outperformance] and to then also be able to better understand the actions companies are taking today to give them confidence that the companies will be able to meet those commitments.

“And as part of that, they need to kind of assess a broad range of kind of governance systems and broader policies, as well as looking at other parts of business transformation.”

Analysis at scale

To tackle the unknowns in the ESG penetration of companies, Morningstar has deployed 80 analysts doing the analysis at scale so that investors can also compare companies across geographies and different markets as well.

“Currently the coverage is about 4000 [companies]. By July 1 we’re going to expand that to roughly 6000, and then continue to roll out new coverage every quarter, to get to about 12 500 by early next year. So again, kind of really ensuring that we’re able to provide this research at scale.”

“By July 1st, we’re going to expand that to roughly 6000 companies, and then continue to roll out new coverage every quarter, to get to about 12 500 by early next year.”

Wisely for an organisation that evaluates the climate claims of thousands of companies, Morningstar Sustainalytics takes a lead from the Task Force on Climate-Related Financial Disclosure (TFCD) which explains that:

“Climate-related risks are far-reaching and differ from other risks to financial stability. The effects are spread over long time horizons, and actions today may determine the severity of risks in the years ahead. The breadth of climate-related risks – including their possible simultaneous occurrence across multiple jurisdictions and sectors – also has implications for the resilience of the financial system.”

Morningstar Sustainalytics notes that “as part of our assessment, we also have what we call a TCFD sub-module. And so essentially, what we do is we take the indicators that we’re evaluating for a given company, so we have a pool of about over 80 indicators, and for each company, we’re assessing about 20 to 30, and we recategorize those indicators based on the TCFD themes”.

Solovieva says based on the TCFD recommendations, “Sustainalytics does two things, first it provides a clear indication to the investor if this is something that is recommended by the TCFD and if the company reports or not, so that we can come up with a TCFD disclosure sufficiency score that gives them kind of an assessment of the completeness of a company’s climate reporting.

“Essentially that could help investors identify maybe companies that have weak climate risk disclosures to be able to then say, “Okay, why are you not doing more?” But then our evaluation of the indicators, what we call a management score, can be used as a proxy to evaluate the quality of a particular theme.

“An investor may then identify limitations around the strategy portion of the TCFD recommendations and use the research as a starting point for a dialogue with the company.”

Given the system’s sophistication, it comes as no surprise that Morningstar’s primary market for the product is “some of the more sophisticated asset managers that maybe already have had processes for assessing climate risk and see this as kind of additive”

She further notes that “interestingly, we’re getting good traction with hedge funds globally as well.”

“Of course, they’re very tight-lipped about their processes and how they use the research, but there seems to be some interest there.”

“And we have a number of conversations globally already ongoing with some of the larger pension funds, both I would have to say in the US, as well as in Europe, and in Asia.”

The Management Score: A measure of how a company deals with carbon transition risks

·       Seeing how they diverge from net-zero: Companies’ implied temperature ratings.

·       Industries with strong carbon transition risk management

·       Essential indicators to look at for climate risk management

·       What companies with strong climate management are disclosing

·       Emissions reduction targets

·       Use of carbon pricing in decision making

·       Governance structures to achieve net-zero target

·       Countries getting tough on climate are making a difference

·       To truly assess transition risk, more disclosures from more companies are needed


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