By Andrew Wetzlel, CFA®, Managing Director of Sustainable Investing
As we look back on sustainable investing in 2022, our outlook for a more challenging market growth and product development environment as industry standards and regulations developed was on the mark. What we underestimated was the level of politicization and backlash as confusion around sustainable investing went mainstream. The media, politicians, and even a major electric vehicle company CEO created a cacophony of confusion as they tied ESG to values-based exclusions around oil and gas, weapons, and even failed government policies. Against this backdrop, the investment industry has retrenched and reevaluated its sustainability marketing, creating a foundation for improved transparency and future growth.
As we have discussed many times in our communications, ESG is simply the analysis of material environmental, social, and governance risk factors. It is not values-based exclusions, thematic growth opportunities, or impact (please see our 2022 Q2 Market Outlook Sustainability article for more detail). The investment industry is increasingly centering on this understanding of ESG and differentiating ESG from these other sustainable investing approaches. The CFA Institute ESG Disclosure Standards along with European regulations and proposed SEC guidelines have started to create momentum toward a common language. The keys to combatting confusion and greenwashing are a common language, improved communication, and increased transparency.
Emerging standards and regulatory scrutiny have put a spotlight on sustainability marketing claims and fund classifications. The USSIF, a long-standing industry organization, modified guidelines for fund inclusion in their biennial sustainable investing industry survey. The recently released 2022 report shows total sustainable assets under management (AUM) in the US of $8.4 trillion, down from $17.1 trillion in 2020, as firms deemed to have insufficient disclosure were no longer counted in the latest report.
The retrenchment and reevaluation of sustainable funds in the US and around the world in 2022 is a healthy development. F.L.Putnam has carefully distinguished between sustainable investing approaches because we know that each has distinct risk and return characteristics, and clients have a range of implementation needs. We are encouraged to see the broader industry moving beyond marketing taglines and toward better communication of the detail and nuance that matters in this part of the market. Our hope for 2023 and longer-term is that some of this clarity feeds through to the broader conversation around sustainability in media and political circles.
For 2023, our top 5 trends to watch are:
⚖️Regulatory developments lead to additional refinement of fund development and marketing
📈Corporations are pressured to provide consistent disclosure, improving credibility of data and targets
🔍Private market investors seek greater detail and transparency around sustainability approaches
🌎Climate adaptation increasingly an area of focus for investors as are biodiversity and natural capital
🔄A growing acceptance of credible improvement or transition plans at corporations
A note on improvement and transition opportunities:
An improver is a company moving toward better management of its ESG risk, while a transition company is one where the mix of products or services is shifting to something more environmentally or socially beneficial.
An academic paper published in April of 2022, ESG Rating Score Revisions and Stock Returns, explored the effects of ratings changes on stock returns over medium-term holding periods. Among many interesting conclusions, the authors found a 3-percentage point spread between upgraded and downgraded stocks and note that downgraded stocks experience a drop in return on assets relative to upgraded stocks after a revision. The takeaway is that ESG ratings changes can contribute to relative performance as investors assess the information content of revisions including fundamental factors. It is increasingly important for investors to assess the potential for ESG rating changes along with other return drivers in active investment strategies. Identifying improvers may well add value over time.
In contrast to changes at the margin around ESG risk ratings, transition opportunities are more about a shifting business model or product/service mix. Recent research from Morgan Stanley identified businesses that are transitioning toward more environmentally beneficial products or services. One notable conclusion from the report was the relative performance spread between utility companies that are actively shifting from a higher carbon intensity toward a lower carbon profile and those that have already lowered their carbon footprints. From the end of 2014 through mid-2022, Morgan Stanley’s “Active Rate of Change” basket outperformed the lower carbon intensity utility basket by about 8% per year. In this case, shifting from higher-cost coal generation to lower-carbon and lower-cost sources of generation has been beneficial both economically and environmentally.
While there are opportunities ahead for both ESG improvers and environmental transitions, it is important to note that these businesses often don’t “screen” well on traditional sustainability metrics for most sustainable investors. Therein lies the challenge and the opportunity. Our approach to both improvers and transitions is to focus on the details, assess past performance, current targets, and likelihood of success. We will explore these opportunities in more detail in future letters.