(Bloomberg) — ESG funds that are peddling bogus engagement strategies are about to feel some heat as Morningstar Inc. moves to the next stage of its quality control of the industry.
“We are going to look at engagement more closely, engagement activities related to climate especially, to hold managers to account,” said Hortense Bioy, global head of sustainability research at Morningstar.
It’s the next step in a review designed to weed out greenwashers and make sure investment firms actually live up to their marketing hype around environmental, social and governance strategies. And it comes after a major purge by the market researcher earlier this year, when Bioy cited “ambiguous” ESG definitions as grounds to strip the label off funds representing more than $1 trillion.
Few corners of the financial universe have been surrounded by as much marketing froth as ESG, which by some estimates represents more than $40 trillion in assets. According to Morningstar, genuine ESG funds held about $2.7 trillion in managed assets at the end of the fourth quarter.
The ESG fund industry has gone through a particularly fraught period since February, when Vladimir Putin’s war on Ukraine revealed that large numbers of ESG managers were trapped in questionable Russian holdings. ESG-labeled funds have also been regularly criticized for including stakes in fossil-fuel producers, or companies exposed to questionable labor practices in supply chains.
Asset-Owner Concerns
ESG fund managers tend to defend such holdings by pointing to so-called engagement strategies, whereby the goal is to try to influence a company’s conduct by holding meetings with C-suites and then voting at shareholder meetings. But there’s little in the way of policing of such claims and asset managers often have inconsistent approaches.
The asset owners that hand mandates to fund managers have also started to voice concerns over the extent to which engagement, as it’s currently practiced, does any good. Institutional investors overseeing a combined $10 trillion earlier this month called for adjustments to ESG engagement strategies to help reduce carbon-dioxide emissions more effectively.
Read More: ESG ‘Engagement’ in Crosshairs of $10 Trillion Asset Owner Group
Europe’s revised Shareholder Rights Directive requires institutional investors to development an engagement strategy or explain why they haven’t, while the EU’s Sustainable Finance Disclosure Requirement tells asset managers and banks to report how they intend to respond to controversies that may erupt at the companies in which they invest. SFDR also requires brief summaries of engagement policies.
Bioy said fund managers interviewed by Morningstar in connection with ESG controls can expect to be challenged.
“So they say, ‘Okay, the portfolio is what it is, but you need to understand that we are trying to improve the energy profile of these companies,”’ Bioy said. The question then becomes “understanding how far they go, how much they do, and what the ultimate result is.”
Bioy has previously said that managers who allow their engagement strategies to drag on for much longer than two years have some explaining to do.
“In their escalation policy, would they even divest?” she said. “Some would divest; they would put an ultimatum to the company and say, ‘Hey, we will engage with you for two, three years. After that, sorry but if we don’t see any progress, we will divest.’”
And engagement isn’t only a strategy for shareholders, but also for bondholders, she said.
“We are going to see more sustainability-linked bonds, green bonds, all this type of financing,” which “will end up in all portfolios at some point,” Bioy said. Bondholders “are always asked to participate in new issues, but then this has to come with new commitments.”
(Adds reference to EU directive; comment from net-zero asset owners alliance)
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