The scale goes straight to $50 trillion! Is the global wave of ESG funds an opportunity or a bubble?

Some have warned that the current global popularity of ESG investment may be at risk of a bubble, while others take the opposite view.

In recent years, there has been a growing urgency to limit global warming and address other issues such as social inequality, and environmental, social and governance (ESG) investments have become welcome. According to a Bloomberg Intelligence survey, the pool size of assets managed by ESG is expected to increase from $35 trillion last year to $50 trillion by 2025.

The narrow definition includes only exchange-traded funds (ETFs) and mutual funds that host ESG or socially responsible investment (SRI), which are growing even faster, reaching 10 times, about $2 trillion.

The Bank for International Settlements (BIS), the central bank of the world's central banks, warns of a growing risk of price bubbles in the environmentally conscious ESG asset market.

"There are indications that the valuation of ESG assets may be too high."

<h2>The risk of ESG assets is increasing</h2>

ESG investing is often referred to as "doing the right thing", and while consistently performing well, it may not be an effective strategy.

Bloomberg said the good performance of ESG-related investments could be a surprise: Many ESG funds are investing heavily in tech companies, and the rise in tech stocks is likely to be unrelated to ESG.

The Financial Times noted that a large flow of undisciplined money into the renewable energy sector could lead to mispricing because it would drive up the price of assets and blind the market to what fair value was. Distortions in corporate valuations have in turn affected companies in the sector from issuing bonds and stocks, paying dividends, reinvesting and paying employee compensation. It would also hurt mergers and acquisitions because it increases the risk of companies paying in the deal.

While the market is significantly premiuming "renewable" assets, traditional energy sources are also significantly discounted. Of the 11 sectors of the S&P 500, only the Energy and Utilities sector has not yet recovered to pre-pandemic levels.

This trend partly reflects the fact that institutional investors are exiting these industries in order to prove their ESG qualifications to shareholders.

Essentially, the new pattern of investment flows is underpinned by a new market credo that "all renewable stuff is great, all things related to fossil fuels are scary."

As a result, less investment in traditional energy companies and assets could reduce investment in the global energy supply, create shortages, and push up inflation. If this continues, it could lead to the disappearance of the fossil fuel industry, adding to the roughly 1 billion people already living in energy poverty.

But fossil fuels will remain a key component of the global energy balance over the next 30 years. According to the International Energy Agency (IEA), even under its most aggressive energy transition program – achieving net zero energy emissions by 2050 – fossil fuels will still account for 20 percent of global energy by 2050, up from about 80 percent today.

The Financial Times warned that if capital flows continue at their current pace, the real prospect of an ESG bubble bursting is largely like the similar outcome seen in the tech and property markets.

<h2>Is ESG a bubble? JPM: Not necessarily</h2>

J.P. Morgan argues that concerns about whether ESG will become a bubble reflect a confusion that conflates two different strategies: ESG investment and sustainability-themed investment.

By definition, ESG investing is an investment strategy that incorporates environmental, social and governance factors into the due diligence and financial analysis of investment managers. Companies focused on the environment (carbon footprint, renewable energy), society (privacy and data issues, community investments) and governance (board diversity, business ethics) tend to have better, more consistent long-term performance.

Investments in sustainability themes include investments in companies, technologies and projects that target specific sustainability themes and will continue to grow rapidly. Examples include carbon capture and storage (CCS) from renewable energy, electric vehicles, and greenhouse gas emissions.

Some sustainability themes show early warning signs of bubbles. Take the S&P Global Clean Energy Index, for example, which fell 37% after rising 181% between early 2020 and January 8, 2021, and eventually remained at a level 90% above the January 2020 trading level. JPM expects this pattern to be likely to be repeated in many sustainability themes.

Contrary to sustainability trends that can lead to bubble-like valuations, ESG is not a trend, but an evolution of the investment strategy itself.

Investors focus on important ESG issues (such as diversity, energy efficiency, financial disclosure, and transparency) that can have a positive or negative meaningful impact on a company's financial outcomes.

In a sense, ESG investing is an extension of the quality factor of equity investment, that is, ESG is the trend of high-quality stocks that generally have more stable returns, stronger balance sheets, and higher profit margins to perform better than low-quality stocks.

Therefore, JPM believes that investing in the theme of sustainability may become a bubble for the time being, but investing in ESG is another matter.

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