Ways To Analyze ESG ETFs

A VP at Sustainalytics argues for considering climate risk and opportunity within a fund.

"ESG" may be a hot catchall term for socially conscious investing, but a leading ESG researcher argues that a new framework needs to be deployed for determining how climate-friendly a company or ETF really is.

Speaking at the 2021 Morningstar Investment Conference Wednesday, Simon MacMahon, the executive vice president of ESG and corporate governance research at Sustainalytics, argued that a company has to be measured by both its past-facing climate impact and its forward-looking climate risk when an investor is considering its ESG credentials.

He defined "climate impact" as a company’s track record as an emitter or customer of heavy-polluting industries, such as an oil and gas operator’s emissions, and "climate risk" as how much the company stands to lose in the transition, such as stranded oil and gas reserves in areas that have banned new drilling.

Five Types Of Climate Funds

MacMahon also laid out five categories that climate-related funds fall into. There are low-carbon funds that prioritize investing in low-emitting companies; climate-conscious funds where management has laid out strategies around climate change; climate-solution funds that invest in developing products to reduce emissions; green bond funds that hold corporate debt meant to finance zero-carbon capital projects; and clean-tech funds that prioritize investments in renewable energy companies.

Each of those sections has a different mix of climate risk and impact, which doesn’t always appear obvious in a top-line ESG scorecard.

For example, several green bond funds exceed the benchmark for constituent companies’ carbon emissions because the company in question has a clean energy division commingled with a relatively higher-emitting business.

At the same time, climate solutions and clean-tech funds tended to rank the highest in future financial risk due to climate change, because several of those companies are fossil fuel producers trying to carve out a business in the post-carbon world.

“The focus on emissions for [low carbon] funds makes them avoid capital-intensive industries, and therefore in many cases, they’re avoiding the companies that are producing climate change solutions,” MacMahon said.

'Confusion In The Marketplace'

While he believes companies on the whole are being fairly truthful in their ESG representations, MacMahon said there’s plenty of incentives for companies and funds to greenwash their products based just on how much money has come into the sector in the past several months.

Speaking to ETF.com, MacMahon said there’s “confusion in the marketplace” over what exactly goes into an ESG rating. He encourages investors to dig into the methods of a scorecard to see how much of that rating is based on what could be material to the company’s future financial performance versus how much is based on reduction of emissions and other climate-friendly targets.

“You really have to dig into the methodology,” he said.

Contact Dan Mika at [email protected], and follow him on Twitter