Morningstar will integrate ESG into its stock ratings; here's how it'll work

Investment research firm Morningstar has announced it is adding ESG (Environmental, Social, and Corporate Governance) factors into its analysis of stocks.

Morningstar analysts will identify valuation-relevant risks for each company using ESG Risk Ratings by Sustainalytics.

Sustainalytics, which has been acquired by Morningstar, built its ratings around 20 material ESG issues.

These range from the immediate environmental and social impact of products and services and emissions to business ethics.

Once the risk are deduced, analysts will evaluate the probability they materialise and the consequential impact on a company’s valuation.

Results from this research will inform Morningstar’s assessment of a rating. Specifically, it will contribute towards a stock’s intrinsic value and the margin of safety.

Doing ESG ‘in a more formal and consistent fashion’

Stockhead spoke to Morningstar’s regional director of equity research Adam Fleck.

He explained Morningstar wanted to recognise the importance of ESG factors. But it wanted to do so without launching a new rating or data point.

“While we’ve always sought to capture ESG risks in what we were doing, we felt the time had come to do it in a more formal and consistent fashion,” Fleck said.

“We were afraid doing it outside our core process would miss an opportunity to integrate it into traditional realm of long-term valuation based investing.

“We’re not going to be launching another separate rating within Morningstar equity research. It’s going to be integrated into principally the moat rating, their competitive advantage, and our uncertainty rating.”

Fleck said ESG could include anything from any of those three letters.

“So environmental impact – you think about carbon [emissions] for instance – for social impact you think about sugar or tobacco [consumption].

“If you think of the governance side we’re thinking about remuneration or human capital.

“And we’re going to be thinking about the [risks] and ask as equity analysts what’s the probability there could be development in that issue that impacts the value of the business or negatively impacts how what we think about what the required margin of safety to pay for the business will be.”

Focused on valuation not values

Nonetheless, Fleck explained Morningstar’s move to ESG was not moving away from its goals of achieving financial returns.

As ESG has risen so has impact investing – which look at a company’s social impact ahead of – or maybe even disregard for – financial returns.

“We’re ultimately focused on valuation not values,” he declared.

“We’re trying to incorporate ESG into the realms of traditional investing.”

Nonetheless, Fleck recognised ESG analysis was gradually becoming “essential” for long term investors.

“It is critical to think about ESG risks as much as you’d think about risks not categorised as E, S or G,” he said.

“I cover Coca Cola Amtil (ASX:CCL) for example and I have to consider the company’s water usage and the impact of potential sugar taxes as social factors for instance.”

“Those are just two risks in the company that are ESG by definition. But [they] are important in considering the ultimate future cash flow of the business.”