The Bank for International Settlements (BIS), has warned of the growing risk of overheated prices in environmentally friendly-focused asset markets that could parallel the dotcom and sub-prime mortgage bubbles that were seen in the first decade of this century.
In its latest quarterly report, the BIS, often called the central bank of central banks, said the explosion in assets embracing environmental, social, and governance (ESG) criteria has ballooned valuations for ESG-linked funds and stocks, invoking a comparison to sky high technology and mortgage prices which played a significant part in triggering the financial crisis of 2008.
Claudio Borio, head of its monetary and economic department, referred to it as the “green bubble” risk, highlighting how the surge in exchange traded funds (ETFs) )and mutual funds was comparable to parts of the mortgage- backed security market in the runup to the global financial crisis.
“You could have too much, too quickly of a good thing,” Borio said. “We know valuations are rather rich”.
The report said thar the price/earnings ratio of the S&P global clean energy index spiked to 80 at the end of 2020, and fell to about 45 by mid-year, above the S&P 500 index of US leading equities, still a roughly albeit significant gap.
The clean energy index includes firms producing energy from solar, wind, hydro and other renewables.
As for this year, the report said that “even after a decline from their peak in January 2021, price-to-earnings ratios for clean energy companies are still well above those of already richly-valued growth stocks. Rich valuations in credit markets would be more relevant for assessing possible risks of financial distress, given the potential for defaults.”
The report added, “More analysis would be needed to evaluate this possibility, including by estimating the size of any “greenium” or “socium” – the lower premium that market participants require for bearing financial risk when their investments support environmental or social causes – as it could signal market overheating. “However, despite its concerns over the frothy prices, the BIS noted that the potential for contagion between ESG and the real economy is far more limited than the 2008 mortgage market, calling faulty ESG investments “of indirect concern from a financial stability perspective.”
In part, this is because the ESG phenomenon is mostly occurring within stocks, which tend to pose fewer systemic risks than debt markets.
In addition, studies show that only a few sectors seem significantly overweight in ESG indices compared with the broader market, such as renewable electricity, have moderately higher valuations. However, these constitute only a small weighting in market benchmarks.
Current holdings of ESG linked bonds are only estimated to account for about 1% of total bond portfolios for both US insurance companies and European banks.
“Assets related to fundamental economic and social changes tend to undergo large price corrections after an initial investment boom. Railroad stocks in the mid-1800s, internet stocks during the dotcom bubble and mortgage-backed securities (MBS) in the Great Financial Crisis (GFC) are cases in point. It is thus noteworthy that the pre-GFC growth and size of the private label MBS market are comparable with those recently observed for ESG mutual funds and ETFs,” it said.
For now, the BIS is keeping a watchful eye and “closely monitoring developments in the ESG market. If the market continues to grow at the current pace, and more elaborate instruments emerge (eg structured products), it will be important not only to assess the benefits of financing the transition to a low-carbon world, but also to identify and manage the financial risks that might arise from a shift in investors’ portfolios.”
The BIS also flagged several widely discussed issues in ESG investing such as limited disclosure rules and a lack of standardisation as well as “greenwashing,” where ESG fund providers exaggerate the benefits are potentially being over-exaggerated.
As the report points out, “One set of industry estimates relies on a broad definition that includes various approaches to integrating ESG criteria as well as “thematic”, “impact” and “community” investing.
It said the sheer proliferation of ESG-themed investment means that clients can struggle to tell them apart, and that there are insufficiently profitable opportunities for investors to chase. Ironically, the recent sharp spike in gas and energy prices, bringing threats of potential power shortages in countries such as the UK, appear to raise questions over whether commitments to achieve “net zero” carbon emissions by mid-century are wise
Over the past two years, financial service firms across the spectrum have embraced ESG investing, launching a plethora of fund, loan and other products as well as asset management capabilities catering to the burgeoning demand of green and sustainable forms of investment.
The latest Global Sustainable Investment Alliance (GSAI) report showed that sustainable investment assets grew to $35.3 trn globally last year amid mounting concerns about climate change and social societal inequities.
That translates into about $1 of every $3 managed globally is looking to generate a profit from ESG concerns.
However, the bulk of that money—around $25 trn—is directed towards strategies labelled “ESG integration,” also known as “ESG consideration.”
In theory, GSIA, says this means that managers are including ESG data in their financial models.
©Markets Media Europe 2021