The tectonic shift to sustainable investing

Three powerful forces are converging to drive a long-term trend in favor of sustainable assets. Investors who position themselves for the new world stand to benefit.

Investing is undergoing a long-term transformation toward sustainability. "Climate risk and transition risk are going to impact every portfolio across the board," said BlackRock's Chairman and CEO Larry Fink, speaking with Bill Gates at BlackRock’s recent Future Forum event Sustainability: The path to net zero. "It's become clear to me that this is going to be a sea change."

The confluence of three powerful trends sets the stage

Recognition of the enormity of climate change
A growing body of evidence that the climate status quo is untenable
Reallocation of capital toward sustainable companies
A global reallocation of capital toward more-sustainable companies, driven by evolving customer preferences
Data linking sustainable investing to alpha
Data demonstrating that sustainable investing may help deliver alpha and boost portfolio resilience

We believe these factors, taken together, create an inexorable, generational and unprecedented shift in favor of sustainable investments. We are convinced that this trend will raise the relative prices and valuations of assets with stronger sustainability characteristics, and that investors who act now to position themselves for this change are likely to benefit in the years to come.

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Climate risk and transition risk are going to impact every portfolio across the board.

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Larry Fink Chairman and CEO at BlackRock

Three forces shaping the new paradigm

1. Recognition of the enormity of climate change

Around the world, people in every sphere—citizens, consumers, policymakers, corporate decision-makers, investors and more—have begun to realize the urgent need to address climate change. Indeed, the mounting costs of extreme weather events have become impossible to ignore.

Extreme weather events have increased drastically in the last decade, leading to higher costs

Extreme weather events and costs chart

Source: Munich RE, Record hurricane season and major wildfires – The natural disaster figures for 2020, as of January 7, 2021. All amounts given in USD.

Investors are taking note: 88% of investors polled by BlackRock’s Global Sustainable Investing Survey ranked the environment as the top priority among ESG factors.1

The rising focus on climate change is already disrupting industries. Consider automobiles: General Motors has pledged to electrify all its light-duty vehicles by 2035 and be carbon-neutral by 2040.2 The need to act on climate change “caused us to start in earnest developing the platform…to provide an electric vehicle for everyone,” said GM CEO Mary Barra, speaking at BlackRock’s Future Forum on Sustainability.

As legacy companies adapt, opportunities open for innovation. “What we're witnessing is perhaps one of the most interesting transitions we're going to see for a long while,” said RJ Scaringe, founder of electric truck and SUV maker Rivian, another speaker at the BlackRock Future Forum. “A massive, massive industry – everything from the fuel supply, to the supply chain around the components in a vehicle, to production of those vehicles, to how those vehicles are distributed, to how they're serviced, to how they're operated – all of that is going to change, and change in a meaningful way over the next 10 years.”

Sustainability at the portfolio level
We analyze the impact of allocating to sustainable investments on the return, risk and ESG profile at the whole portfolio level.
Sustainability image (windows) by BlackRock

2. Reallocation of capital toward sustainable companies

New global flows into sustainable funds increased from US$30 billion in 2016 to US$360 billion in 2020, rising every year.3 This trend is just beginning. Institutional investors worldwide representing US$25 trillion in assets expect to double their sustainable assets under management over the next five years.4

Institutions to double sustainable investments by 2025

Allocations to sustainable assets

Allocations to sustainable assets by asset class

Source: BlackRock 2020 Global Sustainable Investing Survey, as of December 3, 2020.

We believe this shift will accelerate as more investors price the impacts of sustainability into their assumptions. Rising asset flows are likely to boost the asset prices and valuations of more-sustainable investments, benefiting the investors who hold them. "We're in the very early stages of this journey,” said Fink, noting that he expects it to last decades.

Some investors remain hesitant: BlackRock’s Global Sustainable Investing Survey showed that nearly a third of investors believe there are insufficient products available to meet their sustainability objectives.5 Innovation in the investment industry is likely to dispel concerns long-term. Sustainable investment options now encompass virtually every asset class, from green bonds to renewable infrastructure to targeted thematic climate strategies.

Investors’ options continue to expand rapidly. For example, sustainable investments are the fastest-growing type of exchange-traded fund (ETF).6 Given the ease of market access ETFs may offer, the growth of sustainable ETFs could facilitate climate-aware investing for many more investors—especially considering institutions’ stated intention to increase allocations to sustainable assets.

Historically, a lack of robust data measuring environmental, social and governance factors has been a barrier for many investors. In the BlackRock 2020 Global Sustainable Investing Survey, more than half (53%) of institutional investors cite lack of high-quality ESG data and analytics as the biggest obstacle to implementing sustainable investing.7

But the quality and quantity of sustainability data are increasing rapidly. Nine out of 10 S&P 500 companies reported ESG metrics in 2019, up from two in 10 in 2011.8 As companies provide greater transparency and disclosure, says Fink, "We will be more equipped to judge how they're trying to move their business in terms of the transition to net zero." As a result, more investors will be comfortable embracing the shift to sustainable investments.

3. Data linking sustainable investing to alpha

A growing body of data now show that sustainable investments produce risk-adjusted returns at least on par with less-sustainable investments.9

Consider this: A historical back-test of ESG-focused equity benchmarks showed better annualized returns than their conventional parent indices between 2012 and 2020.10

Comparison of historical annualized returns of traditional equity benchmarks and back-tested annualized returns of ESG-focused equity benchmarks, 2012-2020 (by region)

Annualized returns comparison chart

Source: Blackrock Sustainable Investing, as of August 2020. Notes: The data cover December 3, 2012 to August 31, 2020. Returns are annualized gross returns in U.S. dollar terms of the US indices and annualized net returns for the EAFE and EM indices. Indexes used are the MSCI USA Index, MSCI EAFE, MSCI EM Index (*Traditional columns) and MSCI’s ESG-focused derivations of each (MSCI USA ESG Focus Index, MSCI EAFE ESG Focus Index and MSCI Emerging Markets ESG Focus Index). The data shown prior to inceptions for each MSCI ESG Focus Index (August 2016 for U.S.; April 2019 for EAFE; April 2016 for EM) are back tested by MSCI. They are optimized to maximize ESG exposure within constraints (example: a tracking error of 50 basis points and maximum active weight of 2% for each index constituent for USA ESG Focus). Back tested performance is hypothetical, simulated and is not indicative of actual future returns. Back tested performance is developed within the benefit of hindsight, has inherent limitations and invariably shows positive rates of return. ESG scores shown are average scores for each index based on MSCI data. See important notes on the next slide.

Furthermore, investing for sustainability especially seems to boost resilience during times of market turmoil. Take the first quarter of 2020, when COVID-19 threw markets into upheaval: Funds in the top 10% on sustainability measures delivered performance in the top half of their peer group, on average.11 By contrast, funds in the bottom 10% on sustainability had average performance near the bottom of their groups.12 These results were consistent across asset classes.13

Average peer group performance ranking, Q1 2020

Comparing funds with highest and lowest sustainability rankings within peer group

Average peer group performance ranking chart

Source: BlackRock Sustainable Investing as of December 31, 2020, Morningstar as of May 11, 2020. For illustrative purposes only. See “Average peer group performance ranking” for more detail. Peer comparison shown is for illustrative purposes only and does not purport to compare all funds in the same investment universe nor does it compare all characteristics of the funds.

Likewise, indices of sustainable investments held up better than conventional indices during other challenging markets in recent years.14

Percentage of sustainable indices that have outperformed during downturns

Percentage of sustainable indices that have outperformed during downturns

Source: BlackRock Sustainable Investing as of December 31, 2020, Morningstar as of May 11, 2020. For illustrative purposes only. This is a set of 32 globally representative, widely analysed sustainable indices and their non-sustainable counterparts. Indices are unmanaged and used for illustrative purposes only and are not intended to be indicative of any fund’s performance. It is not possible to invest directly in an index. For important detail, see: https://www.blackrock.com/corporate/literature/investor-education/sustainable-investing-resilience.pdf

These data suggest that investing in more-sustainable assets and companies has the potential to enhance risk-adjusted performance over the long term, paving the way for wider adoption among investors. That outcome is consistent with BlackRock’s 2020 Global Sustainable Investing Survey, which found that two of the top three reasons institutions engage in sustainable investment activities relate to risk and performance.15

Top reasons institutions employ sustainable investing:

  1. To achieve closer alignment to investment objectives and/or organizational mission
  2. To seek improved risk-adjusted performance
  3. To mitigate investment risk

We believe the confluence of these factors will force a supportive repricing of all assets, and we have incorporated that expectation into our capital market assumptions.

  • Climate change will affect macroeconomic variables such as economic growth and weather impacts, leading investors to adjust the risk premia they apply to different assets.16
  • Differences in asset flows between more- and less-sustainable investments will drive premium pricing for the former.17
  • Companies that position themselves for sustainability will reap revenue, brand and risk-mitigation benefits that result in stronger fundamentals, justifying premium valuations.18

Framework for climate-aware portfolios

Climate-aware portfolio construction graphic

Source: BlackRock Investment Institute, as of February 2021. Climate-aware capital market assumptions incorporate the impacts of climate change on macroeconomic variables and asset class returns, in addition to traditional return drivers.

The shift toward sustainability is in its early stages, so markets do not yet fully reflect its long-term implications. This dynamic is typical of large, decades-long trends: For example, the markets took decades to price in the market and economic implications of the Baby Boom generation. Over time, we believe the markets will grant more-sustainable assets a return and valuation premium.

Estimated 5-year expected return differential for MSCI U.S. sectors in green transition vs no-climate-action, Feb 2021

Estimate annualized return impact chart

Source: BlackRock Investment Institute, with data from Refinitiv Datastream and Bloomberg, February 2021. Notes: The chart shows the difference in five-year U.S. dollar expected returns for the highest sub-category of MSCI USA sectors under two economic scenarios – a green transition and a no-climate-action scenario. The difference in expected return is attributable to repricing – the return impact of changing cost of capital – and fundamentals – or the return impact of changing earnings per share growth. This information is not intended as a recommendation to invest in any particular asset class or strategy or as a promise – or even estimate – of future performance.

Portfolio approaches to net zero
Read an overview of the different approaches available to transition an equity portfolio to net zero alignment, focusing on carbon intensity and risk factors.
Sustainability image (construction) by BlackRock

Actions for institutional investors

In our view, the economic benefits of mitigating the impact of climate change can outweigh the economic costs of doing so. We believe that avoiding climate-related damages will help prevent economic degradation and improve the returns of risk assets. And we expect the markets to reward companies, sectors and countries that adjust to the post-carbon transition and to penalize those that don't.

Many investors appear to agree and are already changing tack. "More and more investors are asking: How should we be prepared?" said Fink. "We're seeing tens of billions of dollars moving away from traditional investment strategies to sustainable strategies.”

We urge investors to take environmental, social and governance factors into account as part of a holistic portfolio construction process:

  • Ensuring that ESG considerations around risk and return are integrated across your portfolio
  • Where appropriate, exploring dedicated sustainable strategies that offer both a financial objective and a specified sustainable outcome, whether broad, thematic or impact in nature

We firmly believe that investors who effectively incorporate these factors are likely to outperform in the new sustainable investing paradigm.