Sustainable finance is defined as the incorporation of environmental, social, and governance (ESG) principles into business decisions, economic development, and investment strategies. Sustainable finance and ESG investing has become a trend in 2020. A single phrase sums up the appeal of environmental, social and governance investing: “doing well by doing good”. ESG strategies allegedly promote the greater good and provide superior long-term financial performance. However, whether this is true for companies and funds that adhere to ESG strategies is yet to be proven.
There are many valid reasons for firms to engage in ’good’ corporate behaviour. Firms may choose to invest in ESG projects in response to evolving investor and consumer preferences – a choice that could lower costs of capital or improve profit margins. Adherence to ESG strategies may lead to a more motivated workforce, greater trust between firms and stakeholders, or a reduction in firm-level tail risk from carbon emissions. Firms may choose to become more ESG-friendly as a result of policy-driven actions, such as the cost of meeting forthcoming regulatory requirements that would make delayed compliance expensive. However, a company incorporating these strategies does not guarantee that the company represents a profitable investment decision, or that it is accurately valued.
We are already seeing a rapid increase in the valuation premium of companies with the best ESG scores – a sign of rampant demand for the hot investment theme. Investors last year ploughed a record 21 billion USD into socially responsible investment funds in the US, almost quadrupling the rate of inflows in 2018, according to Morningstar. Companies with the top ESG rankings now trade at a 30 percent premium to the poorest performers as measured by their forward price-to-earnings ratios, according to Savita Subramanian, head of US equity strategy at Bank of America. “This is not just a function of growth stocks doing better than value stocks,” Ms Subramanian said, explaining the dichotomy in US markets where inflows into ESG funds “are driving this valuation discrepancy”.
ESG effects have been clearest in the energy sector where oil and gas stocks have faced big headwinds, given their carbon emissions. Conversely, a surge in renewable energy stocks in the last three to six months has prompted some analysts to question whether these assets are overheating as there appears to be a growing disconnect between operational performance and share price returns. Manfred Wiegel, Green Benefit’s chief executive, said he can see indications of “overpricing” in companies in the hydrogen and fuel-cell sector, which is closely linked to the demand for clean energy storage solutions. For example, Ballard Power Systems, which makes hydrogen fuel cells for forklifts and buses, has had its share price more than quadruple since last May. The Vancouver-based company, which listed on Nasdaq in 1995, has not turned an operating profit since then.
The world’s largest fund manager, BlackRock, wrote an open letter this year saying that “sustainability- and climate-integrated portfolios can provide better risk-adjusted returns to investors.” There are good reasons for investors to own portfolios that align with their values. However, this idyllic concept that investing in ’good’ funds will always generate good returns is not one of them. Not only is the evidence that ESG outperforms over long periods is inconclusive; the win-win argument does not make sense.
Over a realistic time horizon, an anti-ESG portfolio may very well offer the best available return. There are two ways investments outperform: either they generate greater than expected cash flows over time (growth stocks), or they are bought at an undervalued price (value stocks). Putting aside the question of growth, to argue that a carbon, tobacco, or gun-heavy portfolio cannot outperform over the long term is to argue that it will never be bought cheap. Nevertheless, the goal of the ESG movement to push investors away from anti-ESG portfolios – making their prices cheap and setting them up to outperform ‘virtuous’ portfolios over time. The win-win pitch is a fallacy. Illogic is not the only problem with the win-win theory. Another is performance attribution. ESG funds have had a nice run lately. Since its inception in late 2018, for example, Vanguard’s US ESG exchange traded fund (ETF) return of 28 percent has beaten its broad-market ETF’s 17 percent. However, the top seven holdings, accounting for a quarter of the funds’ value, are Apple, Microsoft, Amazon, Facebook, Google and Tesla. Tech has led the market this year. But has ESG, really? And if tech stocks become overpriced and their prices crash, does that mean ESG is suddenly a bad strategy?
There is no doubt that sustainable finance is here to stay, and this is undoubtedly a very good thing. However, investors should be wary of jumping on board of any fund labelled ESG and we shouldn’t dismiss the possibility of a bubble beginning to form in this market.
Analyst: Olivia Pepper
Sector Head: Sophia Li
Editor Harry Forbes-Nixon