A] Prelude*
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B] Several objectives
Why do asset owners around the world pursue sustainable strategies? The reasons range from the purposeful to avoiding risks, such as the negative impacts of environmental issues, to the purely financial. And many institutional allocators today pursue both purpose and alpha, alongside a more granular understanding of how to approach and measure their sustainable investment portfolios.
Asset owners are expressing themselves very clearly on this point, said Hortense Bioy, Morningstar Sustainalytics’ head of sustainable investing research. “We’re hearing from some asset owners that the current state of climate investing isn’t meeting their needs,” she said. “Some have criticized benchmarks aligned with the Paris Agreement and certain climate transition metrics. Paris-aligned benchmarks are a regulator-driven initiative that aims to reduce carbon in portfolios, but they’re quite constraining.”
Asset owners have two primary goals, Bioy continued: To provide capital to companies that offer solutions to climate change and to encourage corporate decarbonization. They’re more concerned about leveraging their position as large investors to foster real-world decarbonization than about their portfolios’ carbon exposure.
Pablo Berrutti, portfolio specialist at Stewart Investors, cites several objectives that sustainable investing seeks to achieve. The first is simply to generate good performance. “Some asset owners focus on ESG ratings and sustainability considerations,” he said. “But ESG is usually just one of many criteria they use to make decisions. They want to know how we intend to generate attractive long-term returns and how our investment process connects with our investment philosophy to accomplish that.”
Berrutti also cited government reporting requirements as a reason why asset owners pursue sustainable strategies. The U.K. and New Zealand, for example, have mandatory climate change disclosures. Asset owners in those jurisdictions need their investment managers to deliver disclosure-friendly information.
Ultimately, Berrutti said, “asset owners’ motivation comes down to two things. One, How does the incorporation of sustainability enhance a manager’s investment process? And two, How can shareholders use their influence as stewards to encourage companies to improve their sustainability efforts, reduce risk and capture opportunities?”
C] Data
The world of sustainable investing continuously evolves as technologies, data and marketplace factors advance at a dizzying pace. It requires regular monitoring of innovations across the space.
Bioy of Morningstar Sustainalytics said, “Sustainable strategies are typically benchmarked against a broad-market index. But new strategies call for new indexes, which explains the rise of sustainable indexes over the last 10 years.” According to the Index Industry Association, there currently are more than 50,000 sustainable investment indexes.
“If you want to measure your sustainable strategy’s risk, return, ESG quality, carbon profile, etc., you need to compare it not just against a sustainability benchmark, but also versus the broad market,” Bioy said. Institutions are asking sustainable index providers for more than benchmarks: They want data and insights that can enhance their analysis and decision-making.
Asset owners are focusing on how they should invest as the transition from fossil fuels to other energy sources unfolds, said Kuh of Morningstar Indexes. In the last year or so, the climate research team at Morningstar Sustainalytics has introduced its Low Carbon Transition Rating (LCTR).
LCTR not only provides insights for investors on traditional metrics for carbon footprint but also uses forward-looking data that examines companies’ net-zero plans and the related capital expenditures they need to make. “This gives investors a clearer sense of whether companies are actually following through on their net-zero plans and moving on to pathways that, in the future, will meaningfully reduce their carbon footprint,” Kuh said.
D] Just a start
Asset owners and managers have long complained about the lack of standardization in the data, metrics and disclosure requirements used to evaluate sustainable investments. Some index providers believe that things are moving in the right direction, while acknowledging that true standardization will take years to happen.
“There’s more and better quality ESG data now than five years ago, because investors have engaged with companies to request that information,” said Bioy of Morningstar Sustainalytics. “But there is still no standardization because disclosure remains voluntary in most markets. This is changing, though. The EU has enacted its Corporate Sustainability Reporting Directive, for which the first reports will be published in 2025. The International Sustainability Standards Board has consolidated several standards into one that countries are starting to adopt as their mandatory framework.”
However, standardization remains uncertain in the U.S., Bioy added. The SEC adopted a climate disclosure rule in March 2024, only to pause it in the face of political opposition. A federal appeals court will hear arguments on the rule’s legality.
“We’re quite cautious, skeptical even, of ESG scores because measurement methodologies vary greatly among providers,” Berrutti explained. “It can be difficult to know whether you’re comparing apples to apples. Often the scores seem to be based on the previous year’s data, and they get updated only annually. The data is also backward looking, which means it can’t take into account a company’s ambitions, future strategies, where it wants to go — which is the most important thing for us as investors.”
E] Focus on biodiversity
Index providers are actively creating new products that meet asset owners’ needs.
Kuh referenced Morningstar Sustainalytics’ Low Carbon Transition Rating as the basis of a new index. “We developed a benchmark to track carbon transition leaders that builds on the LCTR’s management assessment. It reflects not only the historical trajectory of these companies’ carbon profiles, but also where they’re going,” he said.
Institutions are expressing considerable interest in biodiversity, Kuh said, which is adjacent to, and intersects with, climate change, making it a greater priority for sustainability investors. “It’s fair to say that we should expect biodiversity to become increasingly important to investors concerned about transitioning to a low-carbon economy,” he said.
“Climate change’s impact on biodiversity, in terms of species loss and depletion, is profound and has long-term ramifications.”
F] Attractive opportunities
Although Stewart is a bottom-up investor, there are certain sectors in which it tends to find appealing opportunities, including healthcare, information technology, software and digitalization, Harley said. The intersection of industry and technology is particularly interesting as well, he noted. Companies that formerly were straightforward industrial producers now use different business models. They’re seizing opportunities that arise because of digital connectivity, processing efficiency and automation.
G] The future
Sustainable investing is a hotbed of innovation across asset classes, though its shift into the mainstream may come in fits and starts. Asset owners currently favor equities for their sustainable portfolios but fixed income is gaining traction and appears headed for larger allocations.
Within sustainable fixed income, investors are most enthusiastic about green bonds, according to Bioy of Morningstar Sustainalytics. “Green bonds are at the intersection of climate, finance and impact,” she said. “Investors like them because they use quantitative metrics to measure how specific projects meet their environmental goals. Compared to public equities, they offer a better way to assess a sustainable investment’s impact.”
Private markets play a pivotal role in the climate transition, Kuh added. “They’re where a lot of the new and emerging technologies are being incubated. At Morningstar, we have the benefit of access to private markets data through PitchBook. We’ll be increasingly taking advantage of access to that information to help investors think about where the new technologies are coming from and how the transition will be financed,” he said.
H] Finally
For Kuh of Morningstar Indexes, the big story is data as the foundation on which sustainable investing strategies are built. “We are in a world of big data, advanced computing capabilities and artificial intelligence. Our ability to gather and analyze new types of data is transforming business practices in many industries. We can now collect and analyze information that wasn’t even available before and do it much faster than ever. Which will fundamentally transform how sustainable investment is practiced,” he said.
What does sustainable investing look like in the longer term? Stewart’s Harley expects to see a gradual shift in the sense that ultimately, sustainability should be absorbed into the investment mainstream. “I think the importance and idea of sustainable investing will gradually take hold, but the process won’t be fast, uniform or neat. It’ll likely be patchy and staccato. Parts of the industry will resist and move slowly,” he said.
Bioy sees ongoing evolution. “ESG is moving from voluntary to regulated and from proprietary to market-level standards. It’s being shaped by disclosure regulation,” she said.
Let’s hope the U.S. will wake up and join in this global trend!