Sticking with sustainability

2022 was a very challenging year for all investors, but there were additional headwinds for those with a sustainable tilt. The strong performance of oil and gas companies led many sustainably tilted strategies – particularly those that apply blanket exclusion policies – to underperform benchmarks, while the growth tilt of renewable technology stocks was also problematic in a year where surging bond yields prompted a broad-based growth sell off.

A closer look under the surface of the equity market helps to track how sentiment ebbed and flowed. Fossil fuel companies were the major beneficiary of high commodity prices, outperforming global stocks by more than 40% over the course of the year. Sustainably focused strategies that tilt away from the traditional energy sector were therefore likely laggards. Performance across the broader renewable energy sector was more nuanced, with a sharp sell-off at the start of the year as bond yields rose followed by a turnaround that began with the Russia-Ukraine war. Strategies linked to hydrogen stocks suffered much more, with several of the most popular funds down more than 40% in 2022 given their acute sensitivity to rising bond yields (Exhibit 17). 

Exhibit 17: Performance varied widely across the energy spectrum last year

Energy sector performance in 2022
Index level, rebased to 100 in January 2022

Source: MSCI, Refinitiv Datastream, J.P. Morgan Asset Management. Alternative energy is the MSCI Global Alternative Energy index, traditional energy is the MSCI ACWI Energy index and hydrogen is a custom-built, equally weighted index of five hydrogen focused ETFs. Past performance is not a reliable indicator of current and future results. Data as of 31 October 2022.

Despite these recent difficulties, we see many reasons why it would be a mistake for investors to shy away from reflecting sustainability considerations in portfolios.

In Europe, the energy crisis is forcing governments to prioritise energy security in the short term, with coal demand reaching new highs in 2022, and oil and gas companies delivering strong profits growth as prices surged. Yet these events must not obscure the bigger picture. To reduce dependency on Russian fuel while also meeting climate objectives, Europe needs to reshape how it sources and uses energy, and fast.

An accelerated rollout of lower priced renewable projects is the only medium-term solution, with associated earnings tailwinds for energy companies that can scale up their renewable capacity. Clean energy investment is accelerating in response, with the International Energy Agency estimating at least USD 1.4 trillion of new investment in 2022 and the sector now accounting for almost three quarters of the growth in overall energy investment. The European Union’s (EU’s) REPowerEU plan allocates nearly EUR 300 billion in investment by 2030 to help reduce the bloc’s dependence on Russian fossil fuels. The US is also joining the party, with the Inflation Reduction Act including tax credits and other financial incentives aimed at making clean energy more accessible.

Fears around windfall taxes – not just for energy companies but also for electricity providers – may be one reason why this earnings optimism has not been fully reflected in prices so far. Clearly it is not socially acceptable to allow utility companies to reap large windfall profits from surging electricity prices in the midst of a cost-of-living crisis. Yet given the need for governments to encourage investment as part of the energy transition, we would expect any impact of windfall taxes on renewable providers to be far less than for traditional energy companies. If the marginal cost of electricity is eventually de-linked from the natural gas price – as the EU and UK are examining – then renewables providers would probably fall out of scope of such taxes too.

Changes in the broader macro environment could also be more conducive for sustainable equity strategies in 2023. After a historic sell-off in the bond market, our base case sees moderating inflation leading to more stable bond yields this year. This should help to reduce the pressure on companies pushing for technological breakthroughs who have a much greater proportion of their earnings assumed to be further in the future (and are therefore much more sensitive to changes in discount rates).

Sustainably minded investors should not only look to equity markets this year – we also expect green bond markets to see significant development. With governments and corporates across Europe looking to raise capital to tackle environmental challenges, there is no shortage of projects that could be financed via greater green bond issuance. Issuers in these markets benefit not only from strong demand that can help to drive down yields (Exhibit 18) relative to traditional bond counterparts, but also an investor base that is tilted towards more stable lenders of capital than conventional syndications. 

Exhibit 18: The green premium between green and traditional bonds continues to widen

Spread between green and traditional corporate bonds
Basis points

Source: Barclays Research, J.P. Morgan Asset Management. Data shown is for a Barclays Research custom universe of green and non-green investment-grade credits, matched by issuer, currency, seniority and maturity. The universe consists of 164 pairs, 99 EUR denominated, 61 USD denominated, and 4 GBP denominated and 88 financials and 76 non-financials. Spread difference is measured using the option-adjusted spread. Past performance is not a reliable indicator of current and future results. Data as of 31 October 2022.

While the prospect of greater issuance is rarely something to cheer for bond investors, this activity should go a long way to addressing one of the green bond market’s key deficiencies: the lack of a “green yield curve” that makes manoeuvring portfolios in this universe more challenging. As the green bond market matures, an expanded opportunity set that offers greater flexibility will be a major requirement. The key for investors will be to scrutinise covenants for measurable and specific targets, and ensure that proceeds make a material difference to the ability of the issuer to deliver their green, social or sustainable project.

In sum, many investors will have ended 2022 feeling battered and bruised and, unlike in recent years, a sustainable tilt is unlikely to have helped to boost portfolio resilience. Yet we believe it would be short-sighted to shun the sustainable agenda as a result. Policy tailwinds look set to combine with improved valuations and a more conducive macro backdrop, creating investment opportunities that are too exciting to ignore.

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