Integration of ESG factors, exclusions, impact and the environment: the universe of sustainable finance is wide, social and green investments are varied; however, there are criteria for classifying and evaluating sustainable funds, which are also useful for other types of investments.
Funds that exclude critical sectors such as arms, managers that integrate environmental, social and governance factors into the investment process and pursue environmental and social impact objectives alongside the search for a financial return. It’s not easy to navigate ESG investments, but Morningstar’s classification of sustainable funds can help investors understand the characteristics of ESG investments.
At a first level, “sustainable funds” are defined as those with a strategy that, in the prospectus or other official documents, is described as focused on sustainability, impact or ESG factors. The classification of sustainable investments becomes more detailed at the second and third level.
How to identify and classify ESG investments
A second level of categorization of sustainable funds (I repeat: it also applies to other investments) distinguishes between:
- ESG funds (mainly incorporate sustainability factors into the investment process)
- Impact funds (they seek, in addition to financial returns, a measurable impact on specific issues such as the environment, the development of local communities or gender diversity)
- Environmental funds (have a focus on sectors such as water, renewable energy, etc.)
The third level of classification offers a further description of the funds.
Incorporating ESG Factors: strategies that use ESG criteria in stock selection and generally spell out the criteria they use. They can employ positive and negative screening and also engage in active ownership.
- Gender and diversity: strategies that aim to have a measurable impact on the issues of gender or ethnic inequalities, or that direct their investments to companies that meet certain requirements on the issue
- Low carbon / Fossil-fuel free: strategies that seek to have a measurable impact by investing in companies with low carbon emissions or without exposure to fossil fuels, or that have a low carbon risk, or in any case try to reduce it
- Community Development: strategies that aim to have a measurable impact by investing in companies committed to the development of local communities
- Environment: strategies that invest in companies that pursue a positive environmental impact
- Other: impact strategies that do not fit into the previous categories
Funds that invest in water or renewable energy, however investing in the environmental sector in general.
Exclusion criteria: in which sectors sustainable funds do NOT invest
They are strategies that exclude certain sectors. They can be sustainable funds or funds that simply do not invest in some industries, such as alcohol, weapons, tobacco, thermal coal, etc. They can also explicitly refer to international agreements, such as the United Nations Global Compact or the Universal Declaration of Human Rights, to invest responsibly.
Difference between Sustainability rating and classification of sustainable funds
The Morningstar classification of sustainable funds is not to be confused with the Sustainability rating, which helps investors understand how the funds are addressing the challenges related to ESG factors and is attributed regardless of the indication of a socially responsible mandate in official documents.
The fundamental pillar is the ESG risk rating, calculated by Sustainalytics (a company of the Morningstar group), for the individual companies. It measures the degree to which the economic value of a company could be at risk due to environmental, social or corporate governance issues. It therefore makes it possible to assess the financial and material ESG risk in the portfolio of funds and ETFs and compare it with that of competitors. It is expressed in “globes”, the best rating is five (low ESG risk) and the worst one (high ESG risk).