Determining an ESG score using the Morningstar method. A Puke(tm) Audiobook

Determining an ESG score using the Morningstar method.

Morningstar, whose website is located at Morningstar dot com, utilizes a methodology to determine ESG scores.
A portfolio is examined to determine the contents, and organized into the various risk categories.

According to Morningstar:
“The Morningstar Sustainability Rating is designed to support investors in evaluating the relative environmental, social, and governance risks within portfolios.”

The Morningstar Sustainability Rating, MSR, was introduced in 2016 to enable investors to examine the Environmental, Social and governance factors for their portfolios.

The methodology was update in 2021 to include the Sustainalytics’ Country Risk, SCR, Ratings.
Sustainalytics, a Morningstar company, is located at Sustainalytics dot com.
According to Sustainalytics:
“The primary differentiator between Sustainalytics and MSCI is that the methodology underpinning Sustainalytics’ ESG Risk Rating takes an absolute approach to highlighting risk, which allows investors to evaluate companies across sectors and geographies using consistent standards.”

The SCR is an attempt to quantify a sovereign entities ability to sustainably manage its wealth.
The Morningstar system assigns one to five globes, with a higher number indicating lower ESG risk.

Exposure is broken into manageable risk and unmanageable risk.
The managed risk is then divided into managed risk, and the un-managed risk, so the total unmanaged risk is left over.
The ESG rating reflects the managed and un-managed risk of a company or a country in its economic activity.
There are five ESG risk ratings, negligible, low, medium high and severe.

Qualification.
The initial distinction of a portfolio is between the qualified and non-qualified components.

Qualified components include equities, fixed-income instruments, commodities, real estate, and alternatives.
Non-qualified components include short positions, cash, and currency, as well as derivatives and synthetic holdings.

This means that gold and platinum would be qualified, whereas a stack of cash is unqualified.
A house or an apartment building would be qualified, whereas a financial derivative is unqualified.

Additionally Morningstar breaks out Qualified Holdings into three ESG risk types.
These are corporate ESG risk, sovereign ESG risk and other ESG risk.
Sovereign securities include government bonds and securitized debt.
Corporate securities include equities and select securitized debt.

For example, a portfolio consisting of rental assets worth 2 million dollars, one million dollars in corporate stocks and one hundred thousand in cash has a total portfolio of three point one million.
The cash is not considered qualified, so the total qualified holdings are three million dollars, or 96.8 percent of the total.

Eligibility.
The holdings are then examined to determine the eligibility. At least 67 percent, or two thirds of the qualified holdings must be eligible for the portfolio to receive a rating.
Eligible holdings are the holdings for which a risk ratings framework exists and therefore can potentially contribute a measure of risk toward the Morningstar Sustainability Rating.

The portfolio components that are corporate or sovereign are considered eligible, and are considered to contribute to the risk. Components of the portfolio that cannot be classified as corporate or sovereign will be considered “Other” and will not be used in the ESG calculation.
Effectively, the non-corporate, and non-sovereign components have no rating framework.

As an example, consider a portfolio consisting of one million dollars in real estate and three million in corporate stocks, and five million in a personal instrument. Even if the instrument was considered “qualified” and included in the total position of nine million, only 44 percent is in an eligible component.

Consider then a portfolio of fifteen million in Corporate equity. Ten million in corporate bonds, five million in sovereign bonds, one million in cash, and one million in alternative instruments.

The total portfolio is thirty two million dollars. The cash in unqualified risk, and so 31 out of 32 or 96.9 percent of the portfolio is qualified to be rated. The one million in alternative instruments is not eligible, so it is excluded.
Therefore 30 million is eligible out of 31 million qualified to be included in an ESG rating, or 96.8 percent of the qualified component is eligible, which is greater than the 67 percent minimum, so an ESG rating will be calculated.

Portfolio Corporate Sustainability Score and Portfolio Sovereign Sustainability Score.

Once it is determined that the portfolio has a sufficient fraction of eligible assets that are qualified, the Sustainability score is calculated.

The Corporate sustainability score and the sovereign sustainability score for a portfolio calculated using the Morningstar methodology are asset weighted averages.
These asset weighted averages use the Sustainalytics' company-level ESG Risk Rating and Sustainalytics' Country Risk Rating.
Here at least 67 percent of the assets that are considered eligible must have an ESG weighting provided by Sustainalytics for either the Corporate or Sovereign sustainability rating to be determined.

For example, if a portfolio has ten million in eligible funds, out of eleven million total, 91 percent is eligible, and so it will proceed to this step. However, if only five million of the eligible, or 50 percent of the eligible, has a Corporate Sustainalytics rating number, it will not receive a Corporate sustainability rating.

Normally, a portfolio must have both a Corporate Sustainability Rating and a Sovereign Sustainability Rating to receive a Morningstar Sustainability Rating.
However, if the portfolio is predominately, meaning 95 percent or more, exposed to only corporate or sovereign holdings it may still receive a rating.
This means if a portfolio has 80 percent corporate eligible assets it will receive a Corporate sustainability rating. If the twenty percent is unrated sovereign assets it will not receive a rating.

ESG risk ratings are pure numbers, such as 19 or 22. For example in August of 2024, 501 c agencies trust was given an ESG risk rating of 35.1, and Finning International incorporated had an ESG risk of 13.6.
CSR ratings are the ESG risk numbers times the fraction of the portfolio with that number.
As an example, Consider the ten million eligible out of eleven million total portfolio.
Five million is in an equity with an ESG rating of 22. And five million is in a corporate bond with an ESG rating of 19. The CSR, Corporate sustainability rating is one half times 22 plus one half times 19, or 20.5.

Similarly, there are sovereign Country risk ratings.
As an example a portfolio with a single sovereign bond for a country with a CSR of 17, would have a Sovereign Sustainability Score, SSR or one rimes 17, or seventeen.

As an other example, consider a portfolio with three million in Corporate equities, three million in real estate and three million in corporate bonds with one million in cash.
The qualified amount is nine out of ten million, or ninety percent, since the cash is considered un-qualified.
The resulting nine million is 100 percent eligible, as it consists of corporate assets.
The ESG rating for the equities is 20, the ESG rating for the real estate is 25, and the ESG for the bonds is 32. Weighting these by the fraction of the portfolio, which is one third in each category, the final CSR is:
Twenty times one third, plus 25 times one third, and 32 times one third, which equals 25.7

Historical Corporate Sustainability Score and Historical Sovereign Sustainability Score.

The historical sustainability scores are the trailing twelve month averages of the corporate and sovereign sustainability scores, weighted towards the more recent months.
The most recent month receive 15.38 percent weighting in calculating the historical average, and the rating from eleven months ago receives a weighting of only 1.28 percent.

The historical weighting over a twelve month period, with weights that decrease as the data becomes older means that the ESG must be recalculated on a monthly basis.
Fifty three percent of the weighting comes from the most recent four months, and eighty percent in the last seven months. ESG ratings from a year ago are not significant, so to be of any value, ESG ratings must be kept current.

Portfolio Corporate Sustainability Rating and Portfolio Sovereign Sustainability Rating.

Once the ESG has been determine, a number of globes are awarded, from one to five to indicate approximate corporate and sovereign sustainability ratings. The ratings required for corporate and sovereign globes are different.

The ratings and the required historical corporate sustainability values are:

4 to 5 requires a HCSR of 18.63.
3 to 4 requires a HCSR of 22.6.
Fiftieth percentile, or average requires a HCSR of 23.64.
2 to 3 requires a HCSR of 24.55.
1 to 2 requires a HCSR of 26.79.

Higher CSR ratings, or higher ESG values receive fewer globes, and are considered more of a risk, and less sustainable.

For Sovereign asset systems, the ratings are different and are:

4 to 5 requires a HCSR of 15.26.
3 to 4 requires a HCSR of 15.89.
Fiftieth percentile, or average requires a HCSR of 16.34.
2 to 3 requires a HCSR of 17.09.
1 to 2 requires a HCSR of 19.38.

Morningstar Sustainability Rating, MSR.

Morningstar assigns the Sustainability rating by taking the historically weighted CSR and SSR’s, the Corporate and sovereign sustainability ratings, and adding as a weighted average.
The corporate weighting is 0.65, or sixty-five percent, and the sovereign is 0.35, or 35 percent.

For example, consider a portfolio with a corporate globe rating of three, and a sovereign rating of 4.

The corporate globe rating of a portfolio is 3, and is multiplied by 0.65, and the Sovereign componet is 4, multiplied by 0.35. The final result is:

Three times 0.65 plus 4 times 0.35 equals 3.35.

The final result is reported as three globes, as they are rounded to the nearest while number.

What does this mean?

Weighting a financial instrument by historical weights is not unusual.
The essential item is the ESG risk values, as provided by Sustainalytics represent some rating or assessment of a companies risk. At present, 2024, these Sustainalytics values are completely unregulated.
The ESG allows the rating of a portfolio based on Sustainalytics parameters, and will change as the trading positions are altered. Therefore it is possible to boost a portfolio in terms of its ESG score by obtaining positions of assets with low ESG values.

The ESG value is not necessarily related to the assets economic performance, hence it has the capacity to build in trading of junk bonds and shell companies to artificial deflate the ESG risk.
The ESG is an alternative instrument to promote and justify the manipulation of the stock portfolio.