As Canadian markets rallied after the pandemic-induced downturn of spring 2020, one market segment seemed especially — and to some, surprisingly — robust. Investments in ESG funds (those that consider environmental, social and governance factors) started performing better than non-ESG investments.
Investors quickly took notice of this ethical investing boom. In 2020, ESG inflows in Canada exceeded C$3 billion, more than triple those from 2019. In the first two quarters of 2021, that figure rose to nearly $7.5 billion. And new investment products are quickly emerging to satisfy this booming demand, the most recent being sustainability-linked bonds (SLBs), a relatively new debt vehicle.
But does the sustainable investing trend have staying power?
“I think it’s a fundamental and permanent shift,” says Sarah Keyes, principal with ESG Global Advisors, which advises individuals and companies on ESG issues. In part, she says, it has to do with the ongoing wealth transfer from the baby boomer generation to millennials and Generation Z, to the tune of around $700 billion.
“Younger investors tend to be more invested in social movements, in environmental concerns, and climate change especially is now seen as an issue of overriding importance,” says Keyes. “I think we’re in a new world in which companies will need to operate under greatly increased scrutiny.”
Looking under the ESG hood
Unfortunately, there are no hard-and-fast regulatory principles in Canada around what exactly constitutes an ESG investment. That means that investors still need to perform plenty of due diligence to make sure that supposedly sustainable investments truly align with their priorities.
That hasn’t changed much in recent years, despite the increasing popularity of ESG branding.
Tim Nash, the founder of ESG-focused investing-advisory website Good Investing, and a certified financial planner, says the first thing to do is simply put hard questions to your advisor.
“First and foremost, you want to understand a fund’s methodology — how it screens for ESG principles, what it excludes, and what is the threshold for exclusion and inclusion,” he says.
Secondly, ensure you can get a fairly recent list of all the fund’s holdings.
“One reason I love ETFs (Exchange Traded Funds) is that it’s often easier to see that list than with mutual funds,” says Nash. “Either way, it’s a gut check. If companies elicit an emotional reaction, you’ll see that, and everyone has a different threshold, from doing less evil to complete crunchy granola.”
Auditing a fund’s holdings can also help to highlight obvious instances of greenwashing. “Because of the surge in demand for these products, a lot of investment funds are kind of slapping the ESG label on things, without the follow-through,” says Nash.
He points to a recent example: In July, Franklin Templeton released the Franklin Martin Currie Sustainable Global Equity ETF, one of a multitude of new ESG-focused products. A quick look at its holdings reveals investments in oil-giant BP and tobacco company British American Tobacco.
“That might be okay with some investors,” says Nash, “but I think a lot of people attracted by the word ‘sustainable,’ would be very surprised by that. It’s really important to look under the hood.”
ESG meets SLB
Recently, a new ESG option has emerged: sustainability-linked bonds, or SLBs.
Unlike green bonds, which are issued to fund specific environmentally progressive initiatives, SLBs tie bond coupons (the interest rate paid to investors) to sustainability targets. If the company doesn’t meet those targets, the coupon increases, resulting in higher yields to investors. TELUS recently issued the first Canadian SLB, raising C$750 million.
SLBs are an innovative response to investor demand, but there remain concerns about how they operate. Foremost is how sustainability objectives are measured and disclosed. The International Capital Markets Association has published a set of principles to address that, but they’re voluntary. It’s still possible, critics suggest, for companies to use vague or easy-to-achieve benchmarks.
In other instances, definitions of sustainability may be fast and loose. In June 2021, pipeline company Enbridge issued a USD-linked SLB, aiming to raise $1 billion. The bond is based on company-wide goals, including reducing carbon emissions and improving equity and inclusion for the company’s workforce. But because the debt can be used to fund any company initiative — including new pipelines — some ESG investors may balk.
The structure of SLBs also means that investors paradoxically benefit from higher returns when the company falls short of its goals — which is, says Nash, “a strange incentive for ESG-focused investors. You almost want the company to miss its targets, so it doesn’t necessarily align investor values and rewards.”
The next trend?
According to Keyes, a related development that may start to gain more traction in Canada is the transition bond.
“Canada is a natural-resource based economy,” she says, “but forestry, oil and gas, mining, these industries can’t really credibly issue green bonds.” Transition bonds are intended to do just what the name implies: access funding tied to projects or targets designed to improve environmental performance.
Ultimately, Keyes is optimistic that things are getting easier for ESG investors, with clearer rules and more straightforward regulations on the way. In July, Gary Gensler, chairman of the U.S. Security and Exchange Commission said he wanted to see mandatory climate-related disclosures from public companies by the end of 2021.
Which leads to the question: does the growing focus on ESG really represent shifting values in the financial world, or simply a response to changing investor preferences?
“That’s the million-dollar question,” says Keyes. “But I think the important thing is that we’re starting to see recognition that we can’t separate the economy from the society in which it operates, and the environment upon which we all depend. We’re not all the way there yet, but it’s happening.”