Environmental, social and governance-focused investment is on the upswing like no other investment trend.
In the first half of 2021, of 80 exchange-traded funds and mutual fund launches in the UK, 37 were ESG vehicles. Of these, 19 were equity funds, 16 mixed assets, and one each for bond and alternatives (chart 1). Bonds showed rather better last year with 12 launches, but whatever the year, equity launches dominate.
This compares with 207 launches in 2020, of which 59 were ESG, up from just 17 ESG launches in 2017 (chart 2). ESG launches have gone from 7 per cent of the total in 2017 to 46 per cent year-to-date, with no sign of the trend abating. Indeed, institutional investors are becoming increasingly reluctant to touch any product that does not have an ESG tag on it.
This sits within the context of an overall growth in ESG mutual fund and ETF assets globally – now at about $4.5tn (£3.3tn). Overall assets, including government and occupational pension funds and sovereign wealth funds, are said to be about $40tn.
There is a lot of talk about an ESG bubble. The plethora of ESG launches would seem to indicate this. “ESG is just another old-fashioned stock market bubble,” reckons one pundit, and even the former chair of the board of governors of the world’s largest pension fund, Japan’s Government Pension Investment Fund – which has spearheaded ESG both in Japan and throughout Asia – has expressed misgivings. In the UK, flows to ESG assets are strongly positive, while ‘conventional’ assets are often negative. Indeed, Refinitiv Lipper analysis has often identified just this trend.
But hold on a minute: compare this to the level of investment the world needs to achieve a carbon-neutral transition.
According the UN Environmental Programme Finance Initiative, the transition to low-carbon and climate-resilient economies needs an investment of at least $60tn until 2050 – $35tn to decarbonise the world’s energy system, another $15tn to adapt man-made infrastructure to the changing climate, and another $2tn to reorganise global land use in ways that meet growing demands for agricultural commodities while stopping tropical deforestation. And that is not a comprehensive list.
Investment is patchy. While certain renewable sectors, such as power generation, are popular investment options, and the electrification of transport is starting to pick up pace, “renewables are growing too slowly in major energy-consuming sectors like buildings and industry”, reckons the International Renewable Energy Agency. This is despite buildings being the “largest potential for delivering long-term, significant and cost-effective greenhouse gas emission reductions”, according to the UN Environment Programme.
Overall, the UN has identified “significant financing shortfalls in getting [countries] to the stage where they provide real protection against droughts, floods, and rising sea levels”.
Squaring the circle
How do we square this circle of ballooning ESG asset flows alongside too little financing? One answer is to be found in where ESG investments are going. The world’s largest ESG-flagged ETF’s top holdings are Apple, Microsoft, Amazon, Facebook, and Alphabet. The world’s largest 'conventional' ETF, however, has the same five stocks in the same order, albeit with slightly different weightings.
If you strip out the demand for ESG funds – considerable though it is – the same sectors and assets would still be prominent. Going back four years, to June 2017, the same conventional ETF holds Apple, Microsoft, Amazon, and Facebook as its top four holdings. Add up the two share classes for Alphabet, and it, too, easily makes it into the top five.
Facebook is not spearheading a drive to sustainable agriculture, even if Mark Zuckerberg looks like he has been hewn from a length of quorn; Amazon is not developing eco-friendly cities, unless your definition of this relies heavily on Elysium and you have a highly optimistic view of Jeff Bezos’ orbital ambitions.
That does not mean they are bad businesses, it is just that is not what they are for.
Many of the largest ethical funds provide portfolios of assets that have positive ESG scores, not least through low greenhouse gas emissions. That is fine as an investment strategy, and investors have many reasons to be satisfied with the results.
To be clear: I am not criticising this as an investment approach, but highlighting that its popularity does not constitute a generalised ESG bubble. Many stocks that make it through ESG screens may be richly valued (hardly an anomaly in 2021), but that is not the same thing.
Supply, meet demand
It seems wide of the mark to see this as an ESG bubble when there is still a shortfall of capital to many areas that are crucial to the transition to a sustainable economy. That could be because certain relevant technologies are in their infancy, and therefore too high a risk for many investors (some important areas are essentially venture capital plays, for example), lack of relevant investment vehicles (possibly indicated by the low level of ESG bond fund launches), or insufficient investor information about key areas.
Should investors worry about the valuations of certain stocks and sectors? That would seem prudent. Does this mean that there is a specific ESG bubble? I do not think that case has been made. Indeed, unless you are of the opinion that global warming is a bizarre conspiracy, or an Excel error to dwarf anything done by Rogoff and Reinhardt, it is underfunded. By a long chalk.
The challenge is to connect supply with demand in a way that will help meet sustainability targets and which satisfies investors’ risk profiles and diversification needs.
Dewi John is head of research, UK & Ireland, at Refinitiv Lipper
