Could ESG investment fall to the wayside when cost-of-living bites?

With the US economy bracing for recession and Australian markets still contending with high inflation, 2023 could be the year that pits ‘values’ against ‘value’ for the well-meaning investor.

It had already proved to be a tough year financially for most Australian households, who would need to cut discretionary spending by over 10 per cent to absorb cost increases in essential items, as per data from the Committee for Economic Development of Australia (CEDA). 

A recent Betashares survey of over 1,000 Australians also found almost a quarter (28 per cent) were focused on saving, admitting that it had gained emphasis as a key financial goal in the last decade. 

With individuals tightening their belts across the board, could responsible and ESG investment fall down the list of priorities? According to Nathan Fradley, senior adviser at Tribeca Financial and director at data firm Ethos, it wasn’t an entirely alien idea. 

“When interest rates are going up, inflation is going through the roof, gas prices go up, then people stop thinking about ESG and worry about having a roof over their heads,” he told Money Management.

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“So if you ask people ‘do you care if your super fund considers the long-term impact of climate change?’, they just want to pay their mortgage. A client’s ESG preferences won’t be expressed as strongly because it isn’t their priority right now and that’s something for advisers to take into consideration.”

Recent Morningstar data for the first quarter of 2023 reported inflows into Australian and New Zealand sustainable funds fell by over 90 per cent to an “anaemic” $214 million, down by more than $2.4 billion. 

It noted fund launches had staggered slightly at 23 new funds, which was 13 less than the previous year. However, this was still the second-highest year of fund launches on record.  

“Given the market volatility experienced this quarter, exacerbated by US regional bank insolvencies, and concerns around the viability of European bank Credit Suisse (since acquired by UBS), it is not surprising that investor confidence was tested,” the report stated.

ESG as a “sound investment”

Pete Robinson, head of investment strategy, fixed income at Challenger Investment Management, flagged that cost-of-living and ESG investments did not need to fundamentally be at odds.

He pointed to the “several significant commitments” in the 2023 Budget Federal towards sustainable finance, which included including $1.6 million to co-fund with the private sector the development of an Australian sustainable finance taxonomy; $8.3 million over four years to develop and issue sovereign green bonds; and $4.3 million to bolster ASIC’s enforcement action against greenwashing and funding for social impact investment, including a $100 million Outcomes Fund.

“These actions took place in spite of the rise in cost-of-living pressures and reflect medium to longer term trends. As investors, we have to be very aware of the changing political climate and mindful of how policy action can affect our investment universe,” Robinson said.

Additionally, cost-of-living pressures were cyclical and could change significantly over a 12–18-month time horizon while ESG issues were far more long-term, he said.

“Ultimately for us, what matters is the refinancing of our risk position and this point can be as many as 12 years into the future. Borrowers who take less sustainable actions such as reverting to cheaper but more carbon intensive sources of energy may deliver bottom line gains right now but they do so at the expense of their longer-term credibility with lenders”.

Phil Kim, State Street’s global head of ESG product, agreed that, on the contrary, firms were beginning to see it as a “sound investment” to track sustainability factors. 

“I think it's more of a realisation that these factors are material and need to be taken into consideration for better risk assessment,” he told Money Management. “The premise behind ESG and the origin of it is all about long-term sustainability, about increasing shareholder value”. 

The long-term horizon for sustainability

While current market conditions had led to some adjustments in risk profiles, ethical investing would continue to gain market share in 2023, according to Australian Ethical’s deputy chief investment officer and head of multi-asset, John Woods. 

He said: “There is no doubt that when people have less disposable income, their propensity to invest reduces, so the whole investment industry faces a challenging outlook when we start looking at high inflation. 

“I actually believe that ethical investing will continue to take share. We've seen time and time again that when people are challenged, they focus on what matters to them”. 

He added that flows to the ethical investment manager, which had over $8 billion in funds under management across managed funds and superannuation, had been strong through the period, particularly through super. 

“We could argue that, once the market volatility has occurred, that’s the time to stay the course, but we do see some switching between options [as] people tend to step down their risk profile in their super fund. But overall flows towards the business remain strong,” Woods said.

Tim Richardson, investment specialist - global equities at Pengana Capital Group, considered it highly unlikely for ESG investments to witness a decline as cost-of-living pressures persisted.

“It seems more probable that funds which take care to manage ESG risks appropriately should outperform over the long-term. If left unmanaged, ESG risks will tend to detract from returns in the same way as other risks, such as credit, operational or regulatory risks,” he said.

He turned to analysis carried out by Credit Suisse, which indicated cumulative outperformance over the last six years from funds which managed ESG risks properly, though he noted ESG alpha generation was not uniform as relative performance can be influenced by sectoral factors.

“During periods when gambling (Covid lockdowns), energy (early 2022) or defence (since February 2022) stocks perform strongly, ESG funds may see some short-term underperformance,” Richardson explained. 

Additionally, the 2022 Responsible Investment Benchmark Report by the Responsible Investment Association Australasia (RIAA) showed that RIAA-certified products exceeded average performance of traditional multi-sector growth funds three-fold over 10 years, more than double over 5 years and almost double over 3 years. 

RIAA-certified domestic share funds delivered performance more than twice the benchmark for  domestic shares over 10 years.

But beyond performance, ESG investing was not a luxury indulgence which may be renounced when budgets become tighter, Richardson said. 

“This is not how ESG investing is viewed by the majority of investors. Investing in companies that pollute the environment, treat their employees badly, misalign executive pay and have an undiversified board of poorly qualified directors is unlikely to support returns at any point of the economic cycle – in addition to being misaligned with investors’ values”.