ESG Data Guide 2023

Cutting through the noise around climate risk and global regulation

Investors face a complex landscape of identifying and understanding climate risk and opportunity in the context of evolving regulation and reporting frameworks. Azadeh Sabour, senior vice president of climate solutions at Morningstar Sustainalytics considers how investors can cut through the noise.

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Environmental Finance: Investors face information overload when it comes to climate change. What should they focus on to mitigate portfolio impacts?

Azadeh SabourAzadeh Sabour: Investors need data and insights to understand their climate-related risk exposure while addressing the evolving regulatory landscape. The Task Force on Climate-related Financial Disclosures (TCFD) offers recommendations to help investors assess and manage their exposure to and management of climate-related risks with two key drivers to consider. Investors need to focus on physical climate risks due to increasingly intense effects of global warming. They also need to consider transition risks and opportunities, as companies face the costs of decarbonising the global economy, including changes in consumer behaviour and new policy responses. As the low-carbon transition accelerates, companies that do not effectively shift might have reduced access to capital and insurance because they will be deemed too risky.

EF: Many companies are making net-zero commitments as part of their response to the transition. How can investors critically evaluate these pledges?

AS: To protect their portfolios from greenwashing claims, investors need to effectively substantiate these pledges. Commitments that don’t have intermediate science-based targets or disclosed strategies to reach those targets could be labelled as greenwashing and rejected by regulators. We encourage investors to assess the validity of companies’ climate commitments with data that can help identify indicators, such as established programmes focused on managing climate risks in alignment with TCFD recommendations. Examples could include tying executive compensation to carbon emissions reductions or wider climate-related targets, and measuring, tracking, and reporting on key climate metrics.

EF: Speaking of climate reporting frameworks, what should investors expect with the recent publication by the International Sustainability Standards Board (ISSB) of its new Climate-related Disclosures standard?

AS: The ISSB’s new standard builds on several existing sustainability reporting frameworks, such as those from the TCFD and the Sustainability Accounting Standards Board. It responds to a resounding call from companies and investors for global alignment on sustainability reporting.

We expect the new climate standard to be endorsed by several jurisdictions and become a mandatory reporting framework for issuers. Our clients are also considering the implications of other jurisdictions, such as the EU and the US, publishing their own standards. While stacking frameworks may appear counterintuitive to the goal of having one global standard, we consider the ISSB climate standard to be the desired baseline. For instance, the EU’s Corporate Sustainability Reporting Directive focuses on double materiality and reporting on ESG factors – going beyond ISSB requirements. Additional regional or thematic standards would potentially serve as complementary considerations, leaving space for innovation and embracing the needs and values of different clients.

Investors and financial institutions should be engaging portfolio companies to disclose their data to a globally recognised climate framework, such as those from the TCFD or the ISSB. Doing so will provide investors with more reliable data and enable better compliance with regulation.

EF: How can investors respond to criticism of companies that are praised for managing their net-zero transition while operating in heavy emitting industries?

AS: Within a diversified portfolio, some companies face inherently greater exposure to carbon risk by the nature of their industry or subindustry, while other operations (i.e., coal companies) are simply incompatible with a net-zero scenario. When assessing those companies that can act to reduce or eliminate their emissions, investors should consider companies’ exposure to and management of carbon risks and opportunities. Morningstar Sustainalytics’ Low Carbon Transition Ratings evaluates both factors and provides investors with a forward-looking assessment of a company’s current alignment to a net-zero pathway.

A company with a good transition risk management score does not necessarily mean a business or industry is a sustainable investment. However, it does indicate that the company has governance structures and management programmes in place to address low-carbon transition risks. A low management score, on the other hand, could imply that the company’s governance and climate transition planning are inadequate and may lead to higher exposure.