Nathan Griffiths: What next for sustainable investing?
Nathan Griffiths: What next for sustainable investing?
At the end of 2021, the future for sustainable investing was resoundingly green. Sustainable and ESG labelled funds were dominating fund flows and new fund launches. As a proportion of total assets, market share was growing inexorably. Two years later and the tone is more muted.
By Nathan Griffiths, Sustainable Finance, EY Netherlands
ESG fund flows slowed significantly in 2022 as the Russian invasion of Ukraine drove higher energy prices. This has reversed somewhat in 2023, yet market share gains and fund launches have slowed significantly. Moreover, ESG investing is under sustained attack in the US from Republicans, which is unlikely to ease in election year. In Europe there is still limited sign of a similar political backlash. However, the shift towards the political right in the upcoming election period is likely to lead to a slowing of the sustainability agenda in the coming years.
One strand of legislative action of particular note is the attempt to preclude state pension funds from implementing ESG strategies by requiring that the only consideration should be financial returns. The pushback from the investment officers is that taking into account ESG factors is directly linked to long-term financial returns. Intuitively, for many of us this would seem obvious: for example, most of us now accept that climate change is real and accelerating, and rising temperatures will have an impact on the valuation of assets. But can we really demonstrate that ESG leads to better financial performance?
Still unproven
The debate, such as there can be in such a polarized environment, could be ended simply by pointing to better financial outcomes when ESG factors are integrated into investment portfolios. However, it is yet to be demonstrably proven that ESG funds do indeed deliver higher returns. Despite numerous academic research papers, the results remain inconclusive.
We can see this simply by comparing the performance of the MSCI World ESG Leaders index with that of the standard MSCI World index: outperformance in 2023 and 2021, underperformance in 2022 and 2020. Over 10 years the MSCI World ESG Leaders index has outperformed by 0.13% on an annualized basis before fees. When the higher costs associated with funds tracking this index are taken into account, even on a cumulative basis the additional returns are minimal.
Take a closer look at the composition of ESG funds and the picture is even muddier. Most of these funds will be overweight technology stocks, which typically have a lower carbon footprint than traditional sectors. Was the outperformance in 2023 therefore the result of ESG factors or the result of AI mania? After all, the NASDAQ outperformed the S&P 500 by more than 14%.
The need to quantify sustainability risks
The sustainable investment industry can only fully mature when it can demonstrate that the integration of sustainability risks into investment decisions does indeed lead to better financial outcomes. Fundamental to that assessment is the ability to systematically quantify and monitor those risks. And identify which of the myriad ESG factors are performance drivers.
At the core of all finance is the management of risk and return. The long-term winners in the investment industry are those investment managers and funds which deliver the highest level of return per unit of risk. Intrinsic to sustainable investment is the assertion that ESG risks have a direct impact on the long-term valuation of a company. Lowering sustainability risks should therefore improve the share price performance. Ceteris paribus, we should see an inverse relationship between returns and each unit of sustainability risk. However, first there needs to be a clear delineation and quantification of sustainability risks.
Climate scenario analyses and related approaches such as Climate Value at Risk are a step in this direction. These approaches serve an important role in highlighting the potential vulnerability of portfolios to future climate scenarios. However, they are dependent on a number of assumptions, not least that in the near future companies will face a direct financial cost of their emissions. These approaches are not easily integrated into existing risk frameworks. Moreover, sustainability risks go beyond climate risk. As a result, they better serve as additions to risk management tools.
The shorthand for risk in the investment industry, certainly for listed equities, is the volatility of one investment or investment product relative to the broader market. At the individual stock level, risk is broken down between market risk and idiosyncratic risk. The long-term objective should therefore be the isolation of specific sustainability risks as an explanatory variable for stock price movements. This will take time to fully develop and implement. At that point ESG investing really will have matured.