Insights

When sustainability falls victim to its own success

There are lessons to be learned from the rebalancing of the S&P Dow Jones Clean Energy index and BlackRock ETFs tracking it.

Last week, we penned an article in ESG Clarity about the problems facing the sustainable investing market. On the same day, one was realised on a $12bn scale.

We make no secret of our concerns about many ESG ETFs: in particular, their frequent exposure to not-so-sustainable stocks, and the ‘crude oversimplification’ driving portfolio construction.

Too many funds are simply overweight Silicon Valley and renewables. It’s rudimentary. It’s not sustainable in any sense of the word. The consumer, media and investor buzz around ESG is leading to mind-boggling valuations among tech and renewable companies as money pours in. According to Investors Chronicle, the 50 most popular ESG stocks trade at a 33% premium to the market.

Which is where this story begins. Published last month, the Investors Chronicle article quotes Peter Bisztyga, an analyst at Bank of America, as having downgraded the firm’s view on two of the biggest renewable players: media darlings EDP Renováveis and Ørsted. Bisztyga couldn’t understand why the two stocks had rallied more than 40% in just a few months, much less justify it. But his team soon discovered what was driving the distortion.

EDP and Ørsted were among the top-weighted constituents of BlackRock’s mammoth iShares Global Clean Energy ETF ($ICLN) and its European UCITS equivalent ($INRG), whose combined assets surged from near $1bn at the start of last year to over $12bn today. The sharp rise in inflows was largely thanks to US President Joe Biden’s pledge to ramp up green investment—not to mention growing interest in sustainable investing.

An explosion from $1bn to $12bn in AuM is pretty remarkable. Even more remarkable is the fact that the twin ETFs were, until last week, tracking an index of only 30 stocks. As was 45% of the total money invested in non-fossil fuel energy ETFs.

No wonder EDP and Ørsted were looking overvalued.

Unsurprisingly, it wasn’t long until Société Générale raised the alarm and called for an index rebalancing to address concentration and liquidity concerns. In a report sent to clients, Société Générale pointed out that “the problem stems from a cocktail of large money flows in the ETFs replicating an index launched 14 year ago, whose rules seem no longer suitable to the large assets collected by the ETFs.” As a result, the ETFs owned 8% of the market cap of six stocks and more than 6% of a further eight.

“Too much money is chasing too few shares and those shares are too small,” 7IM fund manager Peter Sleep told the FT recently. “$11bn is chasing after these tiny stocks and it just drives up prices.”

On the back of Société Générale’s recommendations, last week the S&P Dow Jones Clean Energy Index was subject to a significant rebalancing, as were the BlackRock funds tracking it.

There were two painful outcomes for the companies and investors exposed.

First, several of the 30 suffered dramatic price shocks as asset managers were forced to sell billions of dollars worth of shares. (Sleep had anticipated as much when he told the FT that “every hedge fund” would be looking at the list to work out which they could short.)

Second, the BlackRock ETFs, while now invested in 82 stocks and thus relatively free of liquidity risks and concentration concerns, are suddenly exposed to a swathe of energy companies whose primary business is not clean energy.

Where the old index was 100% pure-play clean energy, the new is only 66%. That’s an issue, not least because of the problematic financing structure that underpins many ‘transitional’ energy companies. Businesses that produce both oil and renewables get cheaper financing in renewables—and investors may end up unwittingly financing the dirty rather than clean energy parts of the company.

The events of the last week marked an inflection point for clean energy ETFs, and for thematic sustainable strategies more generally. The funds, and the companies they hold, fell victim to their own success. As capital continues to pour into thematic sustainable ETFs, there could be many more similar road bumps on the horizon.

But it needn’t be the case. There are two takeaways from this story.

For companies: there’s plenty of money—too much money—in the market for businesses that are willing to innovate and invest in R&D for new products. Ørsted is the corporate poster child for the transition to a low-carbon economy, having entirely revamped its product line. It has been rewarded accordingly.

For investors: there’s plenty of money, less the risk, in thinking bigger and more creatively about portfolio construction. There’s no reason why sustainable ETFs and indexes shouldn’t have access to a much wider investable universe if they take a top-down, rather than bottom-up, approach, made possible only with truly scalable data. Why should a clean energy fund focus solely on renewable companies? The world is an infinitely interconnected and nuanced network: our data can yield thousands of companies that, while not ostensibly in the energy sector, do in fact have a positive impact on the transition.

Companies: think bolder. Investors: think bigger. And perhaps we can avoid sustainable investing again falling prey to the trap of its own success.