The coronavirus (COVID-19) pandemic has been a boon for environmental, social and governance (ESG) funds, 85% of which are now outperforming their non-ESG peers, according to a paper released by the Institute of International Finance (IIF) on June 18.

As bne IntelliNews reported, companies can be punished for not paying attention to their ESG obligations, but until recently those companies that invested heavily in improving their environment and social scores in particular were not rewarded with a premium to their share price either.

In Russia the most obvious example is Norilsk Nickel. The Norwegian state pension fund banned its funds from investing in Russia’s metallurgical powerhouse, and one of the most popular stocks on the Russian exchange, because of its terrible pollution record. According to some reports, up to a third of its shareholders had to divest from the name, despite the strong company financials and the generous dividends the company pays.

The management responded by pouring $2bn into cleaning up its emissions and reducing its sulphur dioxide emissions in particular, one of the Paris Accord prescribed gases. The company plans to spend another $3bn on continuing its clean-up and has already closed down some plants on the basis of their large emissions of pollutants. However, the Norwegian ban has not been lifted and the stock has not benefited. The management complains that investing in ESG compliance only adds to its costs and does nothing for its profitability.

That may have changed as a result of the coronacrisis.

 

“Sustainable strategies pay off: with the COVID-19 pandemic serving as a real-life “stress test” for ESG investing strategies, the relative performance of sustainable assets has been remarkable this year,” Emre Tiftik, director of Sustainability Research at IIF, said in a paper co-authored with members of the IIF sustainability team.

“In our sample of 41 sustainable equity indices, over 75% of sustainable indices have outperformed non-ESG peers year to date, by a substantial 8 percentage points for the median fund. The resilience of ESG equity indices was even more striking during the sharp COVID-19 sell-off in risk assets in Q1 2020: 85% outperformed their broad market counterparts. While ESG equity performance has been less stellar in Q2, more than 80% of the ESG-focused equity indices in our sample have significantly outperformed their counterparts since end-2015,” Tiftik said.

The trend also extends to ESG bonds, which have also outperformed, according to IIF. Across a commonly used set of 10 fixed-income ESG indices, 70% of them have outperformed their non-ESG counterparts this year, according to IIF.

While ESG-compliant bonds had returns that were on a par with those of non-ESG benchmarks in the first quarter of this year, 80% of ESG-dedicated fixed income indices have outperformed during the second-quarter recovery in the market relative to conventional peers.

 

The results will be welcomed by companies that are increasingly investing into ESG strategies despite the lack of rewards. The feeling amongst most corporates is that the need to be ESG compliant is inevitable and that regulation will come eventually. Moreover, fund managers are increasingly demanding ESG compliance, as they are under pressure from their investors, especially retail investors, for ESG-compliant portfolios. Having said that, ESG funds' share of the market is still in the single digits.

“Out of over 135,000 funds worldwide, only 3,500 – or 2.5% – are ESG-focused,” reports IIF. “However, with appetite for ESG investments growing rapidly in recent years, assets under management of ESG-focused funds have risen from some $340bn in 2015 to over $1 trillion at present.”

ESG funds are dominated by equity funds, which account for a bit less than two-thirds of the total (60%), but the ESG-dedicated fixed income and mixed-allocation funds are growing faster and have more than tripled since 2015, says IIF. The advent of products such as “green bonds” and exchanges to host them are helping to drive the change.

“This is in Greening the fund universe: this is in line with robust sustainable bond and loan issuance activity since the Paris Climate Agreement in December 2015.”

 

ESG funds are concentrated in Europe, which is the region most sensitive to the need to go green and where the majority of regulations covering ESG have been imposed. The US securities market has noticeably imposed no ESG compliance restrictions on funds at all. Having said that, the size of US-domiciled ESG funds market has doubled since 2015, and now accounts for over 20% of the universe, due to rising demand from investors.

ESG funds in emerging markets (EM) remain underdeveloped. The total assets under management in EM funds are currently $28bn, of which ESG funds represent less than 3% of the total.

 

By fund type, over 85% of ESG-funds are in the form of traditional open-end funds. However, exchange-traded funds (ETFs) are becoming increasingly important. Since 2015, the AUM of ESG-focused ETFs has grown by some 15x, surpassing $110bn in early June 2015 – and now comprising over 10% of the market, according to IIF.

With demand for sustainable debt instruments picking up, year-to-date issuance of sustainable bonds and loans has surpassed $200bn.

“The launch of new frameworks, including ICMA’s Sustainability-linked Bond Principles (SLBP), should add to the momentum,” says IIF. “These voluntary guidelines for sustainability-linked bonds, with debt terms tied to specific ESG goals and general use of proceeds, are less restrictive compared to “activity-based” green bond principles and aim to incentivise broad-based behaviour change on the part of issuers.”

Introduced in the second half of last year, the SLBP bonds have seen cumulative issuance of $5bn to date. Similarly, issuance of sustainability-linked loans has reached $200bn since inception – moving more into the mainstream due to the introduction of Sustainability-linked Loan Principles (SLLP) in 2019.

Another noteworthy mention is the evolving universe of ‘transition-oriented’ financial products, including transition bonds.

Introduced in 2017, transition bonds are designed for firms with high greenhouse gas (GHG) emissions looking to raise funds and transition their business models towards greener or lower-carbon activities or forms of production. These have been dubbed “brown bonds” that want to become greener.

The more politely labelled “transition bond” allows issuers from these industries to fund their transition to a low-carbon economy (bridging the funding gap) and reduce the negative impact of their activities (e.g., deforestation, overfishing, etc.).

The transition bond market is still at a nascent stage of development with only a handful of issuers to date – cumulative issuance is around $2bn. Given the broad range and importance of the included industries, this market has significant potential for more growth and development, according to IIF.