Capital Markets Embrace Sustainability: Three Factors That Drive Inflows Into ESG Assets

Capital Markets Embrace Sustainability: Three Factors That Drive Inflows Into ESG Assets

Financial market infrastructures like SIX with its stock exchanges in Switzerland and Spain are playing an increasingly important role in helping sustainable companies – or those in transition – obtain financing through the capital markets. The ascendency of ESG-linked assets, i.e. those taking environmental, social or governance factors into account, shows no sign of decelerating. However, some challenges are not yet resolved.

Assets invested in ESG-linked funds have enjoyed remarkable growth in 2020: Despite all of the volatility unleashed by COVID-19, sustainable funds’ assets under management (AuM), according to the Financial Times, hit 1.7 trillion US dollars, a 50% increase over the course of the year. And the boom continues: In the first three months of 2021, Morningstar notes that 185.3 billion US dollars had already entered into global sustainable funds pushing their AuM over the 2 trillion US dollar mark. On the passive side, Bloomberg says ESG exchange traded funds (ETF) assets could surpass 190 billion US dollars by year-end, adding 1 trillion US dollars that could enter the asset class over the next five years. The majority of this activity is taking place inside Europe, although experts highlight that Asia and the US are beginning to catch-up.

“Here in Spain, we are seeing a lot of activity in terms of sustainable bonds”, says Gonzalo Gómez Retuerto, who heads the Fixed Income Unit of the exchanges of SIX in Spain (BME), which includes the regulated and the alternative fixed income markets. According to Bloomberg sustainable bonds – instruments which let issuers use proceeds to fund green and social programs – increased by 81% worldwide to reach 68.7 billion US dollars last year, with social bond issuances jumped sevenfold to 147.7 billion US dollars as governments and companies borrowed for relief from the pandemic. 

But what makes such investment products interesting for investors? Read on for three factors that are driving inflows into ESG assets.

Three Factors That Drive Inflows into ESG Assets

1. Performance

“One of the most attractive elements of ESG assets over the last 34 months or so has been their superior performance, at least when benchmarked against the returns or yields produced by non-ESG assets,” says Jesus Gonzalez Nieto, head of the Spanish SME equity market "BME Growth". This is backed up by empirical analysis. For example, data from Fidelity’s “Putting Sustainability to the Test” report found that stocks which scored highly on the asset manager’s ESG rating scale outperformed those with weaker ratings in every month bar one between January and September 2020. Of the 2,660 companies analyzed, Fidelity found stocks with the worst ESG ratings depreciated by 23% in those nine months – whereas companies which scored highly returned 0.4%.

There is also strong evidence indicating that ESG bonds outperform non-ESG bonds. Research by Nordea, for example, found that green bonds outperformed in the secondary market during the COVID-19 risk-off period.

2. Risk Management

With investors channeling more money away from energy intensive industries in favor of renewables, and lawmakers imposing restrictions on pollutant businesses, experts believe some companies – if they fail to reform – could become obsolete. Economists call this stranded asset risk. If investors hold positions in these companies, those assets will effectively become worthless. Such fears have already prompted high profile investors such as Norway’s 1 trillion US dollar sovereign wealth fund to reduce exposures to major commodity and utility companies.

However, it’s critically important for institutions to invest in sectors which at the moment may not be considered entirely sustainable, but which require funding to become greener in the future said Karoline Rosenberg, a fund manager at Fidelity, when speaking at the BME annual Foro Medcap Conference in May 2021. Such financing, she continued, is helping previously pollutant sectors, such as the automobile industry, green themselves through the development of electric-vehicle fleets.

3. Regulation

The pivot by global investors towards ESG assets has been abetted by new regulations too. “Inside the EU, sustainability has been top of the political agenda for a long time. For example, the European Commission is pushing through with a sustainable finance package,” says Jesus Gonzalez Nieto. The Sustainable Finance Disclosure Regulation (SFDR) came into force in March 2021, and applies to asset managers, insurance companies and banks. Under the rules, impacted institutions must disclose how they factor in sustainability risks into their investment processes.

The next milestone will be the introduction of a EU taxonomy designed to purge the financial services industry of greenwashing. With the taxonomy a framework will be established outlining which economic activities can be considered sustainable. “There are a huge number of initiatives around standards in markets such as the EU, UK and Singapore and it does make the whole process very complicated", says Rebecca self, a sustainability expert. 

An Asset Class Not without Challenges

Rebecca Self is Director of Sustainable Finance at the sustainability agency South Pole that is specialized in climate issues. She adressed the current competing ESG standards and rating agency scoring systems at a panel discussion of SIX on "ESG and the real economy" in May 2021: "It has taken 50 to 60 years to get comparable standards around accounting. We simply do not have  time to wait this long for ESG standards,” she urged. 

Even ESG ratings are not without problems as the analysis of the rating ageencies could be potentially quite subjective. The methodologies applied when calculating ESG scores are not standardized meaning different agencies can produce wildly different results for identical companies. This is not solely the fault of ratings agencies. As the data which these agencies are obtaining from companies and issuers is rarely standardized, it is incredibly difficult for them to measure ESG performance accurately.

In addition to enabling greater ESG activity, financial market infrastructures are therefore also striving to promote industry best practices. SIX and its exchanges are participating in a number of industry initiatives and national and international working groups. “The Spanish stock exchange, for example, is actively involved in setting up industry standards around ESG bonds and equity securities,” stresses Gómez Retuerto. “This is something we will continue to work on.”