In recent years, ESG investing has emerged as a tidal wave sweeping away all investment approaches on its path. ESG-focused AuM has multiplied by 8.5 times in 2018-21 to reach $5.8tn*, with a staggering 208% growth last year. This extraordinary growth is spreading to every expertise (actively managed strategies, ETF, smart beta and factor investing), asset class (equities, fixed income, diversified investments) and markets.
The huge investor interest for ESG investing has created a demand-supply imbalance, triggering flow-driven price pressure on this market segment. These staggering amounts are sparking bubble fears, but popularity does not necessarily mean a bubble. Other factors, such as the valuation of ESG assets, the economic rationality of ESG, investment needs or the regulatory environment are an integral part of the overall equation and must be taken into account before concluding that a bubble for ESG assets exists or not.
From a valuation standpoint, the figure below compares the trailing PE ratio of the MSCI ESG-tilted indices in the Eurozone and North American regions over time to the trailing PE ratio of their parent indices. The different curves make it possible to directly assess the evolution of the ESG-tilted indices’ PE premiums that investors are willing to pay. The MSCI ESG leaders and MSCI SRI indices target respectively a 50% and 25% sector representation compared to the parent index, aiming to include companies with the highest MSCI ESG ratings in each sector. As such, SRI indices mainly consist of pure-player companies that are pioneers in their field of activity through the development of specific know-how or innovative technologies.
We find that most ESG assets are correctly valued on average. Nevertheless, some very specific assets usually associated with thematic strategies or green assets may be highly valued temporarily relative to the broader market. At end-March, we estimate the SRI PE premium at 23.5% and 17.2%, respectively, compared to their standard counterparts in the Eurozone and North America. These niches require further analysis to determine whether a premium is justified.
Beyond the pure valuation aspect, environmental, social, and governance considerations have fully reshaped the finance industry’s approach to sustainability. These extra-financial criteria have provided investors with a holistic approach to risk management, allowing a full understanding of the companies they invest into. Their contribution is such that ESG investing has become the new standard in the finance industry. Far from being a simple fashion phenomenon, we believe these changes are irreversible.
In addition, ESG investing benefits from a favourable environment, which also promotes its deep roots in our daily lives. It echoes a desire expressed by civil society to save the planet and act for the good of humanity. From a rationality standpoint, the challenges that society faces (i.e., global warming, energy transition, social inequality) require colossal investment and remain overwhelmingly underfunded. Lastly, the evolution of the regulatory framework (e.g., the SFDR in Europe) is a real support by creating a favourable environment for sustainable investments.
In view of these elements, ESG flows should continue to drive the market, particularly outside the Eurozone, partly thanks to the upcoming evolution of the regulatory framework. However, irreversibility does not mean perpetual imbalance. Eventually, once equilibrium is reached, ESG assets will no longer benefit from this upward price pressure and should underperform the broad market because traditional market mechanisms will take over. By traditional market mechanisms, we mean the usual risk premiums, above all the carbon risk premium, which should fully occur because it represents a risk that is set to last.
The authors would like to thank Alexandre Drabowicz for his helpful contribution to this piece. *Source: Broadridge. AuM: assets under management. ETF: exchange-traded funds. EPS: earnings per share. PE: price-earnings ratio.