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Sustainability Matters

Climate Funds Dig Deeper Roots

As the focus on climate change increases, the investing landscape continues to grow.

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Commitments to mitigate climate change have accelerated among investors, asset managers, and governments over the past year. President Biden rejoined the Paris Agreement on his first day in office, the Net Zero Asset Managers Initiative gathered steam, and industry gatherings such as COP26 sought to catalyze global collaboration to address the climate crisis.

At the same time, the market saw increasing demand from investors who want to take climate action in their portfolios. Climate change presents both a risk and an opportunity for investors.

Some of the risks include transition risks, which arise with the shift to a low-carbon economy, such as changes in regulation, technology, and consumer behavior. Physical risks often refer to vulnerability in a company’s supply chain due to increasing frequency of extreme weather events such as flooding or hurricanes.

Opportunities exist, too. Through their portfolios, investors can gain exposure to companies developing innovative solutions to mitigate climate change, such as carbon capture technologies, or to adapt to the impacts of climate change.

In our recently released report “Investing in Times of Climate Change,” we dig into the global landscape of climate-focused funds, map out the products that fit into each category, and demonstrate the growth in climate funds across different markets.

This universe of climate funds comprises a wide and growing range of strategies that aim to meet different investor needs and preferences. To help investors navigate what can be a confusing mix of offerings, we subdivide the universe into five mutually exclusive categories, shown in the exhibit below.

Low Carbon and Climate Conscious funds tend to focus on reducing climate-related risks in portfolios (decarbonizing portfolios) and investing in companies that positively align with the transition to a low-carbon economy. On the other hand, Green Bond, Climate Solutions, and Clean Energy/Tech funds target companies whose products, services, or projects directly or indirectly address climate challenges and opportunities.

graphic of climate strategies and their role in portfolios
In our research, we also highlight the role each climate category might play in an investor’s portfolio. For example, funds that invest in climate solutions typically carry certain risks such as sector concentration that make them more suitable as satellite holdings than as part of a core allocation in a diversified portfolio.

Additionally, we outline the various sustainable-investing approaches in use by climate funds and explore how well fund portfolios match their climate ambitions using multiple Morningstar metrics.

In the United States, Clean Energy/Tech Funds Retain Their Lead

U.S. climate funds have experienced tremendous growth over the past three years, with assets in these funds passing the $30 billion mark for the first time in 2021. As shown below, this represents a 45% increase over the previous record in 2020 and is nearly 9 times the total seen five years ago.

Assets in U.S. Climate Funds

table described in text
  - source: Morningstar Analysts

While Clean Energy/Tech funds retain the majority (61%) of these assets, other categories are gaining ground. As shown below, Climate Solutions funds grew by 116% to $4.5 billion in assets at the end of 2021, followed by Low Carbon funds (142%, $3.4 billion). Equally noteworthy is the Climate Conscious category, which made its debut in the U.S. only last year. Climate Conscious funds tilt toward companies that prioritize climate change in their business strategies and are therefore better positioned for the transition to a low-carbon economy. An example is BlackRock US Carbon Transition Readiness ETF (LCTU), which launched in April 2021 and netted nearly $1.5 billion over the year.

Flows Into U.S. Climate Funds

chart of flows into U.S. climate funds
  - source: Morningstar Analysts

In 2021, U.S. climate funds enjoyed nearly $13 billion in net flows, a 43% increase over 2020's record and 18 times greater than that seen five years ago. Once again, Clean Energy/Tech funds were the winners, attracting more than half of the total for the year ($7.2 billion). While this category continues to lead the pack, these flows represent an 8% decline relative to the total in 2020, which matches broader market trends. In part, this drop is due to investors’ view that the renewable energy sector was overvalued for most of 2020.

 

table of largest U.S. climate funds

Four of the 10 largest climate funds available to U.S. investors are Clean Energy/Tech funds. New to this year's top 10 list are BlackRock US Carbon Transition Readiness ETF and Fidelity Environment and Alternative Energy Fund (FSLEX). In April 2021, the former broke the record for the largest exchange-traded fund launch. The latter netted $474 million for the year, nearly 8 times the fund's net flows in 2020.

Global Assets in Climate Funds Double, and China Enters the Stage

On a global scale, as of December 2021, there were 860 climate funds that fit our definition, with collective assets under management of $408 billion worldwide. Global assets have doubled in one year, boosted by continued fund flows and an accelerated pace of product development.

Global Landscape of Climate Funds

chart of global landscape of climate funds
  - source: Morningstar Analysts

Europe
Fueled by higher investor demand and regulation, Europe remains the largest and most diverse climate funds market, accounting for almost 80% of global assets as of December 2021 (shown below). The years 2020 and 2021 were pivotal for sustainable investing in Europe with the rollout of two groundbreaking classification and disclosure regulatory frameworks as part of the European Union’s Action Plan on Sustainable Finance: the EU Taxonomy and the Sustainable Finance Disclosure Regulation, or SFDR. Both initiatives have had a ripple effect across multiple areas, including climate investing.

Assets in European Climate Funds

chart of assets in European climate funds

The accelerated asset growth can be attributed to increased investor preference for these funds, especially Climate Solutions and Climate Conscious funds. Over the year, flows into the European climate fund universe amounted to an all-time high of more than $108 billion, up 61% from the previous record in 2020. These strong flows accompanied rapid product development in the European climate funds universe, with the launch of 151 new climate funds last year (shown below).

Launches of European Climate Funds

chart of launches in European climate funds
  - source: Morningstar Analysts

Climate Conscious strategies represented almost half of the new launches, including funds such as L&G ESG Paris Aligned World Equity Index Fund, that track newly created EU climate benchmarks. These benchmarks are designed to consider climate risks and opportunities and to match the transition to a climate-resilient economy by ensuring a yearly decarbonization target of at least 7% (in line with the decarbonization trajectory of the IPCC's 1.5˚C scenario).

China
For the first time, China overtook the United States as the second-largest climate funds market. As shown below, China’s universe of climate funds more than doubled in size to $46.7 billion, representing a 149% increase compared with the previous year.

Assets in Chinese Climate Funds

chart of assets in Chinese climate funds
  - source: Morningstar Analysts

The rapid expansion of China's climate fund market can be explained by the heightened focus on climate change and other environmental issues in the ruling party's agenda for economic transformation.

In February 2021, the State Council announced guidance to support the establishment of “... a sound economic system with green, low-carbon and circular development, and promoting eco-friendly economic and social development in all respects.” In March, the government proclaimed goals including: "peaking carbon dioxide emissions before 2030" and "reaching carbon neutrality before 2060." Under these overarching objectives, energy and carbon intensity are targeted to decline by 13.5% and 18% per unit of GDP, respectively, between 2021 and 2025. Other objectives include improving air quality in cities, surface water, and forest coverage.

Launches of Chinese Climate Funds

chart of launches of Chinese climate funds
  - source: Morningstar Analysts

Against this backdrop, energy transition, energy efficiency, and circular economy feature prominently in the development of climate-related financial products and services in China, including carbon credit and the first national emissions-trading system. The evolution of related regulatory frameworks will likely bring forth more structural changes to the Chinese fund market.

Investors Play a Key Role in the Fight for Climate Action

Despite the tremendous growth seen in climate investing and commitments over the past few years, it is increasingly clear that we need to see faster and more widespread action. In its latest report, the Intergovernmental Panel on Climate Change warned that the window of opportunity to take any meaningful climate action is rapidly closing. Ultimately, global cooperation between governments is required to address the full scope of this threat, but the private sector and individual investors can be part of the transition, too.

On the one hand, climate change represents an investment risk that ought to be accounted for in diversified portfolios. On the other hand, investors increasingly have access to innovative climate solutions through opportunity-seeking climate funds. Last but not least, on behalf of investors, asset managers should engage with companies via active ownership and proxy voting to advocate for more robust climate policies.

In this rapidly evolving space, it is still important that investors do their homework. Because many climate funds have a relatively short history, with most launched in the past couple of years, their performance can be hard to assess. Still, investors should understand the funds' investment objectives and how the portfolios are constructed. They should also bear in mind that some climate strategies can result in concentrated portfolios, which makes them more suitable as satellite holdings than as core building blocks in a portfolio.

Alyssa Stankiewicz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.