Sustainable investing has grown; now it must mature

By Igor Burlakov, Chief Business Officer, Sova Capital

As Covid-19 caused dramatic volatility spikes earlier this year, there was concern that sustainable funds would be sidelined as corporations and investors transitioned to remote work and in some sectors, shifted their focus to survival. Instead, global assets in sustainable funds hit $1.2 trillion (£900 billion) during the third quarter of 2020, a record high, while Europe surpassed the $1 trillion mark for the first time, according to research by Morningstar.

Sustainable investing isn’t merely growing – it’s maturing. The progression of credit rating approach in debt markets may provide a roadmap for the future of sustainable investing, as EU investors increasingly integrate ESG ratings into portfolio weightings, and more ESG theme indexes are established. These trends will gradually impact company valuations, further cementing ESG criteria as important for fund allocation and relevance, as passive money (ETFs and mutual funds that track indexes) begins to secure allocation from larger, long term pension funds.

Every market evolution brings new challenges, and as sustainable investing travels the path to becoming mainstream, potential roadblocks include a slower adoption rate in emerging markets, a lack of standardisation, and concern that ESG profitability may not live up to the hype.

Corporates in emerging markets are generally still in the nascent stages of implementing ESG criteria, adjusting their corporate strategies to include sustainability, diversity, and corporate stewardship. While IT-driven companies with digitised workspaces are well-equipped for this change, for some of the traditional heavy industry corporates, ESG criteria implementation will require a complete transformation strategy to new business models. The process is daunting, but not impossible – an illustrative example from developed markets is Philip Morris, which last year announced they’re committing to smoke-free products, with the end goal of eradicating cigarette smoking.

An indicator of ESG’s growth in emerging markets is green bond issuance, which according to the International Finance Corporation, last year increased to $52 billion, up 21% from 2018. New entrants to the green bond market from emerging markets include Ukraine, Czech Republic, Ecuador and Panama, with additional emerging markets countries expected to enter the space.

This momentum is reflected in discussions with large EU institutional investors seeking investment opportunities in emerging markets – for the past three years, emerging markets funds have increasingly implemented internal ESG ratings systems and hired ESG-focused fund managers. Some fund managers have adjusted their portfolios to dispose of unsustainable investments while others have taken it a step further and cut indirect exposure to unsustainable companies, for instance, a transportation company that ships coal.

While emerging markets’ progress on sustainable investing is promising, a lack of standardisation is another challenge slowing the mainstream adoption of ESG. There are no market-wide definitions or interpretations of key concepts – such as “ethical” vs. “governance” – and establishing those standards would further accelerate sustainable investing into the mainstream.

This third challenge is reputational, as widespread claims that ESG investing is inherently profitable face scrutiny: Is the evidence that ESG outperforms in the long term conclusive, and is it even possible for values-based portfolios to be universally beneficial? In theory, sustainable investing could pay off for corporates, investors, and society; however, impacts on the environment and society are often qualitative. Not only is it difficult to develop a numerical value for environmental and societal gains, but it would be almost impossible to measure all of the positive impacts – direct and indirect – generated by the positive behaviour of a company.

Performance measures represent another aspect of sustainable investing that is stalled by a lack of standards. Although economic science will continue to develop measures to estimate ESG impact, the market won’t have a standardised approach to measurement for quite some time. Until then, there is recognition that investing with a focus on ESG brings real, calculable financial benefits such as lower cost of borrowing for “green debt,” access to a wider investor base, and higher allocation for better ESG ranking.

So far, that seems to be enough - according to Morningstar, product development in the third quarter hit an all-time high with 166 new offerings, double the second-quarter number. Most large investment firms have developed or are developing internal analytical expertise for ESG ranking, which will make sustainable investing more commonplace in the market. As major funds continue to implement ESG restrictions or requirements, sustainability will continue its maturation until it is fully mainstream.