With disclosure varying from 98% on the FTSE 100 to 12% for the Russell 2000, voluntary reporting is not working, says Cornelia Andersson of the London Stock Exchange Group
This year has been a challenging one for investors looking to capitalise on the green transition. Energy security concerns, rising inflation and an underperforming global equity market have abruptly ended a decade-long bull run in green stocks, which has delivered a compound annual growth rate of 14% since 2010. By the end of November, the FTSE Environmental Opportunities Index had fallen 18.9% year-to-date, in contrast to the FTSE All-Share, which was up by 1.8% over the same period.
So, does this mean that the rising tide of ESG is abating and we are seeing a slowing interest in sustainable stocks and assets? Not necessarily. If you look beneath the headline figures you can see that the total value of green revenues, that is revenues generated from sustainable products and services, has been largely unaffected by the market turbulence, declining by just 2% between 2021 and 2022 to $4.8 trillion.
Despite the unprecedented rise in wholesale energy prices, the green economy is almost $2 trillion larger than the global oil and gas sector and now accounts for 9% of global market cap. FTSE Russell data shows that, if seen as an industry, the green economy would be the fourth-largest industrial super-sector by market capitalisation. The recent correction is a result of market turbulence and a “flight to safety” as investors switch to more traditional assets, seeking to make the most of increasing energy prices. Longer term, there is every reason to expect continued investment in green stocks.
The green economy represents a diverse set of activities up and down the value chains
While commonly thought of as solely focused on renewable energy, the green economy represents a diverse set of activities up and down the value chains, providing solutions across several environmental objectives.
FTSE Russell’s data from May 2022 shows that energy management and efficiency represents 39% of the green economy, while transport equipment is one fifth by size, having recently grown with the shift towards electric vehicles. Renewable energy generation and equipment makes up a further 18%. Its diversified nature means it spans many sectors, from utilities, to auto and technology.
The picture for the autos sector is a reminder of why it is important to look beneath the data. With the rise of electric vehicles, the sector’s exposure to the green economy tripled between 2018 and 2021 from 15% to 42%. However, until recently, one company, Tesla, accounted for 68% of this.
While concentration in a small number of large-cap stocks clearly exists, the green economy is globally diverse, albeit with larger representation in certain countries such as the United States followed by China. While smaller in total size, Japan and European countries such as France and Germany have comparatively higher exposure than the global average.
The green economy needs to become substantially larger to achieve a net-zero climate target, growing from around 7% of the global economy in 2021, to between 16-25% by 2050. This requires enormous capital reallocation. The Glasgow Financial Alliance for Net Zero (GFANZ) estimates that $125 trillion is needed by 2050, much of it for scaling low-carbon solutions in sectors from energy and construction to shipping.
This recalibration of the economy would have a knock-on effect for investors. FTSE Russell estimates that exposure to the green economy in global benchmarks would jump significantly in a scenario where the global economy pivots to a 1.5C path, increasing more than threefold between 2020 and 2030. Even in a scenario where countries achieve their nationally determined contributions (NDCs), today’s exposure would almost double to 11% by 2030. It is no wonder that future growth estimates imply the green economy could become the first or second largest industry.
57% of investors say the top reason for implementing sustainable investment is to mitigate long-term investment risk
However, performance is not the only reason why almost 90% of investors are now engaging with sustainable investment strategies. They are driven by a powerful combination of three Rs ‒ risk, returns and regulation. A 2022 survey of almost 200 global asset owners found that 57% of investors globally say the top reason for implementing sustainable investment is to mitigate long-term investment risk. Almost half cite the desire to capture better returns and meet client demand as a driver, while over a third point to regulatory requirements as a key driver.
Yet, the challenges facing this rapidly evolving industry are numerous and well documented. Perhaps the top of the list is a lack of corporate sustainability reporting. As a market infrastructure and data provider, we see a mixed picture by geography and company size, even on basic metrics such as carbon emissions disclosure. For example, the proportion of companies disclosing on Scope 1 and 2 emissions data varies drastically, from 98% for the FTSE 100, to 39% for the FTSE Emerging Index and just 12% for the Russell 2000, which tracks mid-cap U.S. equities.
Voluntary disclosure is clearly not working and there is an opportunity for regulation to deliver positive change. London Stock Exchange Group continues to call on regulators to mandate companies to make sustainability disclosures to help bridge the data gap. The adoption of sustainability reporting standards aligned to the International Sustainability Standards Board (ISSB) by 2025 would be a game changer.
As sustainable investment expands into other asset classes such as fixed income, the need for high data verifiable data only increases. Sustainable investment is no longer just an equities game. Despite being over $50 trillion larger than public equity markets, fixed income has been a laggard, but it is increasingly integrating sustainable investment considerations. It isn’t hard to see why. In recent years, an ultra-low interest rate environment has buoyed bond markets, prompting a significant rise in green bond issuance. Refinitiv data shows that global green bond issuance has surpassed $100 billion every quarter since the start of 2021. But as central banks continue to hike rates to combat inflation, the big question now is whether issuance will continue at the same pace.
Sustainable investment strategies are as much about capitalising on the opportunities presented by a green transition as mitigating risks such as climate change. Investors are exploring ways to mitigate exposure to climate risks, particularly in the sovereign debt market as governments are uniquely exposed to a warming climate. By modelling impacts to debt levels and loss of GDP, FTSE Russell research found that in a disorderly climate transition scenario, multiple countries would default on their government debt by 2050, including Japan, Australia and Italy.
Whether it is channelling capital to scale low carbon solutions, or hedging exposure to growing climate risks across portfolios, data is the essential ingredient for investors. Data creates transparency in your decision making. The right regulation can not only support investors to access the data they need to make better decisions, but also direct capital to where it is needed to grow the global green economy.
Cornelia Andersson is group head of sustainable finance and investment at the London Stock Exchange Group
This article is part of the Winter 2022 in-depth Financing the Transition briefing. See also:
Reality bits as finance firms row back on their climate pledges
‘Get the blend right’ and we can unlock billions in finance for Global South
Pact to decarbonise heavy industry through corporate purchasing power picks up steam
Can fossil fuel industry sell world on ‘net-zero oil’?
Energy crisis boosts drive to cut emissions from buildings
From climate-smart farming to electric rickshaws: investors look to make an impact
ESG: The investment world’s troubled teen is forced to grow up
Calls grow for companies to disclose nature impacts in bid to plug finance gap
How deforestation risk continues to be a blind spot for bankers
Needed: a sea-change in climate finance for oceans
Comment: How companies can lead to make the energy transition work for people and planetFTSE Russell green economy GFANZ sustainable investing International Sustainability Standards Board