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Executive Summary
Environmental social governance (ESG) funds are growing rapidly with over 4x the amount (see Figure 4) of net investment assets (per $M USD) compared to normal investment funds in 2020
North America has traditionally held the majority of ESG funds since 1996, but the linkages between CO2 emissions and higher ESG scores demonstrate the need for EU investment and adoption
Relatively close net expense ratios offer possible opportunities for market interventions by policy makers and larger return opportunities for investors
Introduction
As a global leader in the fight against climate change and the green transition, the European Union’s European Commission plays a strategic role in policy and global markets. ESG funds offer significant potential in advancing the Commission’s policy agenda, specifically when considering CO2 emissions. A leading question about ESG funds are what are their true impacts on sustainability outcomes? Do investors really help firms achieve lower emissions, better labor practices, lower environmental footprints? While the majority of investment assets in the EU hold relatively higher ESG scores, the volume pales in comparison to larger economies like those in North America (Seen in Figure 1 below). ESG funds are largely rated AA to AAA which reduces the risk to investors, attracting investment (Figure 2). Further, they are overwhelmingly less carbon-intensive compared to regular funds (seen in Figure 3), To better understand ESG’s significance in the European and Global context it is important to look at growth trends, impacts on emissions, and the barriers to further investment.
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The Rise of ESG Assets
With a forecasted rise of ESG assets under management to $33.9T USD by 2026, ESG investments are at the forefront of the investment landscape and a helpful tool in the global fight against climate change, better business practices, and sustainable development. The European Union will play a strong role in this growth with its own forecasts of €9T by 2025. EU policy makers must be both aware of ESG’s role in its Green Transition as well as what it means for its economy. While ESG funds outmatched net investment assets of regular funds (see Figure 4 below), there are still looming questions about the true value of ESG funds, their scoring, their returns, and most importantly their impact.
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Do ratings reflect impact? Scores, CO2 emissions seem to agree
Blackrock’s August ESG data shows a clear trend around the world between higher ESG scores (scored 1-12 in order of least to most sustainable) and CO2 emissions (mega tons): as funds score higher on MSCI’s index, they also reflect measurably fewer CO2 emissions. While the US dominates Blackrock’s ESG market reporting, the EU shows a more dramatic decline amongst its normal investment funds that have also been rated on the same scale as ESG funds. As the EU implements its Green Deal Industrial Plan, the European Commission should consider regulatory instruments to ensure that there are ample opportunities for ESG scoring of new technology and infrastructure projects to attract both foreign and domestic ESG investment. Ensuring that there are proper protections scoring methodologies and investments will enable the EU to leverage both its private and public sectors to reduce emissions.
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How can the EC get involved? Help with the costs…
The greatest challenge with ESG funds is ensuring that they are more attractive to investors (in addition to ensuring their bonafide sustainability impacts). Looking at net expense ratios throughout Blackrock’s 1996-2022 data, ESG funds closely mimic regular investment fund expense ratios. Helping subsidize or regulate premiums on some of the fixed costs of ESG assets may greatly improve the investment environment and allow greater returns for investors. With the proper incentives this could trigger a cycle of increasing ESG assets, better quality of scoring systems, and long-term impacts of improved sustainability practices. ESG funds that lack quality sustainability outcomes and higher net expense ratios are less attractive to investors, seen in a recent Bloomberg article. The European Union has the power to change this and create another private market tool to aid its larger policy aims.
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Conclusion
ESG funds are noticeably missing in the European market and are a vital component in reducing CO2 emissions and improving sustainability practices in the private sector. There are demonstrated reductions in emissions with higher ESG scores amongst investment funds and there is room for growth with policy and market interventions by the European Commission that will attract more investors. With new Green Bonds, Green Taxonomies, and other parts of the EU agenda in effect, the protection and expansion of ESG assets provide a clear opportunity for the EU to combine public-private sector efforts to fight climate change and improve corporate sustainability impacts.
Sources: Blackrock MSCI Data (August 2022), Bloomberg News, EU, PwC, and Funds Europe
