Illustrations by Frits Ahlefeldt
Investing in socially responsible ways has been a theme that has garnered significant momentum in recent years. The broadest theme is that of ESG – environmental, social and governance – with a range of investment ideals being brought to bear. Within that is the idea of impact investing, where the investment goal is specifically tied to the intended outcome of making an impact in a community or to a cause. The urgency of climate change and the need for capital investment in climate-related initiatives has also spurred a lot of activity and interest.
Green funds are mutual funds or similar investment vehicles that target investments in companies considered to be environmentally and/or socially responsible in their activities. Funds like this can be traced back to the early 1990s but have come into force in the past decade. The initial approach of such funds was to exclude investments in sectors considered to be harmful, such as tobacco, gambling, pornography. In recent years, there is more focus on choosing positive criteria, from renewable energy investments, environmental initiatives, and fair trade.
Green funds are mutual funds or similar investment vehicles that target investments in companies considered to be environmentally and/or socially responsible in their activities.
The returns in these funds have been middling at best, being in line to just under returns from regular funds over similar periods, in the years leading to 2018. Last year, 2019, was the first year when the returns of some green funds beat their benchmarks, but only just. The main message is no outperformance, but no underperformance either. Looking at the underlying companies, the Dow Jones Sustainability Index (DJSI), established back in 1999, had seen marked underperformance until this year, contributing to common lore that sustainability implies the sacrifice of financial return. On the other hand, there is ample research pointing to the correlation between good ESG corporate policy and higher quality earnings and better valuations. However, correlation is not causation, and it is too early to tell whether there is the excess return expected from sustainable investing. This year has seen marked outperformance, to the tune of 200-300bps in “ESG” stocks, as defined by MSCI, but that could also be attributed to energy and industrials being out of favor for pandemic concerns.
Even if there is a question on excess returns, there is no question on the increased capital flowing to these funds. The flow of capital has significantly increased since 2010. Estimates from the Global Sustainable Alliance suggest $30tn (40% of managed assets) have defined sustainable investment criteria. The US alone has seen such investment funds double to $12tn from 2014 to 2018. The pandemic of 2020 has not diminished this growth, with Morningstar identifying 23 new funds launched in H12020, and expectations of record new launches this year. Green bonds, which we describe in more detail later, have seen issuance jump multiplicatively from a mere $2.6bn in 2012 to $257bn in 2019. In addition to this flow of funds, there is more activity in the creation of sustainable benchmarks, and thereby the issuance of passive investment products such as index funds and ETFs. Such products are accessed by a much larger investor base. Blackrock, the leading passive asset manager in the world, estimates only 16% of sustainable investing is done passively, well below a typical 49% for mature markets; their prediction is for $1.2tn assets passively invested in sustainable stocks in the next decade.
While the trend for capital being put to work has been increasing over the last few years, it does feel different now. There is clearly a rising awareness of climate change and the attendant need for investing in new technologies to mitigate or avert climate risk.
Institutional investors are now aware that climate risks affect any kind of business activity, and are demanding action from their company boards and management. The younger generations, such as the Millennial and Gen Z generations, are more actively concerned about ESG issues and are directing investments to these areas as they come into investing age. There has been a significant regulatory push as well, led by Europe, which has not only mandated the need for reduced emissions in many sectors but also created new technological innovation opportunities. Institutional investors are now aware that climate risks affect any kind of business activity and are demanding action from their company boards and management. As an example, the Climate 100+ initiative launched a few years ago by some institutional asset managers, now has more than 450 investors managing $40tn in assets. The initiative seeks to reshape investments in climate change over a 5-year horizon. With the confluence of political will, consumer and investor pressure, and capital availability, companies are changing their investment plans accordingly.
While it is unclear whether one can expect excess returns from these areas, the general expectation of adequate return itself is a tremendous benefit. Too much capital can often drive sub-optimal outcomes if there is no benchmark on the cost of that capital. The trend of seeing sustainable initiatives, not as charitable efforts, but commercially relevant goals, allows for better discipline in judging alternatives. A good example of that is the green bond market.
Institutional investors are now aware that climate risks affect any kind of business activity, and are demanding action from their company boards and management.
Green bonds, first mooted in 2007/2008, are debt securities that are issued to raise financing related to climate or other environmental initiatives. There are several ways these are structured: general obligation bonds, revenue-related bonds, asset-backed bonds. Many supra-governmental organizations, governments and corporations have looked to raise money in this way, to finance airports, dams and other environmental initiatives. The first green bond is traced back to the World Bank in 2007/2008. The pace of evolution was very niche initially, with only $2.6bn issuance till 2012, with the main issuers being the World Bank and the EIB. However, in the period following, the issuance has jumped multiplicatively, with $100bn in 2017, topped by $150bn in 2018 and then $257bn in 2019. Many corporates now issue such securities as well; Tesla and Toyota have issued green bonds to finance their electric and hybrid car builds.
India has its own green bond market, since 2015. There are at least 100 issues, starting with Yes Bank in 2014. The total cumulative issuance till 2019 was just shy of $11bn. Given the significant challenges for climate issues in India, it is a naturally appealing vehicle of financing, given the specificity of usage of funds.
The original expectation was that the green bonds would be a cheaper alternative to regular financing, given the defined use of funds and the alignment with moral imperatives. The “greenium” expectation was partly true, with many of these bonds oversubscribed at issuance. However, the amount of yield advantage is negligible. The main value to the issuer is establishing a reasonable cost of capital for the sustainable initiatives, and also signalling the organizations intent to take ESG matters seriously.
The increased investment has also brought to light many weaknesses in the ESG mandates. A recent KPMG-led survey pointed to the lack of quality reliable data, inconsistency of reporting and the multiplicity of data providers. The standards for covenants in bond financing need more safeguards. There are concerns of “greenwashing”, i.e., trying to present any initiative as green. To address such issues, there are a number of organizational solutions being crafted to provide standards and oversight. Credit Suisse highlights four such efforts: the Sustainability Accounting Standards Board, the Task Force on Climate-related Financial Disclosures, Science-Based Targets Initiatives, EU Sustainability Regulations. These four efforts address the different aspects of standards, from company reporting to scientific assessments of impact. Similarly, there are voluntary Green Bond Principles to guide issuers and provide certification for bonds.
The next ten to fifteen years are critical for climate innovations; the driving forces will be reallocation of capital, political will, and technological innovation. The increased debate in the public realm, coupled with investor focus and the flow of capital, makes 2020 feel like an inflection point in the growth and maturing of sustainable investing.
Sustainable Investing: Investing with a Purpose, Wells Fargo Institute, April 2020
A New Era of Sustainability, Credit Suisse ESG Research, September 2020