The UN climate conference in Glasgow has been all over the headlines for the last two weeks. People around the world are hoping for real progress in the fight against global warming.
However, those hopes have been tempered in recent weeks by an energy crisis that’s disrupting economies in Europe and Asia. The crisis is raising questions about how fast the world can transition away from fossil fuels and the role that environmental, social and governance (ESG) investing will play in that transition.
The reopening of economies has led to serious energy shortages especially in China and Europe and sent the price of oil, gas and coal soaring. While most observers blame the energy crunch on low commodity prices and depressed investments dating back to before the pandemic, some are also zeroing in on the popularity of ESG investing as another culprit.
Certainly, the acceleration of ESG investing around the world has been hard to miss. Just this month, Canada’s six largest banks joined the UN’s Net-Zero Banking Alliance, led by former central banker Mark Carney. It commits the banks to shift their lending away from projects and activities that generate greenhouse gas emissions.
And the Caisse de dépôt et placement, Quebec’s public pension fund manager with $390 billion in assets, joined other huge institutional investors in promising to sell off its remaining oil producing assets.
Meanwhile, individuals have been enthusiastic buyers of environmentally and socially responsible investments. ESG funds, which often shun fossil fuel investments, held a record US$2.3 trillion in global assets through the second quarter of this year. ESG funds seek to choose investments that are aligned with investors’ environmental and social values. They favour companies they judge to be progressive to encourage their business practices and because they will be better prepared to meet future challenges. On the flipside, ESG funds often filter out businesses that are perceived to be damaging or unsustainable in a world where, for example, greenhouse gas emissions must be rapidly reduced.
The effect of all that money being divested from energy companies is to increase their cost of capital—how much they have to pay investors who are willing to buy their shares or lend money to them. That’s a serious impediment for those companies and has led many of the largest to increase their investments in renewables—a win for ESG investors.
However, a higher cost of capital also means higher returns for investors in oil and gas companies. They are also rewarded when high energy prices translate into larger profits for those companies as we’ve seen in Canada this year with the energy sector outperforming the S&P/TSX Composite Index.1
So, what are we to conclude from these cross currents?
First, the world is facing a monumental challenge to reach the UN’s emission reduction targets. While ESG investing will help over the long term by encouraging green energy and penalizing fossil fuel, the transition is likely to be messy as we’ve seen in the current energy crisis.
Second, expressing your values through your portfolio might mean you will underperform an index that tracks the whole market from time to time. After several years of outperformance in Canada, this year it’s led to a small underperformance thanks to the strong returns for energy stocks. To September 30, iShares ESG Advanced MSCI Canada ETF returned 15.9% compared to 17.5% for the iShares Core S&P/TSX Capped Composite ETF.1
Most ESG investors are prepared for variations from market indices and decided it’s a price they’re willing to pay to help create a more sustainable planet.
1 Source: Morningstar