ESG – The next bubble?

I have read and heard first-hand from investors recently that family offices, amongst other professional investors, are allocating an ever-increasing proportion of their investible funds in Environmental, Social, and Governance (ESG) strategies.

This in itself doesn’t come as a huge surprise, given the market trends – Bloomberg Intelligence forecasts that the ESG market will make up greater than one-third of global assets by 2025; and with the influence of younger generations continuing to gain market share, it is clear why investors are seeking to hold a higher proportion of ESG investments in their portfolios.

However, with fears of ‘greenwashing’ and the differing burden of proof for ESG factors in different jurisdictions across the globe, the underlying extent of a company’s green credentials is sometimes unclear. So too is the value that can be attributed to a company’s ESG rating, nowadays often referred to as the green premium, or ‘greenium’.

In the olden days, investors used to consider future cash flows in undertaking asset valuations, but now it seems they instead turn to Reddit. Ok, perhaps that is an extreme example and does a disservice to professional investors, but to keep up with the market there has been a necessary shift in what is considered in determining an asset’s ‘value’. The most obvious examples of (implied) values rising in relatively new asset classes in recent years, without a cash flow in sight, are the substantial price rises in the cryptocurrency and “non-fungible token (NFT) markets”. That said, Bitcoin is often dubbed ‘digital gold’ and one might question what underlying value actual gold truly has, but that is a topic for another day! For now, let’s stick to the valuation of equities and the effect of a company’s ESG credentials thereon.

I am sure it is widely accepted that having a strong ESG rating makes a company increasingly attractive to its customers and a security in that company more desirable to a large and growing group of investors. That clearly suggests that there is an element of value attributable to ESG credentials by way of the greenium, however, the latter part (i.e. the attractiveness to ethical investors) does not bring with it those all important cash flows connected with the increase in value – and that could be a problem. True ethical investors may be willing to take a lower overall return in order to maintain an ESG portfolio, but the jury is out on whether traditional investors who are following a trend trajectory are too…I suspect not!

Therefore, with greeniums increasing and thus prices rising, it is no surprise that people are beginning to compare the frothiness of this market to the dotcom bubble of the turn of the millennium and the mortgage-backed securities bubble that catastrophically brought down the financial world in 2008. Of course, for the benefit of our planet, humanity, and society, ESG considerations are hugely important, so the key is to do it wisely, rather than not at all.

So how is that achieved? Go back to basics. Assess valuations on expected future cash flows or using another suitable valuation methodology, although if you suspect over-inflated values in the market, avoid a market comparable method. If, based on your valuation, the asset’s price demands a greenium, calculate the quantum and undertake due diligence to carefully substantiate what it is purported to represent before making an investment decision. That way you are investing wisely in companies with strong ESG ratings, with your eyes wide open, rather than blindly following a trend into a bubble.

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