What does the rise of ESG means for US equities?

On February 12 2020, the Dow Jones Industrial Average (DJIA) stood at 29,551, but tumbled to a low of 18,591 by 23 March 2020. Since then, stocks have climbed steadily back to their former highs.

The S&P 500 tells a similar story, falling from a high of 3,386 on 19 February to a low of 2,237 by 23 March, only to hit a new high of 3,626 by 16 November.

While the fluctuations of US equities are interesting in themselves, the return profile of US equity investment funds make for an even more intriguing read – particularly when the returns of funds with a strong ESG profile are compared to those funds without a strong ESG selection policy.

In August, as US equities markets had established their fightback, S&P Global Market Intelligence reviewed 17 ETFs and mutual funds that choose stocks based on their ESG credentials. It found that 14 of these funds outperformed the S&P 500 throughout the year to 31 July – helped in no small part by the outperformance of US technology stocks.

A separate study, published in September by the World Resources Institute, similarly concluded that most ESG index funds outperformed traditional index funds during the year.

Political influence

With the US presidential election resulting in a win for Democrat Joe Biden, investors are now anticipating even more investor interest in funds – and stocks – with a strong environmental profile.

In the build-up to the election, Mr Biden made pre-election promises to dedicate $2 trillion of investment into climate and environmental initiatives. This climate plan specifically targets green energy, such as renewable hydrogen, as well as transport and infrastructure, as part of his “Build Back Better” agenda.

“His plan is focused on many of the industries which vitally need to transition to be more aligned with net-zero,” explains Kristina Church, senior sustainability investment strategist at Lombard Odier Investment Managers. 

“We believe this will signal to investors the need to focus on some of the more carbon-intensive sectors which need to decarbonize urgently. By selecting the best-in-class companies in these sectors, those that have understood the urgency of the transition and have laid out profitable business models for net-zero alignment, we believe investors can generate future returns.” 

Biden’s climate policy aims to achieve carbon neutrality in the power sector by 2035 Sam Anthony, Ninety One

Sam Anthony, an analyst in the thematic equity team at fund group Ninety One, agrees.

He says: “Joe Biden has made a clear commitment to addressing climate change with plans to reach net zero by 2050. This commitment could include the US re-joining the Paris Agreement in addition to bringing climate expertise directly into his cabinet.

“Biden’s climate policy aims to achieve carbon neutrality in the power sector by 2035. Despite the Trump administration, renewable investment has been accelerating, but with an administration that supports the growth in renewable energy, the opportunity for clean utilities is even more attractive.”

On the corporate front, there is work to do, despite the way in which tech – generally perceived to be a relatively ESG-friendly sector – dominates indices. To take emissions alone, only 280 companies in the S&P 500 currently report scope one and two emissions – those deriving from either their own operations or those from companies whose energy they purchase – according to data from the International Energy Agency. This is despite climate change having been earmarked by the SEC as a “material issue” for well over a decade.

Many expect that ESG disclosures in general will become more closely watched by regulators under a Biden administration.

Julian Cook, US equity portfolio specialist at T. Rowe Price, says: “Consideration of ESG factors should serve to not only improve behaviours with greater accountability but also, importantly, the disclosures of the future winners in US equities. 

“Disclosures matter as they allow investors to measure and appreciate progress on key ESG factors as it relates to long-term investment programs and ambitions of the best management teams.”

Ninety One analyst Mr Anthony adds: “Investors should look to those companies that are already demonstrating a high level of transparency and understanding of their externalities, which we believe will be increasingly priced by the market. US companies’ carbon disclosure should be of a particular focus for investors.”

Mr Anthony’s view is that investors will have to work harder to truly understand the carbon risk profile if they are to avoid any nasty surprises within their portfolios over the longer term.

He continues: “We believe you need to understand their full carbon footprint, meaning scope one, two, and all 15 categories of scope three [emissions that occur during the use of a company’s products] 

“We would expect those companies that are disclosing their full carbon footprint and addressing carbon risk within their business to be better prepared to address the challenges of climate change, but also to take advantage of the significant opportunity that decarbonisation offers over the long term.”

However, despite the positives that may emerge from an environmental perspective from the Biden win, some market commentators note that the US remains divided on many issues relating to ESG.

Sarah Wilson, chief executive officer of Minerva Analytics, says while Mr Biden has expressed a commitment to re-joining the Paris accord, there are still going to be issues on “social factors” given US history. She notes that the US previously failed to sign up to the Human Rights Charter, for example.

She says: “Biden’s win, while convincing, still shows that the US is polarised. The shareholder vs stakeholder debate is still split roughly down the middle, and there remain concerns that US companies are paying lip service to ESG/stakeholder capitalism.

“That said, US markets are 40 per cent of the world stock market so if US businesses and asset owners can embrace ESG and become ‘net zero heroes’, then the US equity market has massive game changing potential.”

Joe McGrath is a freelance journalist