Macro, geopolitical and regulatory upheaval have set the stage for difficult conversations to be had about ESG, resulting in more sophisticated products and new direction for the sustainable investing movement, according to Rob Edwards, director of ESG product management at Morningstar Indexes.
Edwards argued the past year has sparked a rapid evolution in asset owner expectations of ESG products.
“While the events in Ukraine, rising interest rates and lingering recessionary concerns created a period of broad market instability, uncertainty is the new normal for sustainable investing as well,” he said.
“Energy sector outperformance last year made ESG an easy target for critics, but some of that scepticism turned into productive conversations for the industry on how to integrate ESG within portfolios, whether to exclude or engage and appreciating it is a work in progress.”
Reflecting on Morningstar’s Voice of the Asset Owner Survey 2023, Edwards said a key driver of shifting ESG usage and sentiment has been regulatory changes such as the categorisation of investments following ‘level two’ of the EU’s Sustainable Finance Disclosure Regulation (SFDR).
“Everyone is still dealing with the challenge that is the volume of regulatory changes,” Edwards continued. “Asset owners are going to be cautious in how they respond as they do not want to make knee-jerk changes – these changes are costly.”
However, he noted developments such as French regulators requiring institutional investors to disclose on how their investments impact biodiversity are creating a more sophisticated product offering.
“Biodiversity is a good example of regulation’s trickle-down effect, whereby asset owners are asked to report on more sophisticated nature-related risks and this in turn seeps into the products that asset managers and index providers are launching.”
Morningstar Indexes’ Edwards added another mounting pressure over the past year has been the political and ideological backlash against ESG, however, the materiality of ESG remains the overriding concern for asset owners.
“Increasingly severe manifestations of climate change, from forest fires to extreme weather events, prove this is not about ideology, it is about fiduciary duty. These risks will become more and more material for investor portfolios,” he argued.
While corporate governance has always been of interest to asset owners, Edwards suggested climate issues currently take precedence over social metrics because they are both more measurable and present a more acutely severe risk to investor outcomes.
As part of this, asset owners are demanding more elaborate and forward-looking metrics to be integrated into ESG benchmarks.
“Emissions are incredibly important, but they are backward-looking and do not tell the full story of a company’s climate risk and where they are in their journey to net zero,” Edwards noted.
“Going forward, we will be focused on incorporating things like transition risk and physical risk into Morningstar Indexes products.”
The challenge for index providers and asset managers will be squaring increasingly complex demands and capabilities with ESG products that can withstand the long haul.
This article first appeared in ETF Insider, ETF Stream's monthly ETF magazine for professional investors in Europe. To access the full magazine, click here.