Socially Responsible Investing is Coming of Age

COVID-19 has forced investors to re-evaluate how we live our lives and, for some, how we invest. The fields of “green finance” and socially responsible investing could be major beneficiaries of this tipping point. This is an investment space exploding in the UK.

Even prior to the coronavirus, massive amounts of money were shifting towards environmentally conscious investing. This has taken different forms. By the broadest measure over $31trn has been invested in assets that have been screened to sift out companies scoring poorly on environmental, social or governance (ESG) concerns. This covers a broad span of asset classes, covering stocks, mutual funds, exchange-traded funds, and bonds.

“Green bonds” represent the simplest and most established form of green finance. Gaining significant traction in recent years, these bonds fund environmentally friendly projects. Nonetheless, green bonds still only account for a small piece of a massive broader bond market and suggests a huge potential addressable market.

The problem currently is that green bonds are quite restrictive. Their proceeds have to be used exclusively for green purposes. That has left many companies uncertain whether they would qualify. As a result, there has been a surge in a wider range of debt market instruments designed to be less restrictive and bridge the gap. For example, transition bonds are a separate asset class that help a “brown” company switch to a greener business model.

Transition bonds have come under scrutiny and have been criticised on the grounds that brown industries, such as cattle farming, cannot ever be environmentally sustainable due to the very nature of their business, challenging any green tag. Despite the criticism, transition bonds are growing in popularity.

From a UK investor’s perspective, evidence so far suggests there’s little difference in the performance of green and traditional bonds. However, an increasing body of research suggests that investment strategies that focus on ESG goals do better. This is probably because they screen out poorly run firms.

Total assets in ESG and socially responsible ETFs ($bn)

 

However, investing in this space is not straightforward. Sustainable investing is supposed to steer money towards companies with stronger ESG standards. But so-called “greenwashing” is a risk. This is where a company conveys a false impression about how its products or processes are more environmentally sound. By doing so, the company can attract investors looking to investor in ESG-friendly investments.

Critics complain about a lack of global standards and inconsistency among ESG scoring methods. The European Union proposed a green bond standard and verification system back in June 2019, potentially creating a benchmark that could ease the sale of green securities worldwide. But we are a long way from seeing universal adoption. This is partly because companies in different parts of the world diverge on how to approach growth and governance.

Still, the frontier for much of growth in green finance will come from developing markets. China’s green bond market has rushed ahead as part of the government’s effort to limit air pollution. Countries short of capital such as Nigeria and Indonesia also see green lending as an approach in which to build out their infrastructure, in a way that will support modernisation of their economies. But they are also locations where projects are most likely to have less transparency and pose more risk.

Assets of sustainable mutual funds and ETFs, 2013 – 2028

 

And while climate change has meant many investors have focused on the “E” in ESG (i.e. the environment), recent events have significantly raised the profile of the “S”. The coronavirus and widespread protests over racial injustices are giving the social dimension a big boost. Social impact bonds have become the fastest-growing part of sustainable finance, with more sold in the first half of this year than in all of 2019.

Capitalism itself is under scrutiny. Investors are accelerating their efforts for a lower-carbon global economy. Investment strategies are increasingly seeking to consider both financial return and social/environmental good to bring about social change. Socially responsible investing is here to stay.

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