From Delusion To Debunking

In The Green(back) Boogie(2020), it was argued that market trends and preferences related to ESG are subject to a cycle. Reading the ‘ESG cycle’ was to become as important for issuers and investors as analyzing its older, macroeconomic sibling.


Today, the ESG cycle can be dissected into four phases: (1) Debut; (2) Dilution; (3) Delusion; (4) Debunking. Debut is now in the past. Dilution is the present. Delusion and Debunking are next.


In the Debut phase (2019-2020), investors grew increasingly attune to the attractiveness of companies providing solutions to the climate crisis. They looked for investment opportunities providing superior growth opportunities, with clean energy an obvious beneficiary. Because the pool of investment opportunities was limited, the ‘ESG premium’ paid for these assets was substantial. The COVID crisis accelerated that trend, which led, amongst other things, to a dramatic rise in clean energy valuation and a SPACs boom.


In the Dilution phase (2021), issuers skilfully integrate ESG in their equity story with a view to benefiting from an ESG premium (or to avoiding being subject to an ‘ESG discount’). The pool of investment opportunities deemed to be ESG-eligible grows faster than the demand. Consequently, the ESG premium declines. The S&P Global Clean Energy Index is informative: the index has underperformed the broader market by more than 40% since the beginning of the year, while growth prospects have certainly not come down. Similarly, post-deal SPACs, often a (very) long-term play on a better future, have seen their value come down by close to 40% from their February peak.


In the upcoming phase (2021-2022), Delusion reigns. The vast majority of companies manage to position themselves as ESG-friendly, with long term pledges made with their right hand over the heart as the main tool. ESG may well be integrated, but only in a shallow way. In its extreme version, the ESG premium all but disappears. This phase resembles Urs Fischer’s chalet made of bread exposed at Art Basel this week: a decaying construction.


In the Debunking phase (2022), market participants come to their senses and realize that the prevailing take on ESG has failed to drive change to the extent required. Firms are compelled to rethink their strategy and operations with transformation rather than incrementalism in mind. Greater market discernment returns, and the ESG premium rises again for worthy issuers.


What could trigger the switch to this ultimate phase? COP26, the implementation of the EU taxonomy - it is not easy to say. But it is coming.


If this thesis were correct, the current times would represent an opportunity to acquire ESG-friendly assets since they do not incorporate the warranted premium. Mutatis mutandis, it would now be a good time to sell non-ESG friendly assets since not subject to the warranted discount.


Regions may experience a different cycle. For example, the Delusion phase could last longer in North America, which would allow for arbitrage opportunities, with non-ESG-friendly assets being sold by Europeans to Americans.


More fundamentally, this analysis suggests that well-marketed ESG stories in the current context may only temporarily support a favorable ESG rating. When the cycle enters the Debunking phase, the ESG hurdles will dramatically rise.


Phase four is what to prepare for.


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