ESG investing continued to soar in 2021. The government could boost it even more

Faced with the ongoing calamity of climate change, both seasoned investors and those new to the market are increasingly embracing funds with more sustainable stocks. They’re favoring companies that take action to address the climate crisis and other environmental and social issues, like resource conservation, biodiversity, and human rights—rather than continuing to fund fossil fuel activities.

So-called ESG investing (Environmental, Social, and Governance) has grown exponentially over the past few years, and 2021 was no exception. The pandemic and climate-friendly federal investments helped boost the momentum, showing the financial appeal of sustainable funds for investors, even those focused more on financial return than impact. While ESG growth will likely continue, the rate of acceleration may hinge on the government’s ability to entice investors to ESG through regulatory and legislative action.

Two types of investors, one direction

2021 was a record year for ESG, with an estimated $120 billion poured into sustainable investments, more than double the $51 billion of 2020. As of this year, an estimated one-third of all assets contain sustainable investments. Still, there’d already been tremendous growth for years: the amount invested in ESG increased tenfold from 2018 to 2020, and 25-fold from 1995 to 2020.

Though impressive, 2021 was not necessarily a standout year, says Todd Cort, codirector of the Yale Initiative on Sustainable Finance, who assesses that there were no special benchmarks reached, but a continuation of the positive trend. That said, ESG funds became less of a fringe category, and sustainable stocks seeped into traditional funds. “It’s hard now to find any kind of fund that doesn’t consider climate risks in some way, shape, or form,” he says. “Maybe it came of age [in 2021] because the labeled ESG fund has ceded its information to mainstream markets.”

Part of the lure has been the resilience of ESG funds during the pandemic. They didn’t suffer as much as traditional funds in the initial economic downturn, signaling their stability in times of crisis. “ESG factors tend to have more outsize benefit on the downside risk than on the upside,” Cort says. He adds that the pandemic was also a crucial lesson as we face the climate crisis, long thought to be an incoming “chronic, economy-wide risk.” The pandemic showed that we’re not ready for that kind of colossal drag on the economy, which may get people to turn to funds that are climate friendly.

For that reason, even people not driven primarily by moral stands on social or environmental issues will still continue to invest sustainably. That’s important, Cort says, because by far the biggest portion of ESG investors are spurred by financial performance, rather than ethical inclinations. ESG funds have shown their lower volatility and good return on equity. Portfolios with ESG perform better than those without: 77% of those from 10 years ago have survived versus 46% of others.

The second tranche of ESG investors are those considered true impact investors, open to balancing their financial gain with making a real impact. Certainly, there has been a growth in the market participation of young people and demand for responsible investing across generations. But, that set of investors is smaller than we might think—perhaps as low as 2% of all investors. “Yes, it’s growing,” Cort says. “Is it growing as a percentage of assets under management? Very, very marginally.” In reality, millennials and Generation Z may not yet have the money to invest their values; so far, they’re acting more as cultural catalysts to urge large banks and institutional investors to engage. But, as young people gain wealth, including via intergenerational wealth shifts, growth could increase further.

The government’s role: Raise the iceberg

The government can also play a big role in ESG’s continued momentum, through both direct regulation and environmentally friendly legislation. Cort offers an iceberg analogy: A small slice of sustainable assets, with meaningful impact potential, sit “above the water,” meaning that they are currently financially attractive, and investors will drive these assets forward “no matter what.” But there are yet more lucrative ESG prospects submerged underwater, not yet visible or tempting to the mainstream. With its actions, the government can lift more of these from the depths of the investing pool to the surface, increasing the attractive fodder for investors. “That’s where government can really mess things up, or really do a great job,” he says.

There’s been some modest movement of the iceberg this year. House Democrats have introduced a bill that would require investment advisors to explain how they consider ESG factors in decision-making. Meanwhile, the recently passed infrastructure bill contains lots of dollars dedicated to clean energy, environmental justice, and reducing socioeconomic inequality; that public spending also acts as an incentive for private individuals to invest in the same sectors, Cort says. A free-market economist would argue, in other words, that it distorts the market toward those investments.

But, there’s room for plenty more governmental action in America. In April 2021, the EU passed its landmark Corporate Sustainability Reporting Directive, requiring much stricter sustainability reporting, which could get 49,000 European companies, including large private firms, disclosing sustainability information by 2023. Comparatively, the U.S. still takes a rather laissez-faire approach, in effect leaving regulation to the institutional investors themselves. While BlackRock committed to increasing ESG assets from $90 billion to $1 trillion by the end of 2029, a lot of its so-called sustainable funds still invest in carbon-intensive companies.

A change of administration to a more climate-unfriendly government could affect ESG momentum, but is unlikely to do much more than “create speed bumps at the worst,” Cort says, by loosening public-disclosure regulations, which would make it harder to access corporate information. While that may hinder the pace, it couldn’t stop the aggressive trend toward ESG, due to its now-proven lucrativeness.

That trend is clear: 72% of U.S. adults express interest in ESG; some analysts forecast ESG exceeding $50 trillion in the next two decades. And, Cort predicts that in the next five years, 100% of assets under management will incorporate some ESG factors. “Because there’s just no way not to,” he says. “Climate change is going to impact everything.”