Despite some pushback against ESG in the U.S., investment products such as mutual funds and ETFs that consider “Sustainability” continue to attract capital. This indicates that investors around the world support the thesis that companies can mitigate risks and boost profitability by pursuing more sustainable ways of conducting their business. Through the bond market, investors continue to help to fund renewable energy and other sustainability-related projects such as reducing greenhouse gas emissions, improving clean water resources, and developing more sustainable infrastructure.
The appeal of clean energy in particular is clear, as we are all witnessing the effects of climate change and depend on a healthy planet to sustain life as we know it. However, investors are understandably concerned about greenwashing (claims of environmentally friendly practices that turn out to be mostly marketing hype). To address this, regulators in many countries are requiring companies and investment funds to make detailed disclosures related to ESG issues. A proposed SEC rule would require funds claiming to pursue ESG-related mandates to back up those claims. The European Union’s Green Bond Standard, announced in February 2023, would impose more stringent disclosure requirements on green bond issuers to protect investors against greenwashing.
Separately, the U.S. is experiencing a politically-driven backlash against ESG. Cynical labels such as “woke capitalism” misrepresent the goals of sustainable investing, along with accusations that asset managers who incorporate ESG concepts in investment decisions are not acting in investors’ best interest. Some states have proposed or passed legislation to prevent asset managers from considering climate change or other ESG issues when managing state funds.
Against this backdrop, volumes in ESG/Sustainability-oriented funds globally, as well as the green bond and sustainability bond markets, continue to increase, albeit at a slower pace in some areas.
Capital Markets Activity
ESG/Sustainable Investment Funds
Overall, investor demand for sustainable funds remained strong, experiencing positive inflows of $115 billion during 2022, while traditional funds suffered steady outflows as many investors pulled money out of the market to seek the safety of cash. The net result: sustainable funds continue to grow as a percentage of total assets under management worldwide. This may be interpreted to mean that investors, for the most part, view sustainability as a long-term thesis.
ESG fund launches continue, but growth appears to be slowing. In 2022, a total of 94 sustainable funds(mutual funds and ETFs) were listed, compared to a record-breaking 121 launches in 2021. ETFs dominated in the equities arena but there were almost three times as many new sustainable fixed income mutual fund offerings than ETFs. Not surprisingly, the new mutual funds were all actively managed, while new ETFs were a mix of passive index funds and actively managed funds. Again, this should be put in context. Overall (traditional and sustainable funds combined), new ETF launches declined by over 9% in 2022 versus the prior year, and fund closures were quite high. Furthermore, those new launches included single-stock ETFs.
The number of new funds launched declined in Q1 2023 versus Q1 2022. Morningstar reports that 113 new funds were launched globally in Q1 2023, while fund launches have exceeded 200 per quarter over the past two years.
Performance comparisons between ESG and non-ESG investment strategies can be tricky as they are often influenced by other factors. For example, according to a recent report from Morgan Stanley’s Institute for Sustainable Investing, 2022 was the first year since 2018 that funds in the “sustainable” category underperformed traditional funds globally. Before seizing on this as evidence that sustainable funds are not delivering on the “hype” about the benefits of ESG investing, we should remember that 2022 was a horrible year for investors all around. Furthermore, the technology sector that tends to be overweighted in many ESG-based funds were particularly hard-hit, while energy stocks that are often underweighted or avoided did relatively well.
Green and Sustainability Bonds
Governments and corporations issue so-called green bonds to fund projects with positive environmental impacts, from developing renewable energy sources and improving energy efficiency, to pollution control projects, zero-emission transportation systems, constructing or retrofitting green buildings, and improving wastewater management. Before discussing capital markets activity for green and sustainability bonds, here is a brief review of the terminology used in this arena:
- Green bonds: Issued by governments and corporations to raise funds to use for climate-related or other projects to protect or help improve the environment;
- Social (or social impact) bonds: Issued by a public sector or governing authority to raise capital for social “goods” such as improving food security, increasing the stock of affordable housing, and providing easier access to essential services. Social bond projects are often aimed at specific populations such as those living below the poverty line and people with disabilities.
- Sustainability bonds: Used to finance a combination of green and social projects.
- Sustainability-linked bonds: Issued to fund a wide range of things (including general corporate purposes) interest payments are linked to sustainability-related KPIs sustainability targets or tied to UN Sustainable Development Goals (SDGs). The bond’s coupon rate will increase if target outcomes are not achieved.
Global sustainable bond issuance continues at a strong pace despite the greenwashing concerns, regulatory scrutiny, and political pressures mentioned above. Still, issuance of green and sustainability-related bonds totaled just $864 billion in 2022, a notable decline from the $1.1 trillion issued in 2021. Does that indicate waning interest among investors? As with the decline in ESG fund launches described above, it would be premature to declare this a trend. In 2022, interest rates in most countries rose precipitously from near-zero levels, giving issuers of all kinds of bonds reason to pause. In fact, Bloomberg reports that sustainable bond issuance rebounded in the first quarter of 2023, finishing the quarter up 21.1% year-over-year.
Source: Bloomberg (https://www.bloomberg.com/news/articles/2023-05-25/wall-street-scrutiny-resets-6-trillion-in-esg-debt)
Moving through 2023 and beyond, green bond issuance is expected to rebound from 2022’s slower pace. In the U.S., the Inflation Reduction Act will support green bond issuance as billions of dollars in tax incentives to spur energy and climate spending are already attracting companies from the U.S. and abroad to invest in qualifying projects. China, the largest issuer of green bonds in 2022, published its Green Bond Principles last July to set standards for Chinese issuers that are more consistent with international practices.
Bloomberg reports that in the first quarter of 2023, green, social, sustainability and sustainability-linked bond issuance totaled roughly $278 billion, with green bonds comprising about 62% of that and governments accounting for almost half of the total. Concerns about greenwashing also affect this part of the market. That may have a positive impact by prompting more disclosure, which will then boost investor confidence that their capital is actually funding projects that meet their objectives.
Outlook for ESG Investing
Sustainable investing is still evolving in many respects, particularly in terms of regulatory requirements and data disclosure standards. Investors should expect growing pains. Regulators around the world are issuing rules about ESG disclosure to increase transparency and accountability, focusing on environmental concerns but also for human capital and other ESG-related issues. To the extent that these regulations differ, many companies will have to comply with different standards, which will impose new reporting burdens. Despite this, companies and investors should benefit from this transparency, just as standardized financial accounting is beneficial.
In the U.S., the political pushback is likely to continue. West Virginia and Texas have issued laws against doing business with financial institutions that “boycott” fossil fuel. While this may play well in terms of political theater, the reality is that few, if any, banks or large asset managers boycott the fossil fuel industry. Separately, a coalition of states led by Texas sued the U.S. Department of Labor (DOL) , seeking to freeze a new rule that would allow retirement plans to consider ESG factors when making pension investment decisions. This would harm the very entities the backers claim they want to protect, as the DOL rule does not require any retirement plan to consider ESG factors, and specifically states that doing so must not conflict with pursuing financial returns.
Keeping this in mind, it is notable that State Farm recently announced it would no longer offer property & casualty insurance in California due to the rising risk of wildfires in the state. The growing frequency and intensity of wildfires is, of course, a result of the greater frequency and intensity of persistent droughts caused by climate change. This is just one of the many examples where businesses are being directly affected by ESG-related issues that investors will want to consider.
With respect to sustainable bond issuance going forward, Environment Finance says that investor interest remains high. Improving market conditions means new issuers are likely to come to the market in 2023. Green bond issuance is expected to continue to propel growth in this market in 2023. Sovereign sustainable bond issuance is likely to be a big part of this, particularly from emerging market countries including India, Brazil, and Indonesia, which is planning to issue a blue bond. Recent geopolitical events showed that in addition to accelerating the transition to clean energy, ensuring energy security is also critical. That urgent need is likely to provide a further push for renewable energy projects.