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From green to in the red: why rising interest rates are making ESG stocks underperform

From green to in the red: why rising interest rates are making ESG stocks underperform

Demand for ESG investing keeps rising, with leading banks planning to issue billions of dollars in sustainability-focused bonds in the coming year, but ESG stocks are underperforming despite the apparent unabated enthusiasm for environmentally conscious investments.

One reason? Interest rates are also on the uptick, and that’s making some investors rethink the rush to ESG. They’re taking a second glance at cash-rich companies like oil producers rather than gambling on shares of ESG companies that might struggle to secure funding, face stunted growth, and experience significant volatility whenever the Federal Reserve hikes rates.

And there are additional explanations for why ESG stocks are failing to reach their potential, including “greenwashing” by companies who claim on one hand to be fighting for the planet and on the other conveniently forgetting to follow on their promises, and soaring energy prices.

Add it all up, and green investments in ESG now risk falling into the red.

ESG refers to environmental, social, and governance investing and it’s a broad term that can cover many different types of business. It generally refers to efforts by investors to pressure companies into being socially conscious stewards of the environment, for example issuing a commitment to reducing greenhouse gas emissions by a certain amount and date.

Investor interest in ESG funds has increased year on year, spurred in part by the ongoing debate about climate change and efforts by certain companies to seek public recognition of their efforts to reduce the impact that they have on the environment and natural resources.

The Biden administration is taking several steps that are expected to encourage ESG investing, such as a pending U.S. Securities and Exchange Commission guidance that is likely to push companies more in the direction of disclosing their annual greenhouse gas emissions.

But even with that momentum, several ESG stocks – think Tesla, along with some solar companies and others – are either falling in value or not reaching their predicted potential.

Interest rates play a significant role in the performance of ESG stocks because inflation is already being pushed to new record highs. The stocks are often seen as more of a gamble than conventional index funds, and as a result, suffer more when the market starts to shift away from making decisions based on being socially conscious to being profitable and secure.

There are other explanations for why ESG stocks aren’t having their best moment, including several well-publicized examples of greenwashing. The carbon offset market in particular is rife for false claims from companies that want a simple way to gain green credibility. A carbon offset is an action a company takes to cancel out, or offset another of its actions that lead to an increase in carbon emissions. For example, a company that owns industrial facilities that emit high levels of carbon might invest in planting thousands of new carbon-absorbing trees.

Greenwashing can affect companies large and small, with Nestle and Unilever recently having to fend off claims that their offset program doesn’t actually reduce carbon. That kind of negative publicity can be harmful to any stocks being promoted as ESG.

Rising energy prices, tied naturally to inflation, also have a direct impact on the popularity of ESG stocks. When energy becomes more expensive, it causes a resurgence in reliance on higher-emitting but reliable sources of power such as oil and natural gas, while causing a setback for clean energy technologies that are yet to be fully realized.

Although ESG stocks are underperforming, there’s reason to remain hopeful about their future. The Inter-American Development Bank’s private sector division IDB Invest is weighing issuance of up to $2 billion in ESG bonds in 2022, which would be an important boost.

So there’s the reason for pessimism, and there’s the reason for optimism, with the fluctuating fortunes of ESG stocks serving as a strong reminder of the benefits of having a diverse portfolio.

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