Over the course of this year – and well before – we have grown used to the incredible outperformance of the US technology sector. Such is the size and strength of Silicon Valley that at times US mega-cap tech stocks have accounted for most price moves in the overall stock market. But tech has been far from the only ‘winner’ out of the pandemic, even if it has been the most noticeable. In fact, since global stock markets sunk to their depths in March, green stocks – those that stand to benefit from environmental regulation and the shift towards cleaner energy – have rivalled the performance of the five biggest tech stocks (Facebook, Apple, Amazon, Microsoft and Google). The chart below shows the price action of the US WilderHill Clean Energy Index – a modified equal dollar-weighted index of publicly-traded clean energy companies – against the performance of the S&P 500. As you can see, green stocks suffered heavier losses than the wider market in the early part of the year, but have since recovered all of those losses. In October, with expectations feeding into the market that candidate Joe Biden may win November’s presidential election, it has clearly outperformed the S&P’s mega-caps.
This is somewhat surprising and, to some, may have come as a relief. When the pandemic began, one of the biggest questions was whether a fixation on dealing with the virus and its economic fallout would lead to a neglect of environmental or social issues. History certainly suggested environmental concerns would fall by the wayside. In the aftermath of the global financial crisis, environmental changes that had been prominent in the early 2000s were largely ignored in favour of dealing with a global economy in recession. Indeed, the WilderHill Index itself has never recovered to the levels it reached in 2007.
Things certainly look different this time around. Governments are keen to tie fiscal stimulus funding for the post-COVID economic recovery, which may have quite a long investment horizon, to environmental goals. Politicians and the voting public are rightly focused on building the world back up, and there is a distinct sense that this cannot be achieved through the old environmentally destructive means of the past. This is borne out both through market trends and public policy. Biden – now the clear election favourite – has promised a $2 trillion ‘Green New Deal’ package, while the European Union (EU)’s green recovery plan promises to put hundreds of millions of euros into a sustainable recovery from the pandemic. Private companies are joining in too, with JP Morgan pledging to help its clients achieve net-zero emissions in their investments by 2050.
This backdrop has been a particularly good one for ESG (Environmental, Social and Governance) investors, who choose portfolio stocks not only on the basis of profit outlook, but also on how well a company scores on those three categories. We should distinguish between ESG and straightforward environmental companies – as well as between ESG and ‘Ethical’ portfolios – but these categories are nonetheless related, and often affected by the same trends.
Investor demand is undeniably strong for ESG assets. In the third quarter of this year, green, social and sustainability bonds surpassed $1.3 trillion in cumulative sales, and the EU’s pandemic recovery plan is expected to double the size of the ESG debt market next year. And, throughout the year, we have seen multiple initial public offerings from companies in the electric vehicle sector, with German electric charging company Compleo the latest to go public – with an initial market cap of €168 million.
However, with all this great performance, there is a growing debate about whether ESG stocks have now become too expensive on a valuation basis. Even if the underlying businesses are solid and have strong outlooks for the future, the expected return on ESG assets is, of course, dependent on where they are already. With prices bid up so high throughout the year – and returns comparable to the rampant tech sector – how much higher can or should ESG go?
This is not a debate with any easy answers. But there are reasons for positivity. The environmental sector is still below its pre-global financial crisis peak in price terms. And, with the inevitable drive towards cleaner energy and tighter environmental regulation, the long-term trend is very much in its favour. That is not to say that ESG stocks might not be subject to some profit-taking in the short- term, but a secular shift towards a green world is clearly better for green businesses than it is for those reliant on fossil fuels – which could well become stranded assets years down the line.
Policy is a vital component here. While there is a clear drive for environmental regulation and aid across most major economies, there is undeniably a long way to go. If politicians stay committed to the CO2 reduction cause – and the growing pool of environmentally-aware voters suggests they should – we can expect much more in the future. As such, even though ESG stocks have seen a significant rally already, we could just be at the beginning of this trend.
It is also worth bearing in mind that investors are not just investing in ESG for the monetary gain. Empirical studies show ESG investors hold their selected stocks for much longer, and therefore the underlying stocks may not be as susceptible to short-term speculation. Choosing to put money in socially and environmentally-responsible stocks is more of a personal or ethical decision, rather than a straightforward investment one.
But this is something of a double-edged sword. On the one hand, it can make demand for ESG assets sticky, in that buyers are unlikely to be suddenly swayed en masse by changing profit narratives. On the other, any investment strategy which includes non-profit related goals is – by definition – less profitable over the extremely long-term. Global trends may sometimes line up with these goals in a way that is beneficial for ESG investors, but there is nothing to say that has to always be the case.
That should not be at all surprising. The simple point is that ESG or ethical investing aims at more than just profit, and so investors should be prepared to sacrifice potential profit sources to achieve their other goals. At the moment, that sacrifice is so small it is negligible, and current secular trends mean it may well continue. But we should emphasise that it is not just an investment decision.
