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Sustainable funds will sing a different tune from now

Sustainable fundsRecessions and greenwashing scandals will blow over. What matters is how asset managers dynamically resize risks and opportunities, shore up credibility, comply with regulations and prepare for the next 10-15 years of rapid growth. By Abhik Pal and Rahul Agarwal.

Let’s lay it on the line: sustainable funds didn’t dazzle in 2022.

Environmental, social and governance (ESG) benchmarks underperformed the broader market. The MSCI World ESG leader index was down 17.2% in the first eleven months of 2022, nearly 80 basis points lower than the MSCI ACWI Index.

But neither did they go under.

On the contrary, global sustainable funds attracted $143 billion of net new money over the first nine months of 2022, compared with the overall global fund universe that witnessed outflows of $335 billion, according to a Morningstar report.

Passive funds continued to witness stellar inflows. Among labelled funds, Article 9, or ‘dark green’, funds — with sustainable investment as their objective as defined by the Sustainable Finance Disclosure Regulation (SFDR) — recorded positive inflows, while Article 8 and Article 6 (lighter shades of sustainability in their contracts) saw outflows.

In all this time, Russia’s invasion of Ukraine, unabating inflation risks and rising interest rates have been busy tipping major economies into recession.

Even as the returns on sustainable funds have been impacted by such scares and cyclical factors linked to higher energy prices and a deep correction in the tech sector, the industry is being called upon to keep greenwashing and scandal at bay.

Yet, the long-term picture looks intact. Here are three reasons why we think so:

1) A secular green CapEx cycle is underway

To be sure, recession risks are clouding the market. Threats to energy supplies have meant backsliding on commitments to phase out fossil fuels. But these are temporary bumps.

The climate crisis is not going anywhere, and the world needs a long-lasting green CapEx cycle to pull off a sustainable energy transition. Latest estimates by the United Nations Environment Programme indicate that at least $4-6 trillion of investments would be needed annually for countries to meet net zero by 2050. In the next 10-15 years, massive investments will get off the ground as governments act on their paper commitments.

That has already begun.

The Inflation Reduction Act of 2022, enacted by the US Congress in August 2022, has committed to spending $370 billion on diverse climate initiatives, including such as tax credits, grants and loans, and consumer rebates towards electric vehicles and decarbonisation of residential buildings. The 2020 European Green Deal has sought to mobilise at least €1 trillion in sustainable investments over the next decade.

These, and the breakthrough to establish a loss and damage fund at COP27 to ease the pressure on climate-vulnerable developing countries, means a gush of business for climate financiers and climate-focused funds around the world.

2) The sustainable debt market is growing

The sustainable debt universe has surged 1.5x over the past 12 months to $4.4 trillion at end-3Q22, according to the International Institute of Finance. Despite the growth, ESG fixed income (FI) funds accounted for a mere ~3% of the FI fund assets compared with ~5% for equities.

That said, the sustainable FI investing segment will benefit from a continued multi-fold rise in the supply of sustainable debt across issuers. For instance, the green bonds issuance market is projected to increase from $2 trillion at end-3Q22 to $5 trillion by 2025. This will provide the much-needed firepower to sustainable FI investing.

3) Changing regulations are seeking to put greenwashing concerns to rest

Accusations of greenwashing against sustainable funds got louder this year. While the first phase of SFDR has brought some sanctity to the design and disclosures of sustainable investing products, we expect SFDR 2 to go a step further and streamline products.

Further, the European Securities and Market Authority has recently published a consultation paper on guidelines in relation to fund names, including mandated quantitative thresholds to be met for the usage of ESG and sustainability-related terminology in names. Similar regulatory action on product disclosures is coming from the US Securities and Exchange Commission and the UK’s Financial Conduct Authority.

This should drive up investor confidence and accelerate flows towards sustainable funds.

So what next for asset managers?

As investors and regulators shift gears, asset managers must focus on three key aspects to differentiate their offerings while quelling greenwashing concerns.

First, they will need to ensure deeper integration of ESG within their fixed income portfolios across corporate, sovereign and municipals.

Second, to improve product credibility, managers will need to conduct robust company-level mapping of green revenues and SDG outcomes, estimate forward-looking carbon emissions, and track temperature alignment.

Finally, managers will need to go beyond external ratings and labels. They will need a detailed bottom-up analysis to ensure ESG opportunities and risks are reflected in the financial model, valuation and credit spreads.

This will prime them for what promises to be a steady stream of demand for climate-change solutions, transition financing and social impact products for years to come.

The entire sustainable financing ecosystem comprising asset managers, lenders and development banks are critical to green and impact funding. It is essential for asset managers to get their act together to garner their share of the pie.

Abhik Pal is global head of research and ESG and Rahul Agarwal is head of ESG practice at CRISIL

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