Is the energy crisis pushing ESG investing out of favour?
The recent drawdown is largely the result of the broader setback in optimism and not a failure of the strategy itself
AFTER several years of remarkable capital flows into the world of environmental, social and governance (ESG) and sustainable finance, 2022 turned out to be rather underwhelming.
While even the funds that consider ESG factors have not been immune to the market disruption triggered by the Russia-Ukraine war, their flows have proved to be more resilient than the broader market.
In sharp contrast to conventional funds, which faced large outflows in 2022, global sustainable fund flows remained in positive territory, although at a much lower level than in 2021.
However, they are showing signs of improvement.
According to a Morningstar report, global sustainable funds attracted nearly US$37 billion in net new money in Q4 2022, which was 50 per cent and 22 per cent higher than the third and second quarters, respectively.
Yet, flows at the regional and country levels reveal a mixed picture.
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The rebound in net new money into sustainable funds was seen in only three regions: Europe, which is the dominant market; Australia; and Canada. Sustainable funds in the rest of the world witnessed outflows.
Roadblocks for ESG growth
There have been several roadblocks in the way of ESG’s growth rally.
For a start, companies that fare well in terms of sustainability and have high ESG ratings are often growth companies.
However, these have suffered due to the rotation towards value companies given higher inflation, rising rates, and potential recession risks.
Further, higher oil and gas prices have resulted in strong performance by energy stocks.
This is prompting many investors – particularly those who have dismissed fossil fuels entirely from their portfolios – to reconsider their investment preferences.
Secondly, there is a widespread misconception that ESG is inflationary.
It is believed that the ESG movement has led to lower investments in traditional forms of energy, resulting in oil and gas scarcity, higher prices and, ultimately, higher consumer costs.
In reality, it is the culmination of many issues, with supply constraints stemming from the Russia-Ukraine war at the top of the list.
Lastly, the rapid growth in recent years has attracted many bad actors looking to capitalise on the sustainability trend.
Inconsistencies in ratings have obscured what qualifies as adhering to ESG principles, leading to a lack of investor confidence.
Where does ESG investing go from here?
While the recent decline in financial markets has put ESG investing to the test, the scrutiny in recent months appears to be a healthy and long-overdue sanity check. The strategy has become quite popular in the post-pandemic period and currently appears to be in the consolidation phase – which is normal for any maturing cycle.
Investing sustainably does not mean that investors have to settle for lower returns.
In fact, as shown in the chart below, when measured over a longer period of time, sustainable funds outperform non-sustainable funds.
Sustainable funds may have underperformed in 2022 in part because the previous year was exceptionally good for fossil fuels. Yet, returns were not significantly lower.
It is important to understand that sustainable investments require a longer time horizon and are not necessarily impervious to the short-term effects of traditional macroeconomic variables.
Companies often need time to shift their businesses and processes in order to achieve their ESG goals, which should reflect on their performance in the longer run.
In our opinion, the recent ESG drawdown is largely the result of the broader setback in optimism and not a failure of the strategy itself.
Therefore, there is a need for more robust data to lift investor sentiment.
The level of outcry that we are seeing, to the extent that it increases investor transparency, is actually a win for sustainable investing.
It should enable a much-needed shift away from high-speed growth, towards quality growth.
Better disclosures should benefit businesses as well as they instil greater trust, which could affect both the revenues as well as capital costs of companies.
For the time being, governments may favour energy security over carbon intensity. But high energy prices are undoubtedly a catalyst for a shift towards renewables, which is already underway.
We believe that integrating ESG principles continues to be beneficial for businesses, investors, and society as a whole. This will be especially true as supply issues fade away and energy prices stabilise.
Banks to play a leading role
Increasingly, banks need to take the lead in recognising the growing importance of incorporating sustainability risks into the overall risk management framework. Importantly, this must also be integrated into the investment advisory processes.
For example, Julius Baer has a proprietary ESG rating system that is largely based on granular ESG data and incorporates the expertise of our in-house experts in a systematic manner.
Despite the lack of exposure to traditional energy companies, the sustainability-focused strategies in our portfolio have outperformed their traditional counterparts amid the ongoing energy crisis.
This confirms our belief that ESG can help to better identify and understand structural business growth and responsible corporate behaviour. Both of these are important determinants of financial performance and, as a result, positive for portfolio management.
We have also observed that most investors are emotionally tied to their portfolios, and that sustainability is ultimately subjective and cannot be treated with a one-size-fits-all approach.
Therefore, in addition to providing the necessary regulatory classification, we focus on identifying the key ESG themes related to climate, biodiversity, governance, or social matters, allowing investors to tailor their portfolios to their own personal values and beliefs.
The uptake of ESG-focused investment funds may have slowed in 2022. But rather than the end of ESG, we believe 2023 may be the beginning of its next phase.
Pearlyn Wong is head of investment promotion & solutions for Asia at Julius Baer; Cheryl Tan is head of fund specialists for Apac at Julius Baer
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