At the end of 2021, sustainability was still the hype on the trading floor. The sustainability enthusiasm among investors reached a temporary peak and this was reflected in the enormous inflow into sustainable investment funds and the highly inflated stock prices of, for example, green energy companies. Every company report was full of the buzzwords 'ESG' and 'sustainability'. Due to the inevitability of the sustainable transition, the sky seemed to be the limit.

From sustainability to AI
But nothing is as fleeting as investor enthusiasm. In 2023, sustainable investment funds recorded a significant outflow. And the relative performance on the stock market also points to a decline in enthusiasm. For example, two indices specially compiled by Société Générale, which should benefit from the global energy transition and the European Green Deal, have been performing worse than their respective benchmarks since the beginning of last year.

This change started, not entirely coincidentally, around the rise of ChatGPT, which ushered in the AI ​​hype among investors. Since then, it has been AI that has made investors' hearts beat faster and sustainability seems to be disappearing further and further from the picture.

The political 'move to the right' probably also plays a role in this. Investors foresee a difficult period for sustainable investing. The Green New Deal Index of Société Générale indeed fell sharply after the victory of the radical right in the European Parliament elections. And in this globally important election year, investors on balance withdrew money from ESG equity funds for a longer period for the first time. This has led to rumors that sustainable investing is on the decline.

From infancy to adulthood

To me this seems to be a wrong interpretation of recent developments. Every hype comes to an end, but the question is what happens after such a hype. Will inflows dry up completely, or will there simply be a normalisation of valuations and money flows, after which growth can continue? If we look at the facts, the second seems to apply to sustainable investing.

Firstly, recent developments in the financial markets reflect the development that many sustainable industries have undergone. For example, five years ago the green energy industry was still largely in its infancy worldwide. As a result, growth expectations were enormous, justifying higher price-earnings ratios.

To illustrate: in China, at the time, an average annual profit growth per share of 35-40% was expected for green transition industries, such as electric car manufacturers. The biggest growth spurt is now behind us and growth expectations have fallen to around 15% per share. While this is still a significant profit growth expectation, the decline logically translates into lower stock prices and valuations.

Secondly, legislation and regulations have been tightened considerably in recent years. The EU reporting requirements under the Sustainable Finance Disclosure Regulation (SFDR) have made greenwashing much more difficult and recent rules regarding the naming of funds will further tighten this. While these developments have led to a reduced total AUM of 'sustainable' funds, either temporarily or permanently, because some of them no longer qualify as sustainable, this should be seen as a step forward rather than backward. The time of the proliferation of funds with dubious sustainability claims is nearing its end.

This touches on the third point: despite the extinction of the stock market hype, there is increasing social awareness that the sustainable transition is truly inevitable. This is evident from the increasing interest of institutional investors such as pension funds and universities in sustainable investing. The associated mandates are not included in data on fund flows, but they do suggest that a structural change is taking place in society.

In the meantime, sustainability risks have undeniably become material (from drought to floods), meaning that every investor must now take them into account from a simple risk management perspective, independent of any sustainability goal.

Incremental normalisation

The normalisation of sustainable investing is proceeding step by step. The current phase of declining cash flows and lower stock market valuations is accompanied by a broader social awareness that sustainability risks are material and the transition truly inevitable. The fact that we are beyond the hype and have reached this next phase is anything but bad news: it means that sustainable investing has come one step closer to being the new normal.

This is a translation of Joeri de Wilde's column published by Financial Investigator.