Green is the new black
Summary: Two days ago, the ECB announced it will accept sustainability-linked bonds as collateral. This move confirms the growing interest among investors and institutions for ESG products and the theme of sustainability. We believe that the COVID-19 will accelerate the transition towards green growth and the set up of a green financial system. We discuss the implications of the ECB decision and why investors should integrate ESG products in their portfolio in Q&A format.
Q. What are the implications of the ECB decision to accept sustainability-linked bonds as collateral?
A. The ECB has announced it will accept from 1 January 2021 sustainability-linked bonds as collateral with potential eligibility also for asset purchases under the APP and the PEPP subject to compliance with programme-specific eligibility criteria. This is a first symbolic move ahead of something much more ambitious that may come out of the strategy review. So far, the announcement only concerns four bonds, and only two of them are in euros. It will have obviously very little market implications in the short- and medium-term. But it is bright clear that the ECB, under Lagarde’s leadership, will do its part and commit to help fighting climate change. This is also a timely move as it happens just after Germany’s successful green bond issuance and while the EC is discussing whether 30% of the recovery fund borrowing should be done through green bonds. The message sent by the ECB is that it will contribute to further develop the sovereign green bond market, which has been growing rapidly at the global level, but remains small compared with the traditional sovereign bond market.
Q. Why the theme of sustainability has become so dominant in recent years?
A. Climate change cannot be ignored by policymakers and investors. Natural disasters, often related to climate change, are more frequent and more violent. Based on statistics released by “Our World in data”, there have been 335 natural disasters per year over the past 20 years, which is twice as frequent as 1985 to 1995. At the same time, the economic cost is quickly increasing. It reached $200 billion per year on average over the past ten years, which is four times more than in the 1980s. And, in 2015, according to the Stockholm Resilience Centre, four of the nine planetary boundaries within which humanity can continue to develop have been crossed, namely climate change, loss of biosphere integrity, land system change and altered biogeochemical cycles. Investors and companies cannot only adopt an accounting approach to climate change, they understand more and more frequently that it is also their social responsibility to fight against it and implement ESG processes in their business model and strategic asset allocation.
Q. Why integrate ESG products as part of your portfolio?
A. There are mostly two reasons to integrate ESG products as part of an investment portfolio. The first reason is related to fiduciary duty which applies, for instance, to asset managers. Since the Freshfields Report, integrating ESG consideration is considered as clearly permissible and arguably required and not contradictory with the purpose of delivering financial returns. The second reason is related to financial materiality. ESG products are usually less volatile, with lower risk of divestment, reduced risk of fines and, recently, better return on investment than traditional peers.
Q. How ESG funds performed during the crisis compared with their traditional peers?
A. ESG funds (stocks and bonds) outperformed traditional peers in the first semester 2020. The Morgan Stanley Institute for Sustainable Investing notes:
“An analysis of more than 1,800 U.S. mutual funds and exchange-traded funds (ETFs) show that sustainable equity funds outperformed their traditional peers by a median of 3.9% in the first six months of the year. During the same period, sustainable taxable bond funds beat their non-ESG counterparts by a median of 2.3%.”
This outperformance, which reflects long-term advantages related to ESG products, can be explained by four factors: 1) the exclusion of sectors and industries dependent on fossil fuels that were among those that suffered most from the lockdown; 2) a tendency to overweight the technology and health sectors which emerged as winners from the crisis; 3) the selection of companies based on social and governance criteria which allows the selection of companies in line with the real needs of society and 4) less disinvestment in ESG funds as investors are looking for long term and sustainable performance, thus they are less likely to sell in period of crisis or high volatility.