The combination of a drop in tech stocks (which many ESG funds have a high exposure to) and a rush into traditional energy and commodities (which some see as a hedge against inflation) have led to poor performance from ESG funds in the short term while traditional energy indices displayed record growth. Just 13 of the 66 Morningstar ESG indices outperformed their non-ESG counterparts in Q1 2022 (vs 31 in 2021), for example, while by late May 2022 the S&P 500 Energy Index was up 45% (vs a drop of 16% for the S&P 500).

Overall flows into ESG funds have slowed as a result. Sustainable funds brought in $97 billion of new investment in the first three months of the year, a 35% drop compared with the previous quarter. The ESG sector has also been rocked by concerns over the rise of greenwashing – from the DWS investigation in Germany to proposed rule changes by the SEC to prevent misleading claims by ESG funds.

Understanding what these recent developments mean for the future of ESG requires parsing short-term news from long-term trends. The first thing to note is that while flows have slowed, they fell less than the broader market. And while short-term performance is down, long-term performance of ESG indices tends to outdo that of their non-ESG counter parts. Likewise, sustainable bond funds offer better risk-adjusted returns, according to a recent study by the European Fund and Asset Management Association.

The picture is somewhat different on the debt side, where sustainable debt issuance declined faster than the general bond market in Q1 2022 (19% year on year drop vs 5%). An important exception to this trend are sustainability-linked debt instruments, which are becoming more attractive both because they can be designed so that sustainability performance leads to lower interest rates and because their use of proceeds is not restricted. This flexibility led to that segment of the market to register a year-on-year growth of more than 100% in Q1 2022.

Investments at the VC level are also up, with climate tech attracting $6.4bn of investment in January 2022 alone. Notable deals this year include energy data start-up Arcadia raising a $200m Series E round; Carbon Clean raising $150m in a record round for a point source carbon capture company; Li-cycle, a Canadian battery recycling start-up that garnered $200m and Ather Energy, which raised $128m to expand manufacturing of electric scooters.

Deeper structural trends economic rationales for ESG investing are not just strong but reinforced by current volatilities. Publicly-traded renewable power portfolios notched much higher returns and experienced lower volatility over fossil fuels during the past decade. The techno-economics are moving faster in clean energy compared to fossil energy. A study by experts at Oxford University showed renewable energy technology costs have plummeted exponentially in recent decades following ‘Wright’s Law’, while those in fossil fuels have remained roughly the same for a century.

That is not to say ESG is immune to economic challenges. Low carbon goods require minerals and metals, travel along supply chains, and need a workforce. As inflation mounts, these can create financial pressures on margins and costs.

There will also be regulatory pressure. There are now more than 750 policy tools promoting sustainable finance globally, 300 of which involve ESG. The steady rise in both quantity and quality of these regulations, combined with the need to deliver net-zero in time to deliver the Paris Agreement, will create the strong demand base the sector needs for long-term growth.

The rush into ESG has created novel risks and challenges, and the sector has been rocked by a volatile global economy. To survive in today’s new economic reality, the sector will have no choice but to shed the superfluous and focus on the fundamentals instead. Only then will it become the trusted and transparent mechanism we need to deliver the sustainable transition.

Survival of the Greenest: ESG in a Bear Market Context