Despite the rise of sustainable investing, recent evidence shows that emerging markets receive a very small fraction of the capital allocated by investment funds to ‘green’ companies involved in carbon solutions. This column digs into the dynamics that inform investment allocation decisions by investment funds, exploring the motivations and constraints at both fund and country levels. The findings highlight the critical role of benchmarks, market structures, investment fundamentals, and environmental policies in driving – or hindering – the shift towards greener financial allocations.
As highlighted once more by the difficult discussions at the recent UN Climate Conference (COP29), finance to developing countries still falls short compared to the estimated investment requirements. This gap reinforces the need for the contribution of private finance in a context of constrained public finances (Dees and Seghini 2024).
However, increasing geopolitical tensions are weighing down on the green finance outlook (Javorcik et al. 2023, Weber et al. 2024). As shocks to transition risk are predominantly politically driven (Meinerding et al. 2024), additional uncertainty lies around the climate policies of incoming administrations – an uncertainty which has already been priced negatively in green indices such as the S&P Global Clean Energy Index.
As we highlighted in a previous column (de Crescenzio and Lepers 2023), emerging markets (EMs) account for the largest part of investment needs but their green companies receive very little private financing from advanced economies. Global capital is domiciled – and predominantly reaches firms – in the US, which receives almost 70% of green investments by specialised green funds. After the US, the People’s Republic of China is the next largest investment destination and represents the lion’s share of investments in EM green companies.
In a recent paper (de Crescenzio and Lepers 2024), we examine the factors that influence investment fund decisions on green and fossil fuel investments, delving into the motivations and limitations for both fund and country characteristics. This research underscores the importance of benchmarks, market dynamics, investment principles, and environmental policies in facilitating – or impeding – the transition to greener financial allocations.
Investment funds, ranging from institutional giants to retail-focused ventures, display distinct patterns when it comes to asset allocation. Using a unique micro-level dataset on a detailed portfolio-level sample of the 37,000 largest investment funds globally and a unique classification of ‘green’ companies based on revenues in carbon solutions (renewable energy, green transport, and infrastructure), we are able to answer the following questions:
- What drives investors’ decisions when they allocate capital towards green companies?
- Why are some countries able to attract more green investments than others?
- What obstacles must be overcome to align financial flows with sustainability and climate change goals?
Which investment funds go green?
Our empirical findings (summarised in Figure 1) reveal that fund domicile is a major determinant of allocation to green companies. Funds targeting EMs, especially with single-country mandates (e.g. a fund with a mandate on a specific EM like Brazil) or domiciled in an EM, are more inclined to invest in green assets, raising the green share by 2% compared to, for instance, foreign funds with global investment mandates. This showcases that funds domiciled and investing in a single country are typically more likely to invest in green assets. These funds are more likely to be specialised and can mitigate possible information asymmetries regarding green companies compared with foreign funds.
Figure 1 Fund-specific drivers of allocation to green or fossil fuel companies
Note: Dependent variable is the fund level share of green or fossil fuel companies’ assets in the portfolio. Regressions are run using OLS on holdings of 37,000 funds as of 2023Q1. Other controls include fund size and fund category dummies. Clustered SE at the fund level. CI 90%.
The age of a fund is also a key determinant. Newer funds, responsive to shifting trends and the rising demand for sustainability, allocate more capital to green assets. They reflect a world increasingly attuned to climate realities. Conversely, older funds seem to remain anchored in legacy and less innovative structures, with comparatively higher shares of fossil fuel investments.
Another interesting dynamic emerges between institutional and retail-focused funds. Institutional investor funds are less likely to allocate significant portions of their portfolios to green assets and more likely to invest in fossil fuel companies. Their more traditionally risk-averse approach and focus on stable returns may be holding them back from this type of investments while retail funds may be driven by the priorities of individual investors and exhibit greater flexibility in allocating towards green assets. Finally, we find that passive funds show a higher preference for green assets than active ones but also play a prominent role in fossil fuel investments, likely due to broader energy exposure within traditional benchmarks.
Why are some countries able to attract more green investments than others?
Beyond attracting green investment from domestic funds, why are some EMs more successful at attracting green portfolio flows than others? The distribution of green investments, already described in our previous column, points to a highly concentrated global economic dynamic, where a single country among EMs, China, is able to attract the majority of investments, while other EMs (Brazil, Chinese Taipei, South Africa, India) lag far behind.
Leveraging from our detailed fund-country dataset constructed at the security-level, our analysis of the drivers of global EM funds’ allocation highlights the key role played by benchmarks. This finding is in line with Raddatz et al. (2017), regardless of whether mutual funds are passive or active, and this is especially the case for EM investments (Arslanalp et al. 2020). This can be highlighted in simple correlation exercises (Figure 2) and confirmed in formal econometric analysis. Inclusion in major indices, such as the MSCI EM equity index, is the single most important factor that seems to influence global investment fund choices. Indeed, major EMs like China and Brazil, with substantial representation in these global benchmarks, are able to attract significant shares of green investments.
Figure 2 MSCI emerging market country weights versus country allocation of green assets of global EM equity funds
Note: Sample of 700 global EM equity funds. China is removed from the chart to enhance the focus but appears “overweight” with Y=65% and X=31%. Corr: 0.91.
Countries such as India, South Africa, and Thailand appear underrepresented, with smaller allocation of green investments relative to their MSCI EM index weights, clustered near the bottom-left corner. On the other hand, countries like China and Brazil show an opposite trend, as they receive a relatively higher share of green investments, above the country allocation in the benchmark, reflecting the appeal of their green companies. Overall, the gaps between green capital allocation and country economic weights in global indices point to other complementary factors driving allocation.
Indeed, other country-specific factors also influence country-level green investment (Figure 3). Greater green allocation in EMs is linked to higher portfolio flow openness and economic freedom, which are considered common drivers of investment in general, but are found to also particularly impact green investment.
Figure 3 Drivers of global EM fund green allocation: country characteristics
Note: Dependent variable is the fund level country share of green assets in the global EM fund portfolio. Sample of 700 global EM equity funds. Poisson regressions. Clustered SE at the fund level. See source for detailed description. Green highlights a positive coefficient while brown highlights a negative coefficient. All coefficients are significant at the 1% level.
Countries with high renewable energy generation and strong green exports are able to attract more capital. Conversely, structural barriers, such as concentrated ownership of listed companies (following the work by Medina et al. 2022), deter investment by limiting the availability of tradable shares.
In contrast, in such a cross-section setting, we do not find robust statistical evidence across models for a role of climate policies in affecting green investment shares in country portfolio allocations.
To sum up, the dominance of benchmark effect on green investment allocations underscores the need for EMs and green companies to achieve index inclusion. At the same time, developing robust green sectors – ranging from renewable energy production to green exports – can position countries as prime destinations for capital. Maintaining openness and a favourable investment climate remains critical.
Next on the research agenda: From cross-section to time series analysis
While our research provides a granular analysis at the security and fund level of the cross-section of holdings in green companies at a single point in time (March 2023), finding appropriate proxies available in time series format for properly classified companies involved in the green transition would offer a more dynamic perspective on global investment behaviour. A time series approach similarly classifying green companies could help better understand how global investors adjust their portfolios in response to changing environmental policies, such as stricter carbon emissions regulations, renewable energy incentives, green taxonomy frameworks, or other political events. This would help identify whether investors rebalance portfolios away from or towards countries implementing specific policies, or certain sub-sectors (e.g., renewable energy, electric vehicles) (see Hale et al. 2024 for an analysis of banks). Moreover, such analysis could reveal potential spillover effects, where (environmentally ambitious) policies in one country could deflect flows towards another (less environmentally prone) economy. As we enter a period of increasing regulatory uncertainty, it could be particularly important to understand these dynamics and the interlinkages among countries’ policies.
Source : VOXeu
