Green Investing: The Rise in Popularity of ‘Green Bonds’ and ESG Investing
The move towards green investing is a global shift. 2020 marks the first year that investment in ESG-oriented funds topped US$1 trillion (FT Advisor 2020). Far from being an ‘investment fad’, ESG investment is here to stay. And as this article will show, it’s likely to become the dominant investment theme over the coming decades.
The Growing Importance of Socially Responsible Investing
If the importance of socially responsible investing could be summarized in two words, they would be ‘attracting capital’. In 2019, nearly 500 green bonds were launched on the market, a 25% increase on 2018 (CNBC 2020). Despite a tumultuous year for markets, investment in ESG funds have set a record pace for launches in 2020, with the year likely to finish with a record number of ESG-oriented funds (Morningstar 2020). The implication for companies everywhere is clear: Improve their ESG credentials or risk being overlooked by asset and fund managers. Even oil and gas companies have picked up on the message: When BP announced plans to increase investments in renewables ten-fold in 3Q 2020, to many it felt like a pivotal moment (Ecowatch 2020).
Outside of attracting capital, two further ‘mega trends’ are hastening the move towards socially responsible investing. The first is regulation. A survey of 300 European investors conducted by State Street Global Advisors in 2019 (Harvard Law School Forum on Corporate Governance 2020) showed that over half of them said that getting ahead of regulations was the main reason for them incorporating ESG measures in their investment strategies. They noted that this included domestic regulation and the Global Reporting Initiative. The second megatrend outside of attracting capital is demographic: Dave Nadig of ETF.com puts this succinctly when he says: “We’re in the middle of a $30 trillion intergenerational wealth transfer from baby boomers to their children. And those kids-not really millennials only, but people from 25 to 40 years old — simply think about their investment decisions differently.” (MSCI 2020).
What is ESG investing?
The UN’s 17 Sustainable Development Goals (SDGs) (United Nations 2020) provide the most widely used point of reference for ESG investing; if an investment doesn’t straddle at least some of the categories proposed by the SDGs, it’s unlikely to be ESG-compliant. For the sake of pinning down a definition, the MSCI definition of ESG investing is: “Sustainable investing is about investing in progress, and recognizing that companies solving the world’s biggest challenges can be best positioned to grow” (BlackRock 2020). The expression ESG Investing is usually used interchangeably with ‘green investing’, ‘sustainable investing’, and ‘impact investing.’
Different Types of ESG Funds
The explosion in the growth of ESG investing has meant that ESG funds have sought to differentiate by themes and strategies. For example, water-focused ETFs, such as Invesco’s S&P global water index, invest entirely in water-related assets. These could include everything from utilities firms to companies focused on water desalination. A renewable energy ETF, probably the most common type of ESG-oriented of all, will inevitably focus on renewable energy firms (solar, wind, biomass, etc.). But the rush to be included in these ETFs and other ESG-oriented funds has companies rushing to talk up their sustainable credentials — simultaneously creating a need for an ESG taxonomy.
Morningstar has made a valuable contribution to this endeavor by defining four broad categories of sustainable funds: ESG Consideration funds (funds which refer to ESG criteria in their prospectuses as one of the factors considered in their investments), ESG Focus Funds (those funds which make ESG factors a featured component of their investments, often working with companies to drive ESG-related activities), Impact Funds (funds with a focus on broad sustainability issues), and finally, Sustainable Sector Funds (funds aiming to profit from the transition to a green economy — e.g. renewables, green real estate, etc.)(Morningstar 2020).
How to Incorporate ESG into your Portfolio
With so much enthusiasm to incorporate ESG criteria, even passive investors will have noticed a ‘greening’ of their portfolios over the past five years. Assuming an investor wishes to diversify into ESG-compliant assets, there now exists a wealth of funds to choose from (refer to the introduction of this article). The easiest way to make a thematic investment is through one of the many ETFS currently on the market. The three biggest ESG-oriented ETFs by AUM are iShares ESG MSCI USA Leaders ETF (SUSL), iShares MSCI KLD 400 Social ETF (DSI) and Xtrackers MSCI USA ESG Leaders Equity ETG (USSG) (CNBC 2020).
The UN Principles for Responsible Investing have also provided a useful outline of the tools and strategies which investors can apply when considering which ESG-oriented assets to add to their portfolios. The most important of these tools is screening, which as the name suggests, encourages investors to look at the ESG factors which any assets added to the portfolio should include. They divided screening into negative screening (avoiding the worst performers), norms-based screening (using an existing framework) and positive screening (including only the best performers) (PRI 2020).
Does ESG Investing Make Financial Sense?
Increasingly, there is no trade-off between financial performance and an ESG focus. Although the direct links between financial performance and ESG measures are largely spurious, the Financial Times noted in June 2020 that the majority of ESG funds outperformed the wider market over a 10-year period (Financial Times 2020). Does that mean they’ll do so again in the next 10 years? Hardly. But at least two factors make it ever more likely that ESG-oriented assets will outperform the rest over the long-term: First, their increased access to cheaper capital and second, the fact that they’re compliant with regulations mean they’ll face fewer fines, tariffs and trade barriers as these increasingly become issues for non-ESG compliant assets.
Investment articles are prone to calling ‘the next big thing’ when it comes to asset classes. In the past two decades, you can take your pick from cryptocurrencies CBD and marijuana-related products or even businesses which had a ‘dot com’ after their name. ESG investing is a bigger theme than all of these combined. In fact, it pervades these investment opportunities as well as all others. As industries wax and wane in the coming years, the one consistent will be a continued focus on ESG criteria. Ever widening regulations will ensure that is the case.
The Danish company Orsted offers a glimpse into what is achievable by changing over to the ESG paradigm. Over the past decade, the company changed from the largest oil and gas firm in Denmark to one of the largest renewables firms in the world. This involved a series of disposals of its oil and gas assets and reinvesting the proceeds into renewable energy. Since being publicly listed in June 2016, its shares have yielded over 250% total shareholder return. During the same period, the shares of oil and gas firms have underperformed the broader market. Investors are coming around to a consensus: the new black gold is green.
Originally published at https://www.area2invest.com on October 26, 2020.
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