Examining Why ESG Stocks Are Out of Favor

First, a disclaimer. From the perspective of pure performance, 2023 hasn’t been an outright disaster for environmental, social and governance (ESG) investing. The widely observed MSCI USA Extended ESG Select Index is higher by 7.5% year-to-date.

Problem is that trails the S&P 500 by 370 basis points and the ESG index has been slightly more volatile than the broader market. The other problem is that, more recently, the “E” is betraying ESG investors, meaning climate-related, environmental and renewable energy equities are slumping. This year, the S&P Global Clean Energy Index is off almost 33% and that’s after it tumbled 5.4% last year.

Undoubtedly, that’s perplexing for investors and clients that viewed the results of the 2020 presidential and subsequent passage of the Inflation Reduction Act as potential catalysts for renewable energy stocks and funds. Add to that, during that period, Europe unveiled substantial green energy adoption and spending plans of its own. Point is, ESG and sustainable funds should be performing better than they are.

Blame Interest Rates

For advisors, being able to articulate why ESG stocks and funds are slumping while helping clients see the forest through the trees is important because more investors describe themselves as “values-based.” That takes many forms, but ESG and climate awareness are at the top of the list and that’s particularly true among younger clients.

Regardless of age or demographic traits, clients are likely tired about hearing about the adverse effects of high interest rates, but that is one of the primary culprits behind the struggles of climate-related equities this year.

“Higher interest rates are impacting these companies' finances,” notes Jeffrey Kleintop of Charles Schwab. “The stocks in the MSCI World Alternative Energy Index have a leverage ratio of 3.8, based on debt-to-12-month earnings, compared with just 1.1 for the five biggest energy producers by market capitalization. That means higher financing costs are much more costly for these companies.”

Higher interest rates are also prompting a break in historical precedent for green energy stocks. In bygone eras of high oil prices, benchmarks such as the S&P Global Clean Energy Index and their components often rose on the belief that elevated oil prices would spur adoption of renewable energy sources. Clearly, that’s not happening in 2023, but renewable energy equities have gotten less expensive as a result.

“The higher the discount rate, the lower the present value of future cash flows—especially cash flows expected in the more distant future,” adds Kleintop. “This can drive down the valuation measured by the price-to-earnings and price-to-cash-flow ratios. An example of how this has impacted alternative energy companies can be seen with First Solar, the stock with the largest weighing in the S&P Global Clean Energy Index. The company's earnings per share more than doubled since 2021. Yet, the price-to-earnings ratio plunged from a high of 48.5 in 2021 to now stand at 14.7.”

Forget Politics

It’s not a stretch to say that renewable energy equities are nearly as politically sensitive as the healthcare sector and that’s explained by the assumption that Democrats are “good” for green energy investing and Republicans are the opposite.

However, performance proves differently. From the time President Obama took office in January 2009 through Election Day 2016, the S&P Global Clean Energy Index plunged nearly 43% while the S&P 500 Energy Index surged 84.6%, refuting the widely held thesis that Democrat presidents present danger to fossil fuels stocks.

From the day after the 2016 election through Election Day 2020, the S&P Global Clean Energy Index surged 168.3% while the fossil fuels index lost almost half its value. All that under President Trump – a Republican that made increased oil and natural gas output a centerpiece of his domestic agenda, one that featured little to boost renewable energy.

Point is ESG investors, like the rest of us, can be left disappointed by politicians.

Related: Fintech Still Holds Appeal, but Patience Required