Silicon Valley buoys ESG funds

Hello from New York. For those of you sweating in the city this month, June was the 13th consecutive month to be the hottest on the books, the Copernicus Climate Change Service said. And the world is on track to break the record for the hottest year ever.

For today, I have a piece about ESG fund performance in the first six months of the year. Yes, there have been big outflows from these funds, but performance — thanks to Nvidia — has vaulted many of them over the S&P 500 index return so far this year.

And Lee has a piece about a trade rule under consideration in the EU that could have problematic consequences for some producers of electric vehicle batteries. —  Patrick Temple-West

ESG funds

ESG fund outflows don’t tell the whole story

Environmental, social and governance funds have had a tough slog this year. In the first quarter, ESG funds globally endured one of their largest cash outflows. The political attacks on ESG in the US have prompted some investors to second-guess the strategy.

But when it comes to investment performance, new data shows that ESG funds had a strong run in the first half of this year, thanks largely to their big holdings of technology stocks.

Most ESG funds that don’t specifically invest in renewable energy businesses are overweight in technology companies and underweight in oil and gas stocks. In the first six months of the year, the S&P 500 gained about 15 per cent. Almost 60 per cent of the gain for the year to date was driven by five tech giants — Nvidia, Microsoft, Amazon, Meta and Apple — which are almost always the largest holdings in ESG funds, according to Morningstar.

Vanguard’s US-focused FTSE Social Index fund, which has $20.6bn of assets under management, rose in value by 15.5 per cent in the first half and is up 26 per cent over the past 12 months, compared with 24.9 per cent for the S&P 500. Its largest holdings are Microsoft, Apple and Nvidia.

The best performing big ESG fund in the first half of the year was the Putnam Sustainable Leaders fund, which is owned by Franklin Templeton. The fund jumped 19.4 per cent in the first half. Unsurprisingly, its top holdings are Microsoft, Alphabet and Nvidia.

Katherine Collins, a portfolio manager on the fund, said Big Tech was not the only thing powering returns this year. “It is not an Nvidia-only story,” she told me. Companies like Boston Scientific and Eli Lilly also drove outperformance, she said.

To beat an index, stock pickers need an analytical edge, Collins said. Putnam’s view is that “sustainability issues are increasingly important to the operations of the businesses we are invested in and they are structurally under researched”.

Not all big ESG funds beat the wider market. BlackRock’s iShares ESG Aware fund, which does not invest in tobacco, thermal coal and other polluting businesses, slightly underperformed the S&P 500, with a gain of 14.4 per cent so far this year. Nvidia is now its biggest holding, up from fourth at the start of the year.

The world’s largest ESG fund by managed assets — Parnassus’s core equity fund — is up 12 per cent this year. Nvidia again was the third-largest holding.

Nvidia deserves a reputation as a sustainability leader in part because its chips beat competitors on energy efficiency, Andrew Choi, a manager on Parnassus’s core equity fund, told me. Though Nvidia’s chips are expensive, “there is a reason why their customers are buying it: from an energy perspective, it is the most efficient way to train [AI] models”, he said.

“For us, we are continuing to hold a large position in Nvidia and we don’t think the momentum is really going to let up until maybe some time next year.”

The caveat for the actively managed ESG funds is their fees. The Putnam fund includes a 0.92 per cent expense ratio and might also incur other fees. Parnassus’s fund includes a 0.82 per cent fee. These costs raise perennial questions about what ESG is offering versus low-cost passive funds if their top holdings are virtually the same.

But for investors willing to pay for ESG, performance this year has broadly endured despite negative headlines suggesting its demise. (Patrick Temple-West)

green trade

Is a new green trade rule under EU consideration protectionism in disguise?

As green tariffs start to enter the global trade landscape, governments around the world are wrangling over how to measure, and boost, the climate credentials of their exports.

The EU in particular is hopeful that levies on cheaper, carbon-intensive products will spark a race to the top on green manufacturing. But the rules coming into force also provide plenty of opportunities for protectionism in the guise of climate purity.

One such struggle played out this week, as Brussels considered a new rule on carbon emissions from electric vehicle batteries that has spooked renewable energy trade organisations and industry groups in battery exporting nations such as Japan, South Korea and China.

Countries with cleaner grids — notably France — have sought to press their advantage by denying rivals the use of power purchase agreements (PPAs) when calculating the carbon footprint of electric vehicle batteries, according to multiple observers with knowledge of negotiations.

The spat over PPAs has emerged as the European Commission sets rules for a new “battery passport” system. From 2028, the EU will start imposing a limit on the lifecycle carbon emissions of vehicle batteries, including the emissions involved in their production — and those found to be over the limit will be barred from the EU market.

Critics worry that the exclusion of PPAs could weaken the incentive of producers in countries with dirtier grids to pay for green energy. But the bigger concern is that Brussels will set a protectionist precedent that could be picked up in dozens of future pieces of legislation, with far-reaching consequences for the terms of green trade.

Corporate buyers routinely use PPAs to procure green energy from other parts of the grid, when it is not convenient to build or source renewables directly at the site of production. Under the rule being finalised, Brussels would not take PPAs into consideration when calculating a battery’s carbon footprint.

There is one exception: if a manufacturer uses a PPA to draw on “directly connected” electricity, such as on-site solar, that power can be used to help bring down the product’s official carbon footprint. But PPAs that correspond to renewable energy generated elsewhere would not count.

Barring the use of directly connected electricity, a battery’s carbon footprint would be determined based on national average emissions of the grid in the country where it was manufactured.

Campaigners say that if Brussels moves ahead, the rule could undermine efforts to reduce the carbon emissions of manufacturing. Producers in countries with a dirtier power mix would be denied a crucial tool — the renewable PPA — to compete with rivals in countries that have done more to decarbonise their national grids.

To justify this exclusion, the draft regulation argues that it would be difficult to verify PPAs in jurisdictions outside the EU. Critics say that verification of overseas PPAs is feasible — and point out that they are a feature of recently finalised green hydrogen rules.

The proposal has opened up a rift between countries with cleaner national grids and those with a higher share of fossil fuels in their energy mix, such as Germany, Hungary, and China, which currently produces the majority of the world’s electric vehicle batteries.

Renewable trade organisations including Solar Power Europe, Wind Europe, and Eurelectric, an electricity industry body, this week published a letter raising concerns over the commission’s plan to exclude PPAs, and argued that they provide “crucial investment into new renewable capacity.”

“Such policies can easily be associated with a naked trade barrier,” a Chinese commenter wrote in public feedback on the draft legislation. German, Polish, Hungarian, Japanese and South Korean businesses and industry groups also wrote in to oppose the proposed rule.

But French groups such as CEA, a government-backed nuclear energy research agency, wrote in support of the plan. PPAs would make it impossible, the CEA wrote, “in the current state of affairs, to trace the origin of electricity and therefore to match the carbon intensity of a given product to energy consumption.”

Electric vehicle battery manufacturing is a relatively modest consumer of energy. But climate campaigners and some in the renewable energy industry are peeved because they thought they had already won the fight over defining clean electricity, after an extended battle over electrical emissions from the energy-guzzling hydrogen industry.

For green hydrogen, the EU and US have both backed rules that push manufacturers to procure new sources of renewable power, rather than consuming existing supply. Those rules permit the use of PPAs, with strict guidelines to ensure that hydrogen development prompts renewable energy buildout.

Brussels’s scramble for market share in the electric vehicle supply chain, as the US and China subsidise their own production, could inadvertently create a backdoor for a more protectionist standard for measuring clean electricity — feeding into other elements of future green trade.

The fight, said Killian Daly of EnergyTag, a clean energy non-profit, “is going to colour how the European Commission thinks about clean products and how they’re defined, much more broadly than just batteries”. (Lee Harris)

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