Morningstar research outlines hidden ESG issues within sustainability-oriented portfolios.
Investors need to scrutinise their renewables investments for potential overexposure to high carbon emissions and social-related risks, according to Morningstar research. The funds analysis and data provider’s Global Markets Renewable Energy Index is 10 times more carbon-intensive than the broad global equity market and also carries more ESG-related risk, raising questions about the carbon intensity of other sustainability-oriented indexes.
“Renewable energy investing is not the same as low carbon or low ESG risk. Companies involved with both clean energy and fossil fuels can have carbon-intensive operations, or carry other ESG risks,” said Morningstar. While renewables are an essential component to the world’s transition to net zero, investors looking to decarbonise their portfolios must be cognisant of this risk, the report warned.
Investors are often investing in companies that are transitioning from carbon-intensive operations to renewable alternatives, meaning that a large part of their current business model still involves fossil fuels, the report, titled ‘Hidden ESG Risks May Lurk in Your Portfolio’, noted. The Morningstar Global Markets Renewable Energy Index includes carbon-intensive electric utilities China Power, RWE and US-based AES. These companies are all in transition, but add to the portfolio’s overall carbon intensity due to their continued reliance on fossil fuels.
Furthermore, a company may offer green products and services but still have carbon-intensive operations. Through analysis of the same Morningstar index, this has been found to be the case with Sunrun (solar), Nankai Electric Railway (Japanese railway) and Schweiter Technologies (plastics foam products).
“The carbon intensity of renewable energy investing doesn’t necessarily suggest greenwashing, but it does represent a trade-off that sustainable investors must acknowledge and consider,” the report said.
Companies dealing in renewables may also not be prioritising social-related performance, the report added. For example, Tesla – which offers emissions-free electric vehicles and is an attractive option for responsible investors – has been involved in controversies around workplace conditions for factory workers among other social-related issues.
Morningstar applied Sustainalytics ESG ratings and carbon data across both its equity and sustainability-oriented indexes. As well as assessing renewable investments’ exposure to carbon emissions, the research firm analysed ESG risks within dividend growth strategies, strategies overweight in utilities and industrials, and high-quality companies with thematic strategies focusing on transformative technologies.
This follows prior Morningstar research which determined that funds classified as Article 8 (promoting a social or environmental characteristic) or Article 9 (having a social or environmental objective) under the EU’s Sustainable Finance Disclosure Regulation (SFDR) have similar levels of fossil fuel exposure. More than 27% of Article 9 funds had at least a 1% exposure to firms deriving a minimum 5% revenue from thermal coal. This is compared to 19% of Article 8 funds.
This is because SFDR-compliant funds are investing in utilities firms which both have renewable energy operations and coal-fired electricity generation activities, the report said.
The variety of climate risks still present in listed equities has led to many investors increasingly favouring private equity when looking to increase their renewables exposures. However, this path is also impacted by risk, such as more limited liquidity and less transparency on sustainability performance.
“With the increasing investor focus on ESG investing, it is important to assess whether there are hidden ESG risks in the strategies used to construct investor portfolios. As ESG becomes ever more integrated into investment processes, hidden risks like these will be critical to expose,” said Morningstar.