End of Week Notes

CFTC report: Urgent action needed on climate risk

Also: Morningstar to begin evaluating funds’ “ESG Commitment Level”

As we continue to deal with multiple interrelated crises — the pandemic, racial justice, inequality, weakened global alliances, misinformation, democracy itself — climate has roared its way back to the forefront in just the first half of September.

We’ve seen temperatures hit 121 degrees in Los Angeles County, massive wildfires up and down the West Coast, snow within 24 hours of 90-degree heat in Denver, a slow-moving hurricane drenching the Gulf Coast, and in case you missed it, a 42-square mile chunk of ice broke off of Greenland’s icecap this week.

Against that backdrop came the release of a report commissioned by the Commodity Futures Trading Commission (CFTC), concluding that U.S. financial regulators must recognize that climate change poses serious risks, and should move urgently and decisively to measure, understand and address these risks.

The very existence of the report is surprising because the CFTC is an executive agency with a 3–2 Republican majority. How could this have slipped through the Trump Administration’s net designed to catch — and kill — anything that so much as mentions climate? Your guess is as good as mine, but given the overall competence level we’re dealing with, it probably has to do with CFTC commissioner Rostin Behnam, the Democratic appointee who proposed the report, simply cutting a hole in the net and nobody noticing.

That hole was basically the notion that this report wouldn’t be about climate science, it would be about potential financial risks associated with climate change. That allowed Republican CFTC chair Heath Tarbert to say this about the report upon its release:

“I appreciate Commissioner Behnam’s leadership on convening various private sector perspectives on the important topic of climate risk. The subcommittee’s report acknowledges that ‘transition risks’ of a green economy could be just as disruptive to our financial system as the possible physical manifestations of climate change, and that moving too fast, too soon could be just as disorderly as doing too little, too late. This underscores why it is so important for policymakers to get this right.”

I’m trying to think of a word other than bullshit to describe that statement. Suffice it to say that an actual reading of the nearly 200-page report is unlikely to leave you with that conclusion.

Indeed, you can read the report for yourself here, although just for fun you may want to hit the CFTC website and see how long it takes you to find it.

The report’s key recommendations are these:

• First and foremost, the U.S. should establish a price on carbon. One that is fair, economy-wide, and effective in reducing emissions consistent with the Paris Agreement.
• All relevant federal financial regulatory agencies should incorporate climate-related risks into their mandates and develop a strategy for integrating these risks in their work.
• U.S. regulators should rejoin the international groups that are convened to address climate risks and make sure that climate risk is on the agenda of high-level international economic meetings and bodies.
• The U.S. should incorporate climate risks in fiscal policymaking, particularly for economic stimulus activities covering infrastructure and disaster relief.
• Financial firms should be required to address climate-related financial risks through their existing risk management frameworks, appropriately overseen by corporate management and boards.
• The U.S. should consolidate and expand government efforts to catalyze private sector climate-related investment.
• The U.S. and financial regulators should review relevant laws, regulations and codes and provide any necessary clarity to confirm the appropriateness of making investment decisions using climate-related factors in retirement and pension plans covered by the Employee Retirement Income Security Act (ERISA), as well as non-ERISA managed situations where there is fiduciary duty. This should clarify that climate-related factors — as well as ESG factors that impact risk-return more broadly — may be considered to the same extent as “traditional” financial factors, without creating additional burdens.

Let’s pause on that last point, because it is in direct conflict with the Department of Labor’s impending rule limiting the use of ESG in ERISA plans.

The report also cites four barriers to sustainable investing: misperceptions about ESG performance, a lack of climate transition-related investment opportunities, concerns over greenwashing, and policy uncertainty.

Here is its take on “misperception” about performance:

One involves a common, long-held misperception among investors that sustainable or environmental, social and governance (ESG) investments necessarily have lower returns relative to traditional investment strategies. This is based on the historical view that ESG investing is a values-driven activity, and that ESG data and principles may be incongruent with a fiduciary duty to seek the highest returns. This perspective underlies historical practices like omitting certain companies or sectors via ESG screens. These misperceptions ignore the evolution of a wide range of financial ESG factors and strategies, as well as the proposition that impact investing may yield additional returns.

Morningstar Virtual Investment Conference: Larry Fink talks sustainable investing

BlackRock CEO Larry Fink, speaking at our Morningstar Virtual Investment Conference this week, did not seem fazed by the policy uncertainty around sustainable investing coming out of the current administration, saying:

“We are seeing more and more examples of how climate change is becoming investment risk.”

Fink also noted that BlackRock would be making ESG metrics available for all its portfolios this year, and that flows into the firm’s dedicated ESG strategies are at record highs.

Morningstar Manager Research now evaluating “ESG Commitment” of funds under coverage

Last but not least, we also made the exciting announcement at the conference that our Morningstar manager research analysts have begun evaluating the level of ESG commitment for every strategy and asset manager under analyst coverage globally.

The Morningstar ESG Commitment Level is the summary expression of our analysts’ opinion of the strength of the ESG investment program at the strategy and asset-manager level. It will be expressed on a four-tier scale running from best to worst: Leader, Advanced, Basic, and Low.

You can find the methodology paper here.

The ESG assessment differs from the Morningstar Analyst Rating for funds in that it is focused purely on the ESG capabilities of strategies and asset managers and does not assess the future performance prospects for an investment.

It is also different than the Morningstar Sustainability Rating, which is an evaluation of the ESG risk of the fund’s holdings relative to the fund’s overall category.

Investors can use these measures in tandem to help identify investment strategies with the characteristics that best suit their needs.

Importantly, all funds under coverage will receive an ESG Commitment assessment, both intentional ESG strategies and conventional strategies, as well as the asset managers who run strategies under coverage. For intentional ESG strategies, the asssessment should help identify whether the fund is truly walking the walk. For conventional strategies, the assessment should help clarify the extent to which ESG informs decisions, if at all.