The green dream

03 Jun 2020

Camilla Ritchie, Senior Investment Manager

The future or fad? It’s a question that has dogged funds which take environmental, social and governance (ESG) factors into account since they first came into prominence. Some have argued that the popularity of ESG funds would fade at the end of the bull market, dismissing it as something that’s nice to have while the going is good. The COVID-19 crisis has proved otherwise.

Despite the bear market, ESG has so far been phenomenally robust. ESG exchange traded funds actually saw inflows during the first few weeks of the crisis, at a time when other funds saw significant outflows.

Why is that? One reason could be that people have been buying companies that score higher in terms of ESG more than others because they have appreciated how much less pollution there has been. Or how much society has come together to beat the virus by locking down and keeping safe, and felt ESG investing was a way to change company behaviours by giving the nudge to good ESG companies and avoiding others.

It could also be because of the way ESG indices are made up – they have fewer of the companies that are dependent on market cycles or companies which look cheap but don’t offer very good growth prospects. ESG indices tend to have more companies which are so called “quality” or “growth” orientated which have generally done well, while the cheap or value stocks and cyclical stocks have not.

Finally, ESG has in the past been a good indicator of company resilience with ESG companies less likely to fail than those which score badly. In bull markets some companies borrow heavily against their balance sheet but find when cash flow dries up they struggle to survive. When assessing the E, S and G factors a high level of borrowing would raise warning signals over governance. In a crisis like this there has been a flight from more risky companies such as these to those which are seen to be more resilient.

A greener future?

Looking beyond this crisis is there a desire to change behaviour and work to a greener ESG future? Like a number of countries, the UK has committed to zero carbon emissions by 2050; a challenging target which will require significant renewable energy installations and batteries to store energy and the phasing out of fossil fuel-based energy production for industry, home and transport.

There are also examples of companies taking ESG more seriously, for instance by moving to comply with strict CO2 emissions targets. Volkswagen, which a few years ago was mired in an emissions scandal, is now leading the push into electric vehicles and battery development in the EU, meaning that EU carmakers received €60bn in private and public funding for electric transport last year.

Other companies have been quietly going about their business with ESG as a main driver for many years. Ecolab, which is a stock we hold, was established during the Great Depression of the 1930s in the United States. What started as a hygiene company then moved into food safety and now advises some of the largest companies in the world on water safety. Because it works with companies it is not a household name but it is, for instance, involved in advising on 20% of the production of world electricity. Maybe surprisingly, there is a lot of water involved in the production of electricity because of the cooling that is needed to keep energy generation efficient. Ecolab helps companies to minimise the use of water because it is a precious resource which we are at risk of running out of.

One of the main drivers of water scarcity is development, that is to say people moving to cities and getting used to the convenience of water on demand. And as countries develop so do diets, meaning they tend to eat more meat. A rough rule of thumb is that it takes around 1,000 litres of water to produce 1kg of grain but around 100,000 litres to produce 1kg of beef.

With emerging markets developing a taste for meat, there is simply not enough fresh water to balance supply and demand at the current growth rate. Ecolab estimate 50% of the world will be in supply/demand imbalance by 2030.

So, while there are promising initiatives such as the zero carbon targets and companies operating in the ESG sphere to reduce the amount of water we are using, will this be enough to drive governments to prioritise ESG following this crisis? Or will the crisis put ESG spending on hold, despite the solid arguments that it reduces risk, raises resilience and does the planet good? In the immediate aftermath of the Global Financial Crisis there was much less pollution as economic activity stalled, but then when it picked up pollution levels went right back up again.

Resetting priorities after COVID-19

It needs to be different this time if we are going to achieve carbon reduction targets set by the 2015 Paris Agreement on Climate Change with the goal of limiting global warming to between 1.5% and 2% by 2050.

The consultancy McKinsey has suggested that a low carbon recovery is a distinct possibility. They surveyed both developed and emerging countries for their views with nearly two-thirds of survey respondents saying governments’ economic recovery efforts after COVID-19 should prioritise climate change. Taking a European country as an example, which was provided with up to €150bn of capital for climate related projects, they calculated this would yield over twice that in gross value added with three million new jobs created either directly or indirectly and would enable carbon emissions reductions of the order of 15-30% by 2030.

Maybe the European Commission has read the McKinsey report because it has just announced that it wants to make €750bn available in the form of grants and loans to put into green projects to help the economy after that COVID-19 crisis. The money will only be available to those projects which are green and in line with the Green Deal; this is the EU’s roadmap for making the EU’s economy sustainable, turning climate and environmental challenges into opportunities across all policy areas and making the transition just and inclusive for all. For instance, this could include projects aimed at transitioning a company from being high carbon to low carbon and not just for companies which are on the right side of the energy transition today.

The European Commission announcement has set the bar for the rest of the world. As we know from the McKinsey survey there is a strong desire by other countries for governments’ economic recovery efforts to prioritize climate change.

Will ESG be the long-term winner after COVID-19? There’s every possibility that there will be a very green future for ESG investments. It could also be the tipping point to get the planet on track for carbon neutrality but what probability to put on it – that is the question.

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The value of your investments and the income from them may go down as well as up, and you could get back less than you invested.
The value of your investments and the income from them may go down as well as up, and you could get back less than you invested.

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