Backing sustainable investment against the backlash
The relatively poor performance of green funds has punctured the inflated claims made for them, and highlighted long-standing design issues. But darkening climate news underlines the importance of reform, and renewed commitment
This year the UK has endured something rather like the classic wet British summer. We complain, of course, but with our damp but mild weather we have been fortunate relative to much of the rest of the world, subject to runaway forest fires, scorching heat domes, and warming oceans.
Just as, however, the alarming climate news emphasises the imperative of remaining invested in the transition to a green economy, the seemingly unstoppable momentum of the sustainable finance movement has been checked.
After surging in value for much of the past decade, green funds have trailed the wider market over the last couple of years, their relatively poor performance bringing long-standing concerns over the criteria used for measuring their effectiveness into ever sharper focus. And the very concept of ESG has become entangled in the culture wars, targeted by populist politicians as the prime manifestation of a ‘woke capitalism’ distracting firms from their fiduciary duty to maximise shareholder returns.
So how should investors who acknowledge the reality of climate change best keep faith with the hope that finance can be a powerful tool for supporting the energy transition?
Sustainable investing falls back to earth
First, perhaps, by assessing whether they are committed for the right reasons: to make a difference, not just to make money. The late underperformance of green investments has shown up the facile assumption — much too prevalent throughout the industry — that sustainable investment guarantees better performance.
It now seems clear that the outsized returns secured by sustainable funds in preceding years was due to their weighting towards the tech and growth stocks that did so well during the favourable monetary environment that prevailed after the financial crisis, and through the pandemic. Morningstar data shows that 56% of green funds have done better than the wider market over the past five years, but have fallen behind as interest rates have risen. In 2022 just 41% did better, with the MSCI World SRI index fell behind the World Index for the first time since 2015, down 22% against 17.7% for the broader market. Research by one consultancy reported that many ESG funds trailed the global market by 3 to 4% last year.
Neoclassical oriented commentators have interpreted the reversal as proof of Milton Friedman’s doctrine of shareholder value maximisation: that the social responsibility of businesses consists solely in their duty is to increase profits, it being the job of politicians, not CEOs, to set the regulatory regime within which they operate.
Unfortunately, a potentially interesting debate about the fiduciary duty of listed companies has deteriorated into a culture wars wedge issue. BlackRock, which has promoted a — modest — green agenda, pushing companies to cut their carbon emissions by warning they may (one day) be dropped from the group’s actively managed funds, has lost more than $1bn in asset management business in US Republican states. The backlash has had a chilling effect on shareholder activism, this year fewer than a quarter of shareholders supporting resolutions calling for more action on climate change or human rights, down sharply from 2022.
In Europe too the populist right has seized the moment, exploiting concerns over the costs of green measures to gain electoral advantage. EU plans to retrofit homes, notably through the replacement of gas boilers with heat pumps, have run aground against political resistance. Even the UK’s relatively centrist Conservative government has supported the issuing of new North Sea licenses, and, less noticeably but more controversially, adjusted the Emissions Trading Scheme, which covers the heaviest industrial emitters, to reduce carbon prices below EU levels, prompting a cautious note of dissension from the otherwise studiously apolitical Climate Change Committee.
And as oil and gas prices recovered during the energy supply crisis and the Ukraine war, fossil fuel suppliers have doubled down on their core businesses, notably BP and Glencore, whose CEO Gary Nagle, defending a proposal to list a spin-off coal business in New York, compared climate conscious UK markets unfavourably with more ‘pragmatic’ American investors.
Receding ice, rising seas
But this year’s dismal climate news suggest that this would be, to say the least, an unfortunate time for investors to backslide on the sustainable investment principles embraced so enthusiastically a few years ago.
Heat waves and burning trees have captured the headlines, but the most disturbing trend becoming apparent to researchers, perhaps, is the relentless rise in sea temperatures. Europe’s Copernicus Climate Change Service reports that average global sea surface temperatures reached an all-time high just short of 21C earlier this month.
Marine biologists are worried about the effect on fisheries, and polar regions seem to be warming at unprecedented rates. The most extreme heatwave ever recorded anywhere in the world took place over the ice dome of East Antarctica last March, temperatures hitting 38.5C above the seasonal normal, equivalent to 60C temperatures in London. The World Meteorological Organisation says that over the past decade Antarctic sea ice has declined at a rate not observed since satellite records began in the 1970s. And the Intergovernmental Panel on Climate Change estimates that the Arctic is warming about twice as fast as the rest of the planet. The erosion of polar ice forebodes a catastrophic cascade of extreme environmental events. Melting ice contributes to rising sea levels, and shrinking ice cover means that more solar radiation is absorbed by seas and land rather than being reflected back into space by white frozen surfaces.
ESG matures
Suffice to say, then, it is more important than ever that finance be directed towards the development of new green technologies, and to carbon emitters to account. But the backlash has served the valuable purpose of applying a much needed corrective to panglossian narratives about the magical capacity of sustainable funds to perpetually outperform their ‘traditional’ counterparts. Green investors must now acknowledge the inevitability of periodic underperformance. And it has brought concerns about the design of ESG metrics, which have proved poor criteria for measuring carbon impact, to a head.
A striking new report by Scientific Beta, an index provider and consultancy, found that companies rated highly on widely accepted ESG metrics pollute just as much as lowly rated companies, suggesting that investors would do much better to select stocks solely on the basis of their carbon intensity. Assets that qualify for the ESG mark can be up to 90pc less effective at reducing carbon than those which do not. Environmental, social and governance components tend to be unrelated: a high-emitting firm, for example, could be very good at governance or employee satisfaction. The lack of correlation holds even if a company’s carbon intensity is compared purely to their environmental rating, which is partly determined by factors such as a company’s use of water resources and waste management practices.
The sheer difficulty of accurately measuring carbon output makes it easy for companies to mislead. For example it is possible to make great play of a commitment to reducing the scope 1 and scope 2 emissions that derive directly from operations, or are attributed to the energy purchased by a company. But scope 3 emissions, which encompass emissions in the value chain of the organisation — such as use of the product the company sells — tend to be much higher, and much harder to reduce. For oil and gas companies, scope 3 emissions will be many times their scope 1 and scope 2 emissions combined.
Increasing recognition of the clumsiness of prevailing metrics has obliged regulators to refine rules as to what counts as sustainable. Index provider MSCI has removed ESG status from hundreds of funds and downgraded thousands more, cutting the number of European ETFs with a triple-A ESG rating from 1,120 to 54 in the course of its latest review. The UK’s Financial Conduct Authority is tightening its classification criteria, with expectations that only a third of those currently calling themselves sustainable will be permitted to retain that status. In particular, funds will no longer quality simply in virtue of excluding certain sectors.
The Authority’s changes express a recognition that investors need to engage with rather than exclude the carbon intensive sectors that hold the key to an effective energy transition. Oliver Wyman vice-chair Huw van Steenis writes that a few key sectors account for about 90% of public company emissions and 60% of all global emissions. Making up about a third of the public equity market, their simple exclusion ‘is self-defeating to real-world decarbonisation.’ The next generation of climate-aware indices, such as MSCI Climate Action Index, include ‘carbon improvers’, the big carbon emitters that are progressively reducing their emissions footprint. van Steenis also notes the continual recalibration of impact funds to more precisely target the companies enabling a faster transition, such as new critical metals ETFs, and the welcome development of fresh vehicles for investing in unglamorous, hard-to-green sectors like agriculture and steel production, which investors have tended to overlook in favour of shiny new tech moonshot ventures.
‘Sustainable’ vs ‘non-sustainable’: a false binary?
It seems, then, that sustainable funds are maturing to more accurately direct investment to the companies and sectors that will make a real difference. Investors committed to sustainability need to make use of these new, more refined vehicles. They also need to face up to the hard fact — still obscured by the fund management industry — that sustainable investments are just as likely to trail the wider market as to outperform.
Indeed, research by the University of Chicago Booth School of Business and the Wharton School suggests that green stocks are more likely than not to underperform in the near future. The demand that has pushed up prices over the past few years foreshadows lower expected future returns, as valuations revert to the mean. The authors point to a handy clean comparison offered by Germany’s efforts to promote green bonds. Issued together with non-green ‘twin’ bonds in 2020, the sustainable bonds have consistently produced lower yields to maturity than their twins. This research is speculative. It could be said in response that the return of a lower interest rate environment, should inflation continue to fall, may give green growth stocks a new impetus. The truth is we don’t know.
But perhaps it is worth considering whether the supposed binary between ‘sustainable’ and ‘non-sustainable’ funds applies at all. Certainly, as noted above, it is not clear that divestment from carbon intensive stocks is effective.
One intriguing new paper published by the Journal of Political Economy suggests divestment has no impact. If it is to be effective, the paper reasons, divestment must depress the stock price of the company targeted for change. But if the price does fall, the lower price attracts investors who are not socially conscious and are glad to acquire the stock at a discount. Such opportunistic buying tends, therefore, to eliminate, or at best attenuate, the price decline, eroding the company’s resolve to clean up its act. Divestment from oil and gas stocks, for example, as recent evidence has shown, simply makes fossil fuel companies an attractive buy for less environmentally conscious investors. Divestment, it seems, has a perverse logic, having little effect on climate outcomes, and allowing unconcerned investors to grow richer at the expense of the concerned. The paper argues that socially engaged investors should stay invested and apply the pressure on companies that the opportunists will not apply.
Joe Wiggins, in The Intelligent Fund Investor, holds up the Climate Action 100+ group as an example of the difference engagement can make. A collaboration between some of the world’s most prominent investors formed in the wake of the 2015 Paris Agreement, the group, which has over 615 signatory investors responsible for over $65trn in assets, engages with the largest greenhouse gas emitters to ensure that they report their environmental impact in a transparent fashion and commit to reducing emissions. ‘Given the scale of assets, this form of collective engagement can be incredibly influential,’ says Wiggins. ‘It is highly unlikely that a company like BP would have embarked on their new sustainability strategy without pressure from shareholder and investor groups such as Climate Action 100+.’
‘Core-and-satellite’ … or just ‘core’
There is a case, then, that environmentally minded investors should still simply hold standard issue global tracker funds, which ensure access to the market return, keep fees to a minimum, and, through ownership, even by proxy, offer opportunities to influence ‘carbon improvers’. Those who want to a more direct stake in the energy transition might adopt a core-and-satellite approach, making a global index fund their primary holding, and supplementing it with impact funds supporting developing green technologies. Satellite holdings need not be equities: the green bond market, where proceeds are used to finance environmental or renewable projects, continues to develop.
Such specialist funds may come at a cost. The easy belief that sustainable investments are somehow immune from the inherent volatility of the market is simply false, buried forever, hopefully, by the evidence of the past couple of years. But for those concerned by ever more bleak evidence of the effects of climate change, it is surely a price worth paying.
Photo by Matt Palmer on Unsplash.
