While written in the dense language of central bank quarterly reports, the Basel-based organisation warned that the trend of ESG investments was producing a surge in price valuations, and compared this with other "bubbles" that eventually popped.
The The Bank For International Settlements, known as the central banker’s central bank, says that valuations of assets focused on environmental, social and governance-themes are getting overcooked. It warns that the episode bears some resemblance to the dotcom boom and housing bubble pre-2008.
Banks, wealth and asset managers have jumped aboard the ESG theme in recent years, launching a range of fund, loan and other products and asset management capabilities playing to interest in “green” and "sustainable" forms of investment. It is now almost eccentric for such firms not to stress ESG credentials.
The price/earnings ratio of the S&P global clean energy index spiked to 80 at the end of 2020, and fell to about 45 by mid-year, above the S&P 500 index of US leading equities, at about 27 – a huge gap, the BIS noted in its latest quarterly report. The clean energy index includes firms producing energy from solar, wind, hydro and other renewables. (See graph below text, right-hand chart.)
According to some estimates, the BIS said, ESG assets rose by nearly one third between 2016 and 2020 to $35 trillion, or no less than 36 per cent of total professionally managed assets.
"There are signs that ESG assets’ valuations may be stretched," the BIS, which holds regular meetings for the world's central banks, said.
The BIS organisation's strictures carry weight, as the body helps set to standards on how much buffer capital banks must have to handle economic shocks, as well as examining risks to the financial system.
“Even after a decline from their peak in January 2021, price-to-earnings ratios for clean energy companies are still well above those of already richly-valued growth stocks. Rich valuations in credit markets would be more relevant for assessing possible risks of financial distress, given the potential for defaults,” it continued.
“These considerations suggest that it is worth closely monitoring developments in the ESG market. If the market continues to grow at the current pace, and more elaborate instruments emerge (eg structured products), it will be important not only to assess the benefits of financing the transition to a low-carbon world, but also to identify and manage the financial risks that might arise from a shift in investors' portfolios,” the report said.
“Historical lessons from the investment volume and price dynamics in rapidly growing asset classes could be relevant for ESG securities,” the report said.
“Assets related to fundamental economic and social changes tend to undergo large price corrections after an initial investment boom. Railroad stocks in the mid-1800s, internet stocks during the dotcom bubble and mortgage-backed securities (MBS) in the Great Financial Crisis (GFC) are cases in point. It is thus noteworthy that the pre-GFC growth and size of the private label MBS market are comparable with those recently observed for ESG mutual funds and ETFs,” it said.
There have been rumblings about whether the ESG phenomenon is becoming a fad, encouraging so-called “greenwashing” of investment performance to satisfy popular demands.
A few weeks ago, reports claimed that US regulators were probing DWS, the asset management arm of Deutsche Bank, over claims by a former senior employee that it has been manipulating its ESG processes. DWS has strenuously denied the claims.
A wider concern, arguably, is that the sheer proliferation of ESG-themed investment means that clients can struggle to tell them apart, and that there are insufficiently profitable opportunities for investors to chase. Ironically, the recent sharp spike in gas and energy prices, bringing threats of potential power shortages in countries such as the UK, appear to raise questions over whether commitments to achieve “net zero” carbon emissions by mid-century are wise.