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While ESG fund flows have been exceptionally strong over the last few years, the ESG movement has encountered some headwinds recently, which may be impacting the popularity of sustainable investing.
The increase in prominence of environmental, social, and governance (ESG) factors in investment decisions has dominated the financial landscape, with investors demonstrating an insatiable appetite for sustainable investment products. This trend has been driven by greater awareness of climate considerations and an increased desire for social change.
ESG flows now are impacted to a much greater extent by the political situation in the US, where ESG as an investment criteria has seen significant pushback. Changing regulations about how green investments are labeled and classified have also caused issuers to be more cautious in considering capital raising alternatives for fear of running afoul of the new greenwashing rules.
Sustainable Investment Flows Reverse
Demand for US sustainable funds fell in the third quarter of 2023, according to research from Morningstar, which said investors pulled $2.7 billion from the sector during those three months. This marked the fourth consecutive quarter of net outflows, with $14.2 billion withdrawn over the past 12 months. While Q3 was quite volatile, and the broader universe of US funds lost nearly $3.9 billion, the relative decline in demand for sustainable funds was more pronounced. The assets in US sustainable funds also fell below the $300 billion level at the end of Q3 2023 and are down 17% from the record of $358.2 billion.
The decline in assets is particularly alarming, given the role that ESG and sustainable investing are expected to play as pillars of the transition to clean energy. The reversal is even more surprising when compared to the surge in sustainable funds, green bonds, and sustainability-linked bonds since 2020 to finance projects to reduce greenhouse gas emissions, improve clean water resources, and develop sustainable infrastructure.
Yet the drop in sustainable fund flows may not be so much of a surprise when you look at the underlying performance of the sector. The S&P Global Clean Energy index, comprised of leading companies focused on solar, wind, and other renewable energy, is down over 34% in the past 12 months and is as low as it has been since the middle of 2020. As a comparison, the S&P 500 Energy index, which includes the major oil and gas polluters, is down approximately 8% in the past 12 months.
A similar picture is emerging in the UK, where fund data provider Calastone reported a sixth consecutive month of net selling for ESG equity funds. Over £3 billion has left the sector in an apparent reversal from the boom over the last three years. PwC also said recently that equity funding for climate tech start-ups fell in 2023 to levels not seen for five years.
A biannual assessment published in November 2023 by the Global Sustainable Investment Alliance has also shown that a decline in the global market for ESG investing is being led by the US. According to the report, investors had $30.3 trillion in sustainable assets in 2022 compared with more than $35 trillion in 2020. Meanwhile, US AUM fell to $8.4 trillion from above $17 trillion, primarily due to changes in how US funds can be described as sustainable.
With a general slowdown in sustainability-focused products and the closing of ESG funds, commentators have noted the trend of US investment houses removing ESG labels from mutual funds and other investment products amidst the political furor, although this is not happening in Europe to the same degree
Regulatory Obstacles and Political Challenges
Some states having introduced legislation to prevent ESG considerations from being used when managing state funds, further contributing to political fallout in the US. This changing regulatory framework has contributed to the dampened sentiment. The SEC’s new rule, introduced in September, requires ESG funds to be 80% aligned with the fund’s stated goal. While likely to be successful at preventing greenwashing, many ESG funds or products may struggle to meet those requirements and still achieve performance targets.
In the European Union, net inflows in Q3 2023 were a hefty $33.5 billion, despite the challenging period for risk assets. The EU has a more sophisticated regulatory system, which still creates increased challenges. Specifically, European investors have been drawn towards Article 9 funds, promoting the EU’s highest green standards and must be 100% sustainable. However, managers are finding it increasingly difficult to meet these strict standards. Funds are therefore opting to classify as Article 8 with less stringent requirements. Many investors, however, have already been exiting this market segment for a while, leaving commentators to describe 2023 as a “lost year” for Article 9 funds.
Future Outlook for ESG Investing
According to Bloomberg, there is an expectation that ESG assets will surpass $52 trillion by 2025. This would represent more than a third of $140.5 trillion in projected global assets under management. Continued growth, however, is premised on the assertion of greater returns and increased social responsibility. Achieving these expectations will require continued conviction regarding the positive relationship between ESG practices and shareholder value,. All of this is unfolding as the correlation that has come under recent duress.
The asset management industry has been far from slow in creating opportunities for investors to embrace ESG. However, the sustainable sector is now reaching a crossroads. The key drivers for ESG investment remain strong, with the Inflation Reduction Act in place to encourage private capital for climate projects. See Department of Agriculture’s Inflation Reduction Act Fact Sheet: Inflation Reduction Act
The continued success of ESG capital formation is likely to be determined by how well the industry can demonstrate both its tangible sustainability benefits, but also the long-term potential for higher returns, particularly in an evolving regulatory landscape.
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