Understanding Morningstar's New Sustainability Ratings

"The rating now provides greater insight into how well companies in a portfolio are managing the material ESG issues they face both relative to their industries and across industries," said Jon Hale, in a recent blog post. In the new rating system where a lower score, rather than a higher one, indicates less ESG risk, Microsoft scores a 13.8, Royal Dutch Shell a 34, which is less than Exxon's 44.5.

Morningstar ultimately assigns portfolios a sustainability rating, which ranges from one to five globes, based on their sustainability scores over the past 12 months relative to their global category peers. Only portfolios that have sustainability ratings for at least 67% of their assets are rated.

The new Morningstar sustainability ratings also handle portfolios classified as high or severe risk differently than before.

Portfolios scoring 30 or higher on a scale of zero to 40+ cannot receive more than three globes, equivalent to an average rating, no matter how well they rank within their Morningstar global category. The limits are as follows: three globes for portfolios rated 30 to 34.99; two globes for portfolios rated 35 to 39.99; one globe for portfolios rated 40 or higher.

Fund sustainability ratings can be updated with upgrades and downgrades but not before a rating changes at least one percentile.

"By adding in rating ceilings for high ESG risk portfolios, we are limiting their ability to earn a positive sustainability rating, regardless of where they may fall within a peer group," according Madison Sargis, associate director of quantitative research and author of a new report Interpreting the Morningstar Sustainability Ratings Changes. "By adding buffers around breakpoints we require funds to meaningfully alter their portfolio before a fund can receive an upgrade or downgrade in sustainability ratings."

— Related on ThinkAdvisor:

• SRI, ESG or Sustainable Investing?
• 10 Reasons Advisors, Investors Should Care About ESG Investing
• ESG Funds Outperform in Growth and Returns in 2018: Morningstar