Morningstar - Q4 2022 - 9

contracts with the treasurer's office, a service
long controlled by one firm. In other words,
the state is excluding financial companies it wasn't
likely to do business with anyway. In any event,
we're not seeing severe capital constraints on
energy companies. For example, financing
provided to tar sands oil producers by Canadian
banks rose to nearly CAD 17 billion in 2021, funding
an oil extraction process estimated to have
the highest greenhouse gas emissions in the world.
States that implement more powerful anti-ESG
efforts risk paying a price. In September 2021,
Texas enacted two laws that prohibit government
entities, including local jurisdictions, from
contracting with companies that do not provide
written verification that they don't restrict business
with the oil and gas and firearms industries.
These laws preclude using banned banks to
underwrite municipal bonds. As a result, JPMorgan
Chase JPM, Goldman Sachs GS, Citigroup C,
Bank of America BAC, and Fidelity exited the
market. According to an analysis by Daniel Garrett
of the University of Pennsylvania and Ivan Ivanov
of the Federal Reserve, the law has resulted in
higher interest costs of up to $532 million on
$32 billion of municipal bonds. They contend that
reduced competition led to real financial costs.
We'd also note that ESG has broad-based support
among state pension funds. According to research
from our colleague Janet Yang Rohr, public
pension funds were among the strongest
proponents of key ESG-related proxy resolutions in
2021, on issues ranging from climate change and
political spending to workers' rights and pay
equity.2
What's more, that support crossed party
lines: The average level of support from public
pensions based in Democratic-leaning states,
politically split states, and Republican-leaning
states all outpace support from general
shareholders by double-digit percentage points.
Like funds that charge high fees for greenwashing,
some among the anti-ESG crowd are also guilty
of exploitative behavior with investment vehicles
such as Strive U.S. Energy ETF DRLL. DRLL is
marketed as free of " social agendas imposed by
large ESG-linked asset managers. " But DRLL
charges 41 basis points for operating expenses,
4 times more than Energy Select Sector SPDR ETF
XLE. For all those extra fees, investors hold 19
of the same top 20 holdings as XLE. And anti-ESG
investors may be surprised to find renewable
energy companies such as First Solar FSLR and
Sunrun RUN in the portfolio.
Investor Confusion Can Be Solved
Even the biggest proponents of ESG realize that
retail investor confusion is a problem. Investors
who believe that the use of ESG risk integration
should be expected to drive positive societal
change are bound to be disappointed, adding fuel
to this fiery debate.
To arrive at the Morningstar Rating for stocks,
we incorporate any material risks that ESG issues
could pose on a stock's valuation. This could
include tightening regulation from future carbon
policy, increased compliance costs, or consumer
backlash against corporate activities, to highlight
a few examples. Morningstar Sustainalytics'
ESG Risk Ratings are a helpful consideration in
our analysis and can be a tool for investors to
evaluate the related risk.
Impact is a separate measurement. Here, success
depends on perspective; what is considered a
positive impact by one investor or advocacy group
may be at odds with another. Frameworks such as
the United Nations Sustainable Development
Goals and the Morningstar Sustainalytics Impact
Themes are helpful starting points, but there
may naturally be trade-offs and competing goals.
And, critically, we'd argue that these factors
should be considered separately from the financial
ramifications of ESG-related risks and opportunities.
Regardless of preference, conflating ESG risk
and impact-either by financial product
providers or ESG critics-is disingenuous and
dangerous. We advocate for clarity in
communication around methodology, motives,
and messaging to ensure that sustainable
investing evolves in a way that best empowers
investor success.
2 Rohr, J.Y. 2022. " Public Pensions Overwhelmingly Vote for ESG. " Morningstar.com. Aug. 29.
morningstar.com/products/magazine
9
Regulators and Shareholders Respond
Meanwhile, regulators' efforts have also picked
up steam. The SEC has issued two proposals
around governing fund names and disclosure
requirements for ESG funds. In enforcement
actions, the SEC fined Bank of New York Mellon BK,
is investigating Goldman Sachs over marketing
claims, and raided the asset-management
offices of Deutsche Bank DB over potential
greenwashing. The SEC's Climate and ESG Task
Force is a little over a year old, so more
enforcement is likely to come. But while the
regulatory scrutiny creates uncertainty in
the near term, we think it will help reduce the
risk of investor disappointment.
Shareholders have also voiced their opinion on
these matters: A record number of ESG resolutions
went to a vote in the 2022 proxy season,
including a rise in " anti-ESG " proposals. Many of
these proposals hide their real intent and are
usually submitted by groups that oppose
" pro-ESG " investors. This anti-ESG push translated
into more action on shareholder proposals-
close to 50 such proposals were filed in this past
proxy season. On the ground, however, most
of these shareholder proposals failed to garner
much support. (See " Anti-ESG Sentiment
Gains Spotlight but Not Support, " Page 41.)
In all, this ongoing scrutiny and discussion are
necessary to the maturation and growth
of the industry. As we noted, we think ESG
investing requires a clear distinction between the
integration of financially material risks and
preference-based measures of impact.
ESG is many things to many people, highlighting
the importance of clearer communication
that can improve understanding and
reduce confusion. K
Adam Fleck, CFA, is the director of equity research, ESG,
at Morningstar Research Services LLC. He is a member of
the editorial board of Morningstar magazine.
Kristoffer Inton is an equity strategist, ESG, at Morningstar
Research Services LLC.

Morningstar - Q4 2022

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