The largest class of ESG (Environmental, Social, and Governance) funds, controlling about $5 trillion in assets, has increased its investment in the oil and gas sector by approximately two-thirds since the implementation of stricter ESG regulations in Europe 2 1/2 years ago. According to Morningstar Inc., these funds, which promote ESG metrics, raised their fossil fuel holdings from 1.4% to 2.3% while reducing their renewable energy assets.
This shift reflects both valuation changes and direct investments, influenced by the Ukraine war’s impact on oil prices and a challenging year for renewables, as noted by Hortense Bioy of Morningstar. The trend aligns with growing financial sector calls to integrate fossil fuels into ESG frameworks, highlighted at the COP28 climate summit.
The COP28 agreement, which fell short of climate activists’ hopes for a fossil fuel phase-out, allows for continued reliance on lower-carbon fuels like natural gas in the transition to cleaner energy. It also sets a goal to triple renewable energy capacity by 2030.
European authorities are reviewing the Sustainable Finance Disclosure Regulation (SFDR), which directs $11 trillion in investments, to potentially encourage holdings in “transition assets.” These assets are currently high in carbon emissions but have greening potential.
EU Commissioner Mairead McGuinness suggested more flexibility for ESG portfolios to include high-carbon companies with credible emission reduction plans. The EU may require funds to disclose their greenhouse gas reduction goals to improve transparency and assist investors in identifying funds aiding the transition.
Despite general industry issues with climate-risk disclosures, as highlighted by EY, France’s financial watchdog is adopting a stricter approach, excluding fossil fuel companies expanding production from its national ESG fund label.
Article 9 funds, the EU’s strictest ESG designation, have reduced fossil fuel exposure and slightly increased renewable investments. However, 2023 has been challenging for renewables from a returns perspective, with significant losses compared to oil and gas indices.
JPMorgan Chase & Co. analysts predict a more favorable environment for traditional ESG assets in 2024, considering the current high interest-rate environment. Next year is also expected to be pivotal for ESG regulations, suggesting ongoing evolution in the balance between sustainable investment and traditional energy sectors.
