Ukraine Crisis and Inflation Weigh on ESG Investment Funds

Investment flows to environmental, social and governance (ESG) funds fell to $75 billion in the first quarter of this year amid a sharp decline in global risk appetite, rising inflationary fears and higher borrowing costs, according to Institute of International Finance research.

This was the lowest level compared with the previous seven consecutive quarters.

Inflows to ESG funds in March were $15bn, their weakest since March 2020, the IIF said in a note on Thursday.

“The retrenchment in flows was mainly in equity funds as increased volatility in tech shares reduced investor appetite for ESG funds that are heavily invested in tech,” said Emre Tiftik, director of sustainability research at IIF.

“Higher oil prices were also a factor as investors channelled funds into [non-ESG] energy stocks. Overall, ESG-labelled equity funds attracted some $41bn of net cash flows in Q1, with monthly flows in March 2022 dropping to their lowest level since March 2020, when the Covid-19 shock triggered large outflows from ESG funds.”

In the year to November 30, 2021, a record $649bn was poured into ESG-focused funds worldwide, up from the $542bn in 2020 and $285bn in 2019, Refinitiv Lipper Research found.

ESG funds now account for 10 per cent of fund assets worldwide.

A survey conducted during Abu Dhabi Sustainability Week in January by Masdar and Harvard Business Review to understand how businesses are enacting ESG strategies, found that 83 per cent of respondents indicated their organisations will increase investments in ESG initiatives over the next 12 months.

However, when questioned about the status of their ESG activities, 27 per cent said they had no formal strategy in place, with a further 10 per cent admitting they were not working on improving their ESG activities at this stage.

The most desired outcome from investing in ESG is to enhance brand reputation, according to 61 per cent of respondents, although only 55 per cent believe they have done so to date.

Flows to ESG fixed-income funds also declined sharply to $14bn in the first quarter of this year, compared with $27bn in the preceding quarter, the IIF research showed.

While rising interest rates hit investor demand for all types of bonds in the first quarter, investment grade ESG bonds outperformed their conventional peers, the IIF said.

However, high-yield ESG bonds underperformed compared with their conventional counterparts, which were buoyed by energy sector bonds, particularly in the first two months of the year.

“Looking ahead, [the] ripple effects of the Russia-Ukraine war will have profound consequences for ESG fund markets,” Mr Tiftik said.

Total ESG-labelled debt issuance amounted to $285bn in the three months to March 31, about 30 per cent lower than in the fourth quarter of last year, the IIF said.

“This slowdown came against the backdrop of increased market volatility — driven by tightening financial conditions as the Fed signals a more aggressive fight to curb inflation, and by the Russia-Ukraine war,” Mr Tiftik said.

“In some instances, the recovery in corporate earnings and the moderation in sovereign borrowing needs have been important factors weighing on issuance volumes.”

The decline in ESG debt issuance in the first quarter was largely associated with sustainability-linked loans and green bonds, with volumes contracting by more than half and by a fifth, respectively, the IIF said.

The growing focus on energy security will hasten efforts to scale up climate finance, spurring the development of clean energy funds, the research showed.

“Investor demand will remain underpinned by the continued acceleration in corporate net-zero pledges,” it said.

With a growing number of financial institutions and non-financial corporates committing to carbon emission reduction, further expansion of ESG fund markets should support international efforts to establish global disclosure standards, the Washington-based agency said.

Meanwhile, total issuance in the voluntary carbon offset market also declined sharply in the first quarter of 2022, with the largest volumes coming from China, the Democratic Republic of the Congo, India, the US and Turkey, the research revealed.