How Long-term Value Creation Drives ESG Finance Returns

After years of fledgling interest, sustainable finance is now mainstream. Since the outset of the pandemic, the sector has reached several impressive benchmarks, with sustainable funds in the U.S. seeing record allocations and green bond issuances hitting the $1 trillion mark. Due to COVID-19, investment strategies that incorporate environmental, social and governance (ESG) criteria also faced their first market downturn. Not only did ESG finance assets hold up under this market turbulence, but many performed better than conventional benchmarks. Even as high flying tech stocks hit recent roadblocks, clean energy stocks continue to perform strongly, reflecting a shift toward low-carbon industries. We see this as a megatrend and a paradigm shift that is reflective of increasing focus from major corporations on sustainability and climate goals.

This is good news for investors, climate activists, and the planet. For too long, the environmental and social costs of fossil fuels and irresponsible business practices were ignored or unknown by capital markets. After the 2008 global financial crisis, for instance, many governments and corporations pulled back on sustainability initiatives, thwarting environmental progress. Fortunately, this time, it appears investors and policymakers consider ESG sectors like clean energy and electrified mobility as critical to recovery efforts and investmentment strategies. 

However, green investing strategies still face questions. In the absence of universal standards, investors often take different approaches to reach their ESG goals; some divest from certain sectors, whereas others advocate for change through engagement and proxy votes. There is also debate around how companies’ ESG performance should be assessed. In one study, Massachusetts Institute of Technology and University of Zurich researchers found significant divergences among scores given to the same companies by major rating services like MSCI. For example, many funds labeled as “low carbon” still include oil & gas holdings. In a buzzy market, how can investors, companies and stakeholders discern credible signals from all the noise? 

These are the overarching trends and critical issues shaping sustainable finance looking forward: 

Take the long view

First, consider the scope of the challenge—and the opportunities. While inflows into ESG investments are rising, much more capital will be required to achieve the world’s social and environmental goals. According to the OECD, limiting global warming to 1.5°C requires a fivefold increase in low-carbon energy investments through 2050. For reference, green bonds, which are dedicated exclusively to sustainability-linked projects, still only represent less than two percent of global fixed-income assets. Bringing ESG to scale will require a fundamental reshaping of the global economy. And while not every ESG stock will outperform, sitting on the sidelines of this revolution is an even riskier bet. 

In the long run, it pays to support emerging industries aligned with a low-carbon future and with the potential to build ecosystems around their innovations. Take the energy sector, for example. From high-carbon intensity fuels like coal, energy systems are steadily shifting toward lower-carbon sources: natural gas, then solar and wind, and finally zero-emissions sources like green hydrogen. Each stage is defined by a period of rapid capital inflows that brings down prices, which creates another set of barriers to address—and solutions ripe for investment. Those that wait for the sector to fully mature often miss out, private and public stakeholders alike. 

The evolution of solar power illustrates this dynamic. Investments in technology helped achieve economies of scale in solar panel projection which then spurred a solar supply chain, resulting in photovoltaic power prices falling by 89% from 2009 to 2019. Yet cheap and abundant solar cannot decarbonize electric grids alone, as fossil fuels are still needed to supply power when the sun doesn’t shine. Now, green hydrogen is poised to bridge this gap; it is produced with (surplus or designated) renewable energy, stored, and then used to power grids when other clean energy sources are unavailable. The path to green hydrogen’s commercial maturity represents $11 trillion of investment opportunities through 2050, according to BloombergNEF. So while supporting clean energy pioneers is a win-win-win for investors, the industry and the planet, it often requires a certain degree of patience. 

Sustainability as a team effort

Many have hailed investors’ growing awareness around climate and social issues as a paradigm shift. After all, their capital is essential to mobilizing climate finance. But the clean energy and low-carbon industries of the future cannot achieve scale through ESG investors alone. Government support is critical for building markets and getting promising companies off the ground. Creating a sustainable economy requires a stakeholder approach. 

While many public-private cooperation opportunities exist, there are two key areas where critical interests and responsibilities intersect. The first is government subsidies and financial support mechanisms. Around the world, government support to the energy sector remains skewed toward oil & gas. The most promising new ESG finance opportunities will undoubtedly emerge in areas that level the playing field. “Green” provisions in recent economic stimulus packages are an important initial step in this direction. On a broader scale, carbon pricing would allow all businesses to compete from a carbon-neutral perspective. 

Second, sustainability innovators can only thrive in a transparent, accommodative regulatory environment. Policymakers that provide clarity on disclosures and investment standards will encourage market growth. The benefits of such measures are evident in the EU, which holds nearly 70 percent of global ESG mutual fund assets, and where a spate of sustainable finance regulations are coming into force. Market observers will be watching closely for similar signals in other regions. Those that fail to provide enabling policy frameworks, or worse, curtail ESG investment or mandate lending to the fossil fuel industry, will lose out. 

Only the beginning of the journey 

While enthusiasm for ESG finance may seem sudden, the world is still in the early stages of the sustainability transition. But the long-term horizon will remain the same: climate change represents the world’s most urgent threat as well as its greatest economic opportunity. If they are allowed to compete on their own merits, companies that address this reality will prosper. Those that operate based on yesterday’s business logic will suffer. Long after today’s debates around specific sectors or rating standards are settled, investors that focused on long-term value creation—financial, social, and environmental—will have won the day.