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Downturn signals opportunity for climate-aligned investing

Several frameworks are emerging that sets performance thresholds identifying economic activities that align with the Paris Agreement emissions reduction targets.

With global stock markets having plunged into bear market territory, the conventional wisdom is that the coronavirus storm sinks all boats. Or does it? While it’s true that equity funds experienced severe losses pretty much across the board, some fared better than others.

According to research by Morningstar, sustainable equity funds did better than their conventional counterparts. In the first quarter of 2020, the returns from more than 200 open-end and exchange-traded funds (ETFs) in the United States with a sustainability theme were over-represented in the top quartile and top halves of their broader category, such as for indexes comprised of large cap value or small cap growth stocks.

Furthermore, Morningstar research also confirms 24 of 26 environmental, social and governance (ESG) index funds outperformed comparable conventional index funds. As described, sustainable investing — otherwise known as ESG investing, socially responsible investing or impact investing — is a strategy that considers environmental, social and governance factors in investment decisions and active ownership.

Demand for sustainable ETFs has grown since the market downturn. Recent analysis from BlackRock highlights how sustainable ETFs keep attracting assets, in comparison with traditional ETFs, which are experiencing outflows in light of the market selloff. As of March 24, net inflows to sustainable ETFs had reached $14 billion, exceeding half of the 2019 total amount.

RMI Netinflows chart

ESG funds are not simply doing better as a result of the economic downturn — several of the largest sustainable mutual funds beat the market even prior to the financial meltdown. Here we will look at the outperformance of sustainable investing and how we can reach beyond its existing mandate as we look to rebuild the economy.

Why the ESG advantage?

The pain of the economic downturn has hit energy companies particularly hard. Due to vanishing demand for fuel and an oil price war, oil futures contracts collapsed into negative territory for the first time in history. This accounts for part of the reason why sustainable funds balanced away from fossil energy would outperform the market. In fact, sustainable equity funds with the lowest exposure to energy funds have experienced the greatest returns. 

However, according to John Hale, head of sustainability research at Morningstar, a bigger reason for the outperformance of sustainability funds is due to the "selection effect": the fact that the higher ESG scores that formed the basis for inclusion in these funds are correlated with other characteristics that make these companies more resilient to systemic shocks such as coronavirus. These factors could include corporate policies pertaining to fair wages, labor standards, board diversity and/or stringent environmental policies — all seemingly resulting in greater company resilience. 

Aligning entire portfolios and loan books with long-term decarbonization trajectories of companies and industries, is the way forward. Signs indicate that this shift is already underway.
MSCI attributes the financial resilience of ESG companies to their higher risk control and compliance standards, and highlights as a result, significantly lower volatility in these investments. Other studies (PDF) have attributed the strong performance of ESG investments to the companies’ ability to secure high-quality workers, their management of stakeholder relationships potentially mitigating negative regulatory, legislative or fiscal action, or that these policies simply enhance a company’s reputation.

And while investors could not have predicted the financial repercussions of COVID-19, they have been warned, year after year, about the potential economic consequences of a high-carbon future. Not only are ESG funds demonstrating their economic resilience in light of market upheaval, but the proactive preparations they are making for a low-carbon transition will help them be more resilient to that transition while easing the global and economic repercussions that ultimately would result from runaway climate change.

Strengthening the 'E' in ESG

Even before the economic downturn, ESG investing was catching on, with total assets in sustainable investments more than doubling (PDF) between 2012 and 2018. But while interest in sustainable investing may not be lacking, standardization certainly is. Investors use a range of definitions and a variety of factors in their investment analysis.

A lack of standardization has resulted in an ambiguous kitchen-sink approach, with ESG funds comprising a range of securities based on a slew of policy considerations from board diversity and executive pay, to how they treat laborers, to their policies pertaining to waste and water. As a result, a fund can still be designated as ESG and include holdings in the oil majors, such as Exxon Mobil or Chevron, as is the case for the S&P 500 ESG Index, or holdings in the largest lenders to fossil fuel companies, such as constituents in the FTSE All-World Green Revenues. 

To provide more clarity regarding investment standards relating to climate-friendly securities, several frameworks are emerging, such as the EU Sustainable Finance Taxonomy (PDF), which sets performance thresholds identifying economic activities that align with the Paris Agreement emissions reduction targets.  

The EU framework provides the most comprehensive guidance to date on environmental standards for sustainability investments, creating a common language that ESG investing otherwise lacks. However, even with growing momentum in this space, lack of decision-useful data and lack of standardization in disclosure and methodologies continue to be the investment bottlenecks.

Climate alignment as the new standard

While economists debate whether the recovery from coronavirus will be shaped like a "V," a "U" or a "W," resilient planning requires that the economy we rebuild must be different from the one we’ve been trying to decarbonize.

While the outperformance of ESG funds is an important indication for investors, scaling up ESG allocations, as loosely defined today, is insufficient in moving the needle to drive deep decarbonization and impact in the real economy. The growing investment risk due to climate change and other ESG factors will require capital reallocation, which will have a significant impact on the pricing of risk for every asset across capital markets.

We’re at a crucial turning point when investors who are rebalancing portfolios in light of the current market conditions — and are simultaneously facing growing pressure to take a more holistic approach to portfolio composition — face an opportunity to reconsider their portfolio structure. A climate-aligned approach to investing, aligning entire portfolios and loan books with long-term decarbonization trajectories of companies and industries, is the way forward.

Signs indicate that this shift is already underway, and financial institutions representing $17.2 trillion in investments have committed to align their portfolio emissions with the carbon reduction goals of the Paris Agreement. The dominant banks in the shipping industry became the first to adopt a climate alignment agreement — the Poseidon Principles — that will guide their lending decisions for years and decades to come.

However, moving toward full climate alignment is a difficult journey, not a quick fix. Rocky Mountain Institute has mapped out five barriers to climate alignment for the financial sector and how a sectoral approach can help overcome them. One of the most critical barriers today is the lack of truly climate-aligned investment options in equities markets. But it is already evident that investors can do far more than screen carbon-intensive options out of their portfolios. In fact, financial institutions wield powerful tools to help critical industries support a transition to a viable low-carbon future.

Value of Assets

While ESG investing may have proven its worth, in good times and bad, a further, more holistic shift is required in which climate-aligned investing becomes the new universal standard to support the transition to a low-carbon economy. The shift in paradigm towards climate alignment is a structural one that comes with the promise of a more secure, more resilient future, better able to withstand the weight of crises to come.

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