Making investment decisions that are not only sound from a returns point of view but impactful from an ethics and sustainability perspective was always going to be a tricky nut to crack.
The surge in ESG (environmental, social and governance) investing witnessed in recent years as the climate crisis came to the fore and social responsibility went mainstream has reversed somewhat, with the performance of green investment funds falling below expectations in Europe. Meanwhile, ESG investing has become a victim of the culture wars in the United States, where it has been the focus of a significant backlash.
According to Julie Byrne, professor of finance at Dublin City University’s Business School, the recent slump is not likely to be permanent, for several reasons.
“While it is true that there was a significant net outflow of sustainable funds globally in 2023 and the first quarter of 2024, this trend appears to be reversing,” she explains. Europe is leading the recovery, she says, and while “outflows” have continued in the US, the rate has slowed considerably.
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Byrne says 2023 presented a challenging macroeconomic environment, with high inflation creating additional levels of uncertainty in the markets.
“Additionally, high profile greenwashing cases caused many investors to question the true sustainability credentials of ESG funds, returns on sustainable funds were disappointing and there was increased politicisation of ESG in the US,” she adds.
Carolina Angarita-Cala, head of sustainability with Cantor, says the fall-off in ESG investing should be viewed in context.
“Ten or 15 years ago it was a niche area with only a few enthusiasts – now everyone talks about it,” she points out.
The performance of ESG investing has been affected by an “extraordinary and unpredictable” economic environment, with the war in Ukraine having “created an oil shock that prioritised short-term energy needs, whilst slowing down the energy transition”.
“High interest rates and inflation have impacted spending in general and affected highly capital-intensive renewable energy projects,” Angarita-Cala adds.
Conal Cremen, investment strategist with RBC Brewin Dolphin, agrees that the past couple of years have been tough for ESG investing “following a period of very strong inflows and returns for the sector”.
“For example, we have seen a culture war in the US, with some high-profile investors pulling funds from Blackrock in anti-ESG moves,” he says.
In fact, anti-ESG legislation has been enacted in some US states, including Texas, though now officials are being sued after studies showed those same anti-ESG measures have increased costs for Texas municipalities. In other states, the same anti-ESG laws have been found unlawful and overturned by the courts.
Cremen echoes Byrne, saying the long-term growth prospects within ESG investing remain hugely attractive and sustainability is still firmly on the agenda.
“From environmental pollution and animal welfare to gender equality and human rights, investors are increasingly looking for ways to use their money as a force for good,” he says, “As performance improves, you would expect to see inflows continue to increase for ESG investments.”
Market observers also say ESG investing will benefit from heightened regulation. Deirdre Timmons, director with PwC Ireland, explains that next year will see the first wave of reporting under the Corporate Sustainability Reporting Directive (CSRD), designed by policymakers to provide transparency to investors and other stakeholders around a company’s sustainability strategy and actions.
“This will bridge the data gap for investors looking to truly understand what a company is doing from a sustainability perspective,” Timmons says. “With in excess of 50,000 companies coming into scope over the coming years, it is hard to see how this cannot but achieve the ambition of making ESG not just the norm but yet another factor that investors can use to differentiate when selecting companies to invest in.”
Despite the recent blip, demand for sustainable investing is likely to continue as wealth transfers to the “millennial generation”, Byrne says.
“These are the most likely group to consider ESG issues as central to their investment decision-making process.”
Cremen says Brewin Dolphin continues to see increased demand for ESG investment opportunities – the company maintains a dedicated investing list for funds with a sustainability focus and with restrictions on investment in harmful activities.
“We actively seek out the best investment opportunities for a given level of risk while considering both diversification and sustainability as drivers of long-term return,” he says.
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But for the ethically and environmentally conscious investor, Timmons warns that ESG preference is only one factor when it comes to making investment decisions.
“The risk tolerance of the investor – and hence the potential for returns – is still based on the fundamental rules of investing,” she says. “For example, a fund that uses a strategy called ‘negative screening’ whereby they screen the portfolio to ensure it does not invest in ‘sin’ stocks, might sound exactly like what a conscious investor is looking for. But the reality is that it may result in a fund that has been skewed from a risk perspective such that the return is concentrated in a small handful of stocks or sectors.
“That process may inadvertently make the fund a much more risky fund, due to a lack of diversification.”
The golden rule, Timmons says, is that if the fund is too risky for an investor without considering the ESG aspects, then it will still be too risky when ESG is considered.
However, Angarita-Cala warns that ESG investing must become the norm if we are to avoid financial catastrophe in the not-too-distant future.
“Let’s not lose sight of what’s at stake here: sustainability risks like climate change and biodiversity loss, if left unaddressed, can become systemic and trigger financial instability,” she says. “More than half of global GDP – approximately $58 trillion – is dependent on nature.”