Q&A with Morningstar’s Edwards: DeepSeek and AI’s impact on climate indices

Last month, Morningstar published the latest insights into its sustainable index range, finding wide variation in performance 2024. On one hand, climate indexes thrived, driven by the magnificent seven, but at the same time impact-aligned indices – which focus on companies making a positive impact on the planet – struggled.  

However, while Nvidia and Tesla played a central role in the success of climate-focused investing last year, the launch of DeepSeek’s open-source large language model sent shockwaves through equity markets, wiping out nearly a trillion dollars in US technology value. In the aftermath, while tech stocks have rebounded somewhat, questions remain about the future trajectory of climate indices should more competition come to the market.

Here, Morningstar’s managing director of indexes, EMEA, Rob Edwards, discusses what’s next for climate-related indexes post-DeepSeek, as well as the key findings of the report.

Could you introduce the research you undertook on the performance of Morningstar’s sustainability index range, as well as some of the key findings?

I guess you could say that we launched this paper at a bit of an awkward time, as the day we launched it was the Monday after the DeepSeek news came out. But hey, you can never time these things.

We tried to break this up into ESG risk, climate and impact-aligned indices because they’re very different and are trying to accomplish different things. We’re trying to point out that not all ESG strategies are the same, investors need to do their homework, so that’s part of the education we’re really trying to preach when we launch these studies.

With the climate ones, they’re very much focused on emissions, and emissions data is very backwards looking. So, they tend to be overweight to some individual names in technology such as Nvidia and other magnificent seven stocks, and they’ve performed really well because of the secular trends of the lower-emitting sectors, outpacing their benchmark by quite a bit over the last couple of years.

That’s a big difference versus what we see in ESG risk, where there’s not that uniformity within sectors. We like the ESG risk rating and looking at it that way because it’s supposed to be more of an apples-to-apples comparison across all sectors, determining how much financial risk there is from an ESG factor standpoint. A lot of these indices picked the best-in-class stocks in technology and energy. Any time you leave out some of those companies, it’s introducing some kind of idiosyncratic risk, and we’ve seen ESG risk indices underperform at times over the last two years, and the concentration of the market in these few companies dominating the top end has a pretty big impact in terms of these ESG risk indices. So again, we’re trying to show macro-economics are driving results here and, despite companies like Meta and Alphabet doing well from a performance perspective, they don’t have good ESG risk ratings, even though they’re in low carbon-intensive sectors. For example, in our low carbon transition leaders index, Nvidia drove almost all of the one-year outperformance in the index by itself.

It’s been interesting to look at the performance of impact-aligned indices. Obviously, a lot of them have struggled in the last few years because they don’t invest in any of those companies we just talked about, they have a very big sector tilt toward utilities or energy and the associated sub-industries. Solar, for example, was down almost 36% in 2024 according to our Global Solar Index. A lot of these have very low carbon-intensive, forward looking metrics involved in them, so they’ve really underperformed, particularly since interest rates started to rise a couple of years ago, and they haven’t been appealing investment options since.

The impact-aligned indices are also a little bit harder to compare as it’s probably not fair to compare them to the broader market. But very few people are probably going to do the research into renewable energy versus traditional energy and things like that. We try to peel that back a little bit in the paper, because I think there are very clear drivers for why each has performed one way or the other.

For those climate indices, would you describe the magnificent seven stocks as a safety net? Are other stocks pulling their weight, or has the performance been driven by how well the magnificent seven stocks have done?

I would say so, yes. But I would look at how they are weighted, because if they’re market cap weighted, magnificent seven stocks are going to be a big piece of that. The majority of ESG indices are either weighted by market cap or they’re done on some sort of best-in-class selection. They’ll take the best companies in technology, the best companies in energy, and then they’re market cap weighted. You might tilt the weights, as we do in our Paris-aligned benchmarks towards the lower emitters because we’re trying to achieve a certain level of decarbonisation. But since they’re such a big weight – we could call it the broad market or the parent index – they’re going to be a big driver in the performance of the indices at the end of the day. As long as they have such a huge market cap, a lot of these companies are going to continue to drive the performance of these indices.

The reason why the media has written so much about things like equal weighted S&P500 in the last few weeks, is because it neutralises the market cap, not cap weighting. I do think we’re going to see more interest in equal-weight approaches. But that really dilutes and moves away from market cap weighting. That’s a really important point to factor into investment decision-making, even if something might still be using market cap weighting. We would stress how important it is to understand the weighting element of these indices.

Thinking about the market shock caused by DeepSeek, what could an artificial intelligence arms race, if you like, mean for those indices that are heavy on magnificent seven stocks?

There’s no question that if those companies underperform, those indices will underperform, and that’s going to be for most market cap weighted indices, not just climate, not just ESG, that’s going to be anything. If you look at their weight in any index, it’s going to be a large percentage, maybe a quarter of the index. If those companies have a shock, the market’s going to have a shock. That’s the general risk you have in a market that is so concentrated in these top names. It’s a long-term trend that we’ve seen these companies getting bigger and bigger market caps, and if there is a correction, it might be a little bit steeper, especially if it’s happening to those names because there’s only been a few times in history that we’ve seen so much concentration in the top names of the market. There’s no doubt that if there’s a huge AI rout, and their bets don’t pan out, these indices would probably underperform. But the whole market would underperform too. It’d be interesting to see how it is relative to the broader market because the broad market is going to go down as well, which is what we saw in January.

What conversations are you having with investors about this?

Anecdotally, most people I’ve spoken to see this as a blip more than an exponential threat. I think they’re expecting the market to auto-correct some of the over-enthusiasm and things like that. But I think people view it more as a blip than anything existential.

The bubble hasn’t quite burst yet, then?

I don’t think so. If you think about it, these companies have such a big competitive advantage because their market cap is so big. Under Trump, the US market will probably be very focused on the stock market and its performance and trying to do everything it can to make sure people aren’t scared away every time there’s a market correction. I think a lot of people saw it as a short-term buying opportunity, actually.

Investors are a little nervous, but still relatively bullish on the US market. You can read lots of reports about how overvalued the US market is, but I’m sure when you look at flows at the end of the month, I’m sure there will still be a lot of money pouring into US equity funds and indices.

Do you expect that to continue through 2025 or are there signs that things could change?

Unfortunately, I don’t have a crystal ball. If I did, I’d have a much easier job!

To me, the interesting thing to look at in the climate index space is that you have these tech companies that have historically low carbon emissions, but the data is backward-looking and it takes a few years for that information to flow into indices and investment products. With the proliferation of data centres and things like that, are these big tech companies always going to be looked at as low emitters? Because, if you’re powering these data centres for OpenAI, DeepSeek, or whatever, how much energy will that use, and what’s the knock-on effect on emissions? Right now, we know AI is very intense from an energy usage standpoint. So, that’s the thing to watch in my opinion, how the market evolves around that because while the energy industry is trying to figure out ways to become less carbon-intensive, the tech space is almost going in the option opposite direction, at least in the short-term, moving toward a high energy-intensive process, which is different from where they’ve been over the last 20 years.