The Good and Bad of ESG Investing Today

Continued Forward Momentum

As the world continues to experience the undeniable effects of rising global temperatures, governments and company stakeholders have slowly begun to address climate change. The Paris Agreement of 2016 established a worldwide framework aimed at keeping the average global temperature rise below 2 degrees Celsius. Since then, much of the globe has moved from seeing sustainable investing as a grand idea to seeing it as a compelling reality — one that affects all of us.

The COVID-19 pandemic went global in 2020 and drew additional attention to how tightly interconnected our civilization is at every level: from how public-health measures in a community can have worldwide implications, to how apparently minor local perturbations of the global supply chains can interact nonlinearly and result in enduring reverberations. At the same time, perhaps not unrelatedly, there was an intensification of social protests, concentrated in the U.S., but represented globally. One positive consequence of all this was the increasingly widespread realization that social and governance concerns really are reasonable considerations when evaluating public companies, further legitimizing the core tenets of ESG investing.

Sustainable Investing Sets Records

This legitimization has directly led to a level of interest in environmental, social, and governance (ESG) investing that has never been higher. According to Morningstar:¹

• Global sustainable fund assets expanded by 9% in the fourth quarter to US$2.74 trillion at the end of December 2021 (see figure below).
• Inflows grew as well, driven by continued investor interest in ESG issues and by facilitating regulation. Investors poured US$142 billion into sustainable funds globally, representing a 12% increase relative to the third quarter.
• Continuing to dominate the sustainable space, Europe accounted for close to 80% of fourth-quarter inflows, while the United States accounted for 10%. Flows clocked in at US$15 billion for Canada, Australia, New Zealand, Japan, and Asia combined.
• Product development remained strong, with 266 new sustainable fund launches globally in Q4 2021. Asset managers also continued to repurpose and rebrand conventional products into sustainable offerings (e.g., Intech Global Enhanced Plus – ESG).

Regulatory Landscape

The regulatory picture has increased pressure for investment organizations to move toward a sustainable investing model. Last year, the U.S. Department of Labor proposed rules that would permit retirement plan fiduciaries to consider ESG matters in their investment decision-making and voting decisions as shareholders. And in Europe, where sustainable investing is at a more advanced stage of its lifecycle, regulators raised the bar for “sustainable” strategies with a flurry of regulations, including the introduction of the EU Sustainable Finance Disclosure Regulation. The new rules aim to make the sustainability profile of funds more easily comparable to each other and better understood by end-investors.

ESG Virtuous Cycle or Grade Inflation?

In the context of this strong demand for sustainable investment strategies in recent years and improving regulatory guidance, it’s interesting to note the behavior of index ESG scores, for example the capitalization-weighted average of the composite ESG score as computed by MSCI, which is shown for the MSCI World and the MSCI EAFE Index in the figure below.

The chart starts in 2007 when MSCI ESG data first became available, and there’s an initial equilibration period of a few years, which can be attributed partly to an increase in the quality of the data, and partly to the normalization following the Global Financial Crisis. After that, we see a consistent period of ESG improvement, which starts earlier and from a higher reference point for stocks outside the U.S.

The natural explanation for this improvement is a virtuous cycle whereby more capital flows to companies with higher ESG scores, which in turn creates an incentive for companies to improve their ESG scores. It’s difficult to independently verify how much of that improvement is genuine, but the effect appears to be too consistent and too broad to be completely explainable through greenwashing.

But that was then.

Challenged Returns in First Quarter 2022

Since the invasion of Ukraine by Russia on February 24^th, 2022, the resulting economic and financial fallout has caused some investors to question the continued relevance of ESG strategies. The initial shock appeared to immediately challenge some common assumptions about ESG investing. Further, the ongoing intensification of sanctions by western countries and the resulting reorganization of the global economy is raising concerns about well-established assumptions regarding investment opportunities and goals, including the long-term role of ESG approaches.

The acceleration of energy trends, which originally started after a pivotal point early in the pandemic, has increased the performance gap between the energy sector and the broad market since the beginning of the year.

This appears to challenge ESG approaches both by making fossil fuels more economically attractive as a component of equity portfolios, and by making a case for increasing fossil-fuel production in countries that are not controlled by autocratic regimes, through directing capital flow to them. Similarly, non-energy extractive industries such as mining stocks, which are typically unattractive to ESG portfolios, have been presented both as a must-have, high-return asset, and as an investment priority of strategic importance for western democracies (see figure below). As another argument in the same vein, the Russian invasion has even been used to allege that arms manufacturing also deserves more investment as a bulwark against military aggression.