ESG vs non ESG portfolios: What strikes harder than a slap of Will Smith?
In our article from January 2022, we referred to Netflix show “Don”t Look Up” to depict the ludicrousness of media’s environmental coverage. It so happens that reality is stranger than fiction as Will Smith’s slap has overshadowed the sixth report from the IPCC (Intergovernmental Panel on Climate Change). Less glamourous, but far more relevant, this document has taken stock of climate change impacts, adaptation and vulnerability. Record temperatures of around 40°c above average have been recorded in some parts of Eastern Antarctica are extremely alarming and calls for an immediate action.
Before shedding light on the performance comparison between ESG and non-ESG focused securities, it is worth mentioning some of the results of the latest IPCC report in order to stress out the prominence of responsible investing beyond capitalistic prospects. It is highlighted in the summary for policymakers that “global warming, reaching 1.5°C in the near-term, would cause unavoidable increases in multiple climate hazards and present multiple risks to ecosystems and humans (very high confidence)”.
Curbing global temperature will be a grueling task for developed countries, the largest polluters, all the more so as climate change repercussions are most often felt by emerging nations before others. However, a fast and global remodeling of the economic engine is needed to avoid irreversible consequences. In this perspective, the IPCC has framed five SSP (Shared Socioeconomic Pathways), or scenarios, to estimate the level of greenhouse gas emissions under different climate policies – from most to least sustainable (see Figure 1):
Figure 1: Global surface temperature change and SSP
(warming estimate by the end of the century relative to 1850-1900 levels)
SSP1: Hard sustainability (the Green Road) – the best case scenario (least likely) where the world shifts gradually toward a circular economy with an emphasis on human well-being. Sustainable Development Goals become a priority and consumers favour low resource and energy intensive products and services, which allows us to just slightly overshoot the 1.5°c target.
SSP2: Soft sustainability (the Middle of the Road) – the world improves its energy mix overall, but efforts are uneven and progress is slow. Inequalities improve only mildly and challenges to reducing vulnerability to societal and environmental changes remain. Global warming is partly contained between 1.5°C and 2°C.
SSP3: Regional rivalry (A Rocky Road) - a resurgent nationalism and regional conflicts foster protectionism and self-reliance over globalisation and cooperation. Countries focus on achieving energy and food security goals at the expense of broader developments in education and technology. Since addressing environmental concerns is no longer a priority, global warming pursues its trend to below 3°C.current trend leads to strong environmental degradation in some regions.
Note that current geopolitical tensions between Russia and Ukraine or the US and China are increasingly reminiscent of former economic blocs – a bad omen not only for environmental policies, but also for humanitarian consequences.
SSP4: Inequality (A Road Divided) – a dichotomy between an internationally-connected society that contributes to knowledge and capital-intensive sectors, and a fragmented collection of poorly educated societies that work in a labor intensive, low-tech economy gives rise to social unrest. Environmental policies focus on local issues and investments keep flowing in both carbon-intensive fuels like coal and unconventional oil, but also low-carbon energy sources. Under this scenario, global warming finishes slightly below 4°C. At this level, natural disasters are numerous while biodiversity keeps shrinking.
SSP5: Fossil-Fueled Development (the Highway to Hell) – a myopic scenario (not so likely) where the world only pursues growth while ignoring negative externalities for the environment. There are strong investments in health, education, and institutions to enhance human and social capital, but the push for economic and social development induces the exploitation of abundant fossil fuel resources and the adoption of energy intensive lifestyles. Geopolitical tensions are centered around strategic controls of minerals, especially energy and clean water. Technology offsets some ecological issues, but the magnitude of global warming (between 4°C and 5°C ) is so large that many areas of the globe become inhospitable.
Now that we have a clearer idea of the reasons why sustainable investing makes economic sense to tackle climate change and thus sustain prosperity over the long term, we can proceed to our quarterly comparison of performance between ESG and non-ESG securities.
Over the last two years, starting from after the trough due to the first COVID lockdown, equity indexes have performed exceptionally well until the end of 2021. However, equities have had a rocky start of the year so far. Figure 2 demonstrates that the MSCI World ESG Leaders (white) is behind its non-ESG counterpart (dotted orange) by 109 bps YTD. Both the MSCI KLD 400 Social Index (focused on 400 US stocks with high ESG ratings) and the MSCI USA Index overperformed their global equivalent YTD. Nevertheless, the change in Central Banks’ monetary policies and the prospects of stagflation are challenging valuations of long duration ESG equities, particularly in the renewable energy sector (Source: Bloomberg Finance L.P., 07/04/2022).
Figure 2 : Equity - ESG vs Non-ESG Indexes
In times of monetary tightening and slowing GDP growth, investors are incentivized to opt for defensive, short-duration, large caps of the Old Economy - name it Energy (fossil), Utilities and Defense, or other value stocks in Tobacco and Alcohol. These sectors are typically excluded from ESG indexes or they have very little weight, hence why the MSCI World ESG index has underperformed by 117 bps YTD. In spite of this short-term disappointment, the bull case for ESG investing remains unaltered because limiting the magnitude of global warming remains paramount, as highlighted by the IPCC report.
As far as fixed income is concerned, all the positive performance since April 2020 has been erased for most bonds benchmark (especially since the beginning of the year) except for emerging markets. Figure 3 shows that the Bloomberg MSCI Global Green Bond Index (dotted orange -10.6%) underperformed both the Bloomberg MSCI Global Aggregate ESG (white -8.25%) and non-ESG (dotted yellow -7.95%) YTD. Indeed, green Bonds were particularly impacted by the flight to safety following the invasion of Ukraine and then by the massive outflow from fixed income to take advantage of the positive momentum among equities. Similarly to ESG equities, and in spite of short-term weaknesses, the bull case for sustainability-linked bonds remains intact. Today more than ever, capital flows need to be allocated to a New Economy where the hunt for capital appreciation is as valuable as the pursuit of the greater good. Besides, it is worth mentioning that performance showed can differ dramatically depending on the reference date and the benchmarks selected (Source: Bloomberg Finance L.P., 07/04/2022).
Figure 3 : Bond - ESG vs Non-ESG Indexes
With a view to assessing and fostering clients’ commitment to sustainable investing, FARAD Investment Management has developed an internal proprietary ESG scoring system called GreenEthica Sustainable Scoring System (GSSS). This report aims to provide a reliable and objective way to assess the main ESG portfolio metrics with a comprehensive focus on its alignment to the 17 Sustainable Development Goals (“SDGs”). Thanks to GSSS, FARAD IM can produce a synthetic sustainability report with selected key ESG metrics to unveil the real sustainability profile of a portfolio and to compare it in relative terms with a benchmark. Thanks to this easy-to-read ESG dashboard, investors can visualise their quantified contribution to the achievement of the 2030 Agenda for Sustainable Investments of the United Nations.
Junior Portfolio Manager
FARAD Investment Management S.A.