Sustainable Investing: The New Black of the Financial Markets

In recent years, a new trend has emerged in the financial markets – sustainable investing. It has become the “new black” of the industry. In the field of investment funds, almost all new money in Europe is invested in sustainable funds, and already two-thirds of European exchange-traded funds, or ETFs, take sustainability factors into account. So what is sustainable investing, how does it manifest itself in practice and what are the results so far?

Generally speaking, sustainable investing takes environmental, social and governance (ESG) metrics into account with the goal of earning ethically, not in the short term, but in the long term and with less risk. The main types of ESG integration in investment are inclusion, exclusion and engagement. Inclusion is investing in companies with high sustainability ratings, such as solar panel manufacturers with high sustainability (ESG) ratings. Exclusion is the avoidance of investments with low sustainability parameters, such as not investing in tobacco, arms or oil producers. On the other hand, engagement is addressing companies with the aim of improving sustainability parameters.

How does the investment field evaluate ESG parameters?

“E” is an environmental factor, and the main indicator here is the company’s intensity of direct and indirect greenhouse gas emissions – usually looking at the company’s CO2 (equivalent) tons per $1 million in revenue. However, other factors are also important, such as the company’s climate, waste management, and natural resource policies. “S” is a social factor, and in this case the company’s policy towards employees, customers, suppliers and society as a whole is evaluated. For example, how safe is the working environment, is there an ethical attitude towards customers, do suppliers meet ESG standards, does the company help solve social problems? On the other hand, “G” is the governance factor, and investors here look at the corporate governance aspects of the company. How independent is the company’s board and council, is it inclusive, what is the proportion of women and minorities, what is the board’s remuneration policy and the company’s anti-corruption and risk management policy? These are just some of the parameters that are evaluated.

It should be noted, however, that the most popular form of ESG integration in financial markets is exclusion. Practice shows that most often 5 to 75% of all companies in the market or index are filtered out, depending on the level of sustainability chosen by the investor. The remaining issuers are then invested accordingly and are considered sustainable investments. Every year, the amount of such investments increases, but in Europe, according to market participants, practically all new money flows into sustainable investments. If we look at the European ETF market, now every third ETF takes sustainability factors into account: out of 1,900 UCITS ETFs, 600 already have ESG filters. Conventional funds (not ETFs), on the other hand, were still in a hurry to change the mandate to sustainable investments.

How is a sustainable fund typically built?

It all starts with the ESG methodology, or approach to filtering companies. Each issuer is given an ESG rating, and then companies (or even entire industries) with low ratings are excluded, while issuers with high ratings are preferred. The most popular providers of ESG ratings are MSCI and Sustainalytics. In this way, the “softest” MSCI ESG-filtered index – ESG Screened – excludes around 7% of all companies, while the “strictest” – SRI (socially responsible investments) – excludes 75% of all issuers. Index methodology generally attempts to maintain cross-sector weights (with the exception of the oil and gas industry, which is often excluded entirely). However, as a result, sustainable investing typically means investing more in technology and healthcare large companies, and less in oil and gas producers and small businesses.

How financially profitable have sustainable investments been so far?

Judging by the MSCI ESG stock market indices, until 2018 the dynamics of sustainable investments were practically equal to the so-called conventional indices. However, with the year 2018, ESG investments began to overtake broad market indices. For example, the “greenest” and the most popular MSCI World SRI index (which filters 75% of all companies according to ESG parameters) has outperformed the regular MSCI World index by 9% from the end of 2017 to today. 2022 was the only year when green investments struggled. It was a year when several financial market trends turned upside down – bond markets showed the biggest drop in history, shares of the technology sector fell, but oil and gas companies did the best (MSCI World Energy +55% in EUR terms, when MSCI World -13%) .

Most likely, the positive dynamics of ESG investments so far was related to the influx of new money into this investment idea, and now many are asking the question – has it remained “expensive”? On a P/E basis (the company’s corporate earnings divided by the company’s market value), the MSCI World SRI Index is 18% more expensive than the MSCI World. But here it should be noted that if you invest sustainably, you will in any case invest more in the technology sector, where the P/E valuations are high, because the expected growth of the companies is higher.

Sources: Swedbank, Bloomberg

It should be noted that any new positive trend also has negative aspects. For sustainable investments, they are: 1) reduced diversification, 2) inconsistency with reality (we avoid investing in CO2-intensive companies, but drive by private transport, fly by airplanes), 3) exit of unethical and polluting companies from public markets to private ones and 4) politicization of the financial market. When it comes to diversification, indeed, by excluding 5% to 75% of companies, diversification suffers. However, history shows that despite the exclusion of issuers, ESG and SRI indices have not been more volatile than broad indices. As for the departure of “unsustainable” companies from public markets, in any case, it will be difficult for such companies to attract financing, because even private banks, trying to improve their sustainability parameters, will not offer financing. Politicization of the market – the question remains open to what extent the ESG trend is the merit of left-wing political forces and how it will develop when right-wing parties continue to come to power in the US and elsewhere in the world.

All in all, investing sustainably has not only been ethically but also financially beneficial so far. Most likely, this was due to the great interest of investors and the inflow of money into this investment idea. It should be remembered that the financial goal of sustainable investing is not to make money in the short term, but in the long term and with less risk. In addition, sustainable investing is still a new and rapidly evolving form of investing. Therefore, it should not be written off at the first drops in profitability indicators. For example, only relatively recently did the European Union come on board with its own standards and requirements in the field of sustainable investment. New funds that comply with the principles of the UN Paris Climate Agreement began to gain popularity. Such funds typically filter out about half of all market issuers and place more emphasis on climate aspects. The future will tell if the positive momentum for sustainable investing will continue, but what is certainly clear is that the trend of sustainable investing is to remain as the new investment standard.