Regulators must demand greater clarity from ESG funds

'Policymakers need to standardise ESG disclosures', Morningstar report says

A new report from Morningstar, entitled Sharpening the Tools of the ESG Investor, has criticised the continued lack of consistent information and disclosures on ESG issues, and calls for regulators to push companies and asset managers to improve their stance

Despite efforts by regulators to improve ESG disclosures, investors still lack “complete and consistent” ESG data when investing in stocks, fixed income securities and investment funds, the Morningstar report warned.

In fact, 60% of funds in the US that state “ESG is considered” fail to earn a High Morningstar Sustainability rating, while globally fewer than 30% of stock issuers disclose ESG factors in a “comprehensive and consistent fashion”.

The report said: “Policymakers need to be cautious about stifling innovation, but they also need to help investors by standardising ESG disclosures to make them more comparable, material, and useful.”

Lack of clarity

As demand for ESG investment products grows exponentially and firms respond by launching more and more new ESG funds, Morningstar said regulators must step up to demand better disclosures from these funds to ensure investors know what they are buying.

“Investors need clear and consistent disclosures that make it easy to understand what a portfolio manager is doing when considering ESG factors, and that these considerations may not make it more sustainable,” the report said.

“Passing references to ESG do not necessarily mean a fund is committed to sustainable investing practices.”

At this stage, many funds that purport to incorporate ESG into the security selection process do not state to what extent they do this or which factors are considered – something investors need to see.

“For example, in a recent analysis, Morningstar found that funds that market themselves as climate funds often have exposure to companies deriving revenue from fossil fuels. Such exposure may be appropriate given a fund’s strategy, but it’s important that investors understand what they are getting from their investment.”

Regulatory pressure

With these concerns in mind, Morningstar said regulators must require that funds with ‘sustainability’ in the title must “be able to demonstrate ‘intentionality’—that is, that their process is carefully designed to consider a variety of ESG indicators to arrive at a sustainable investment mix”.

The paper calls for regulators to “require funds that include ‘sustainability’ or ‘ESG’ in their names to evaluate all aspects of ESG, both qualitatively and quantitatively”.

It notes that this is already being done by the Securities and Futures Commission in Hong Kong, which requires green or ESG funds to “substantiate that they invest primarily in sustainable securities”.

Meanwhile, the EU is currently considering introducing a union-wide ‘ecolabel’, in addition to new sustainability disclosures that every fund would have to provide.

Removing barriers

However, although these initiatives are welcome, more needs to be done to improve the consistency of ESG disclosures across the globe, Morningstar said.

“Regulators need to nudge markets toward a more standard set of sector-specific disclosures on their environmental impact, starting with climate change.

“These frameworks should be standardized across issuers, when they are material, and must include forward-looking disclosures, backward-looking metrics, a discussion of risk management, and climate scenario analysis.

“Further, investors need more indicators about the positive impacts companies make if they want to direct capital toward solving sustainable development challenges.”

One area that is in particular need of improvement is the private equity market, especially in the US, where more than half of new capital is being raised this way. However, companies in these markets are exempt from most disclosures.

Morningstar said: “These private issuances have minimal ESG disclosures at best. Indeed, only two out of 45 questions in a recent European consultation about standardized disclosure asked about applicability to non-listed companies.

“This lack of data is particularly problematic because some exempt investments, such as private equity funds, have begun to attract policymakers’ interest for poor labour practices and possible price gouging.

“As more investors gain exposure to private firms, it will be increasingly important to consider the role of ESG data for non-public companies.”

The fixed income market is in an even worse position when it comes to availability of consistent disclosures.

“For example, sometimes a bond’s ESG rating is based on the ESG risk the issuer faces. Sometimes the ESG rating is based on the bond’s use of proceeds—whether they are used to fund greener activities.

“A lack of consistency has made it difficult for investors interested in green bonds, arguably the most important way investors could achieve positive impact with their investments.”

Last, but not least, the report notes the US is far behind its European and Asian counterparts on promoting ESG investing into the mainstream and US regulators have much work to do to keep up.


Natalie Kenway

Natalie is editor in chief at MA Financial covering ESG Clarity, Portfolio Adviser and International Adviser. She was previously global head of ESG insight for ESG Clarity and has been an investment journalist...