Is there an ESG bubble?

For Andy Sloan, the ‘ESG bubble’ is a comfort blanket for the financial sector during stressed times. “It’s become a beacon of hope that things will get better,” says the Deputy Chief Executive at Guernsey Finance, who is driving the Channel island’s green finance agenda. 

“We’ve all taken ourselves on the ESG bandwagon while Covid is going on and we’ve lost our ability to do a lot of the critical analysis along the way. And if you do that analysis, you become a naysayer. We need to keep grounded – it’s gone too far.”

Media and financial analysts have been awash with talk of an ESG bubble in recent months, as huge flows of capital continue to pour into ESG-labeled funds – $326bn in 2020, according to Morningstar data, which is more than double the $154bn the previous year.

Last month, Norges Bank Investment Management’s new CEO, Nicolai Tangen, joined the chorus of names worried about an ESG bubble, after the fund struggled to find investments in renewables (for which it’s had a mandate since 2019) because of inflated prices. A few days later, Tangen’s deputy, Trond Grande, said “we must be prepared for corrections in the stock market”.

‘The bond guys said on one call they’d sell it for £150m on the basis they could sell it’

There is evidence that some are taking advantage of the ‘ESG mania’. One company raised £150m of bonds for a clean energy pipeline, despite people close to the deal estimating it required just a fraction of that – closer to £5-15m.

“We said there’s got to be a practicality to the expenditure of the cash, you can’t just make it up. You’re going to have a management structure in place to be able to actually feed the capital down operationally for the project. At the moment it’s just an idea,” says a source who asks not to be named. “But the bond guys said on one call they’d sell it for £150m on the basis they could sell it.” 

Not all market experts share the view that there’s a ‘bubble’ forming, though. 

Linda-Eling Lee, Global Head of ESG Research at MSCI, points out the importance of distinguishing between ESG and green stocks. “The dynamics are actually quite different at the moment, from the research we are doing,” she says, adding that, when it comes to green stocks, capital is shifting away from assets with the potential to be ‘stranded’ – like fossil fuels – towards greener options. “There's clearly a huge amount of demand and not enough of those investments,” she notes. 

Lee agrees that there is evidence of increased valuations for green assets over the last 18 months. 

“Whether that’s a repricing of the market or a bubble is in the eye of the beholder, and depends on the specific asset. If you look back on the technology boom [of the 1990s], it took time to know which investments were going to be the Apples or the Amazons and which would be Pets.com [one of the most disastrous busts of the dotcom bubble, resulting in a loss of $300m in investment capital].” 

Rick Lacaille, Senior Investment Advisor at State Street, says the new US Administration and the growth in Net Zero commitments could be influencing some changes in valuations for green stocks. 

“I don’t think there’s much evidence of a green bubble, but I would keep an open mind because there’s a lot of liquidity in the financial system, so there’s always a risk it finds a way of creating overvaluation. It is certainly the case that since the US election there has been a reevaluation and repricing of sectors like renewable energy in the US – but that’s pretty rational when you think of the very large scale need for renewable electricity if there is a strong commitment to take the action required to reach Net Zero. 

“The difficulty is that the nature of the carbon transition is such that a lot of the activity is quite distant, and therefore there could be quite a wide range of values placed on some assets.”

Like Lee, Lacaille believes it will take time to see a clear picture. 

“If you look at past episodes of very large technology and infrastructure change, such as the industrialisation of many countries in the 19th century and the build out of railways, they were quite ‘boomy’, with huge amounts of capital deployed. For example, in the mid 1850s, the London Stock Exchange had listings worth about £200m in foreign investments, and from 1858-1869, a further £70m was invested in Indian Railways alone. By 1913, railways accounted for about £1.5bn of the exchange, compared to £1.08bn for all other industries. In the interim there were a number of crashes.”

Jessica Alsford, Global Head Sustainability Research at Morgan Stanley, says the team started looking at the valuations of green stocks in January after concerns from investor clients.

“We set out to try and really analyse across the different green sectors and think about what type of growth is being discounted into share prices. There were quite a lot of differences. There were certainly pockets where valuations did look like very high terminal growth rates were being discounted in, and it was very optimistic, perhaps. And in other cases, the valuations were fairly reasonable.”

‘We’re in danger of ‘PRI-principling’ the whole thing’ – Andy Sloan, Guernsey Finance

Morgan Stanley released a report in February concluding that stocks including US solar firms SunPower Corp and Array Technologies were expensive, while there was still room to go with stocks such as Tesla and Li Auto. 

But events are moving quickly and Alsford says a lot of the stocks analysed in the report, such as Tesla, have since been derated – due to a general market rotation away from growth to value stocks, and the upcoming rebalancing of the influential S&P Global Clean Energy Index.

The popular MSCI SRI sustainable ETF range, which has outperformed its peers over the last five years, saw its largest monthly underperformance since inception (2011) in February, at 2.2%. The primary culprit was Tesla, which accounted for 50% of the underperformance. 

“There's a debate now about whether there is so much demand for green assets that they're just not going to pay the same return on a long-term basis,” Alsford explains. “That's what investors are trying to get their heads around.”

Recent data from private bank Quintet suggests a correction on the demand side may already be underway. Analysis of 2,000 funds found investor appetite for clean energy dipped this month, having tripled in 2020 – although this could also have been impacted by the looming S&P Global Clean Energy Index rebalance.

On ESG stocks, data from Sustainalytics shows that European companies that perform well on ESG (the top 20%) have underperformed ESG laggards by, on average, 6% since the start of 2020, and the FTSE Developed Europe by an average 1%. In comparison, the ESG laggards outperformed by 4.6% over the same period. The underperformance of ESG leaders is attributed to their high exposure to consumer sectors and financials (while companies lagging on ESG sit more within technology and healthcare) and, over the longer term, those companies have outperformed the laggards by 20% since 2019 and the FTSE Europe by 32% since 2016. 

For Vikram Gandhi, an ESG and impact investment lecturer at Harvard Business School and advisor to the Canada Pension Plan Investment Board, the current market conditions reflect an inflection point, with capital flowing to ESG-compliant firms as investors become more aware of some of these long-term performance benefits. 

“A bubble in my mind is something that gets overvalued and crashes. I don’t think any of the ESG indices are overvalued, there is just more money going into them,” he says, but adds that ESG funds often have heavy exposure to blue chip technology stocks, meaning “the run up in tech stocks and the run up in ESG stocks have been synchronous [and] there could be a correction”. 

But Sloan at Guernsey Finance warns another ESG bubble could be growing: not around overvalued share prices, but around overpromising on ESG. 

“You have all of these assets claiming to be ESG-compliant when they are not. It’s analogous to the PRI issue,” he says, referring to the high and sudden uptick in signatories to the Principles for Responsible Investment, driven in part by asset owners making membership to the body a requirement for mandates.

“You go back six years ago and there was this statistic that £67tn of assets were managed by organisations adopting the PRI’s principles. The share of assets was probably 70% of the global fund sector. If you look at the state of the world today that couldn’t be further away from the truth. It’s just an easy box to tick,” 

Sloan, an economist by background and an official reviewer for the International Panel on Climate Change’s Sixth Assessment Report, goes on to warn: “We’re in danger of ‘PRI-principling’ the whole thing. You’ve got confusion about what ESG really is that nobody can follow. It might be flavour of the month now, but in a few months time when people’s views and fashions change, you undermine the rationale of what we are doing.

“There is a risk of derailing all the positive work we’ve done since 2016.”