Why renewable energy indexes can still fail at ESG

Morningstar research suggests investors with a green energy focus may be taking on other ESG risks

Why renewable energy indexes can still fail at ESG

As extreme weather events around the world exert an impact that exceeds even the pessimistic forecasts of experts, the issue of climate change has taken on a new urgency akin to that of a humanitarian crisis. Against that backdrop, investors with an eye on sustainability are increasingly looking at renewable energy as a sector that marries positive ESG impact and rich potential returns.

But according to a new report from Morningstar, those seeking index-based exposure to the world of alternative energy may find themselves falling short of that laudable goal.

Focusing on its range of sustainability-screened indices, Morningstar said its Sustainability Indexes and Sustainability Leaders family of benchmarks uses Sustainalytics' ESG Risk Rating the key selection criteria for portfolio holdings, ensuring that they carry lower ESG risk than broad equivalents. The Morningstar Low Carbon Risk Index family, meanwhile, maintains low portfolio-level fossil fuel involvement, ensuring that it has lower carbon intensity than its broad-market counterpart.

“But even a sustainability-oriented portfolio can carry hidden ESG risk,” the report said.

Morningstar said the Global Markets Renewable Energy Index, the most inclusive member of its Renewable Energy suite of indexes, has a carbon intensity score of 1,719.47, almost a whole order of magnitude higher than its broad equity market equivalent that has a 183.78 carbon intensity score. From an overall ESG perspective, the renewable energy benchmark also carried a significantly larger amount of risk than the broad equity market.

“[M]any companies are involved in both fossil fuels and green solutions,” the report said, noting that a large subgroup of utilities companies in the index includes carbon-intensive companies such as China Power, RWE, and AES. Some companies focused on climate-friendly products and services, such as Sunrun and Nankai Electric Railway, can also nonetheless have carbon-intensive operations, it said.

Morningstar added that Tesla, a prominent member of its renewable energy indexes, also carries ESG-related risks that potentially more than offset the credit it gets for producing emissions-free electric cars. Its factory workforce, the report said, constitute a labour-relations challenge, while issues in its autonomous driving offerings raise questions about product governance.

“Corporate governance is also a concern,” Morningstar added, noting how CEO Elon Musk has made problematic public statements and used his 20% equity stake as collateral for personal loans. Other potential ESG pitfalls come from patent litigation and regulation requiring a separation between automakers and dealers.

“The carbon intensity of renewable energy investing doesn't necessarily suggest greenwashing, but it does represent a trade-off that sustainable investors must acknowledge and consider,” the report said.


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