Turbulent times for green investors but long-term forecast is better

Spiralling oil and gas prices, a war that highlights our overdependence on imported fossil fuels, and a series of catastrophic weather events which have brought home the quite terrifying reality of climate change – you’d think these would add up to great returns for investors in green funds that hold stocks in companies that promote environmental responsibility. You’d be wrong.

The past year has been a tough one for green investments generally and for renewable energy investments in particular.

“It might seem counter-intuitive in the circumstances,” says Ian Quigley, head of investment strategy with RBC Brewin Dolphin Ireland. “There have been a number of profit warnings in the renewable energy sector. Some wind turbine manufacturers are facing a number of challenges including elevated costs, with the price of steel and so on going up.”

The increased cost of capital has had an impact as well. “A lot of renewables companies raise equity and debt to build wind farms,” Quigley explains. “With the higher cost of debt, some projects that looked good a few years ago aren’t quite as attractive now. Investors put the costs of a project and its likely returns on to a spreadsheet and make their decisions based on that.”

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He also notes that the sector had become quite hot in recent years, with large inflows of capital pushing up valuations, and these are now settling back. “Valuations have come down quite a lot and this might provide opportunities for investors,” he adds.

The overall environmental, social and governance (ESG) investment market has also lost some of its lustre of late. “There has almost been a bear market in green transition funds over the past year and a half,” says Quigley. “Generally speaking, up until 2022 more ESG-type investments did quite well. A lot of that was being driven by inflows of capital into the sector. High-growth companies did extremely well. Last year the sector really struggled with inflation, higher interest rates and short-term money coming out, pushing valuations down.”

Quigley believes this drop in performance will be temporary and that the sector will continue to attract a lot of capital over the next decade and beyond.

On the other hand, there is a considerable body of opinion that doubts the long-term ability of green funds to outperform the mainstream, non-ESG-focused market. This is based on the proposition that companies that put environmental considerations and stakeholders such as communities and employees on an equal footing with shareholders will inevitably lose focus on profitability and shareholder returns and are doomed to underperform.

Of course, this is just an opinion and there is as yet no solid evidence to either prove or disprove it.

But there is also evidence of long-term outperformance, according to Andrew Farmer, director of sustainable futures with KPMG.

“There is indeed evidence that green investing can outperform traditional investing,” says Farmer. “These returns are driven by two principal components: risk mitigation and value creation. From a risk mitigation perspective, one might consider an ESG-aligned fund that places an emphasis on board governance. Specifically, if that fund restricted the investment into companies where the chief executive officer also served as the chairperson of the board, thereby acting as his or her own oversight, the expectation would be that the risk of lascivious business practices at the executive level would be greatly reduced.

“From a value creation perspective, a company that is seeking to reduce their Scope 1 emissions, or greenhouse gas emissions resulting directly from the company, is likely to also realise a financial benefit in the fullness of time as greater operational efficiency or cost reductions translate to financial returns. However, the upfront costs of implementing a full-scale decarbonisation plan can be prohibitive.”

It also depends on what people are looking for, Farmer points out. “I have spent a material portion of my career as a participant and observer to the debate of green versus brown funds’ ability to drive financial returns,” he says.

“My conclusion is that it all depends on who is making the argument, as the debate can be easily manipulated based on asset class, time horizon, sample set, definitions and a myriad of other factors.

“However, the key returns differential between brown and green funds are the non-financial returns of those funds. Whilst there will always be a place and necessity for financial returns, investors have reshaped their expectations to include a measurement on the impact – positive or negative – their investments are making in our world. By that measure, I believe that green funds will always have a returns advantage.”