The Intimate Linkage of ESG and Inflation

ESG and the Hegelian Dialectic

May 23, 2022
10 min read


Additional Contributors: Robertas Stancikas, Harjaspreet Mand and Maureen Hughes

Environmental, social and governance (ESG) investing and inflation are two of the biggest strategic trends in investing right now. We suggest the two are linked in a variety of ways, with profound implications for inflation, what we mean by ESG and the investing profession. There’s an intimate linkage and elements of tension. This was the case before the war in Ukraine, but the current conflict has thrust it into the spotlight.

A discussion of the interaction of ESG and inflation can be viewed as a response to this question: How can investors address inflation—responsibly? Formulating an answer will likely involve a grand narrative that ripples through the industry for years to come. We make the case in this note that there are two broad linkages between these topics, at the economic level and the portfolio level. The economic link is that ESG is profoundly inflationary. The portfolio link is that many of the current knee-jerk reactions to protect portfolios against inflation are inimical to a certain definition of ESG investing—creating a potential clash. We think this ESG-inflation dialectic will drive innovation in the investment industry.

Inflation poses a challenge to ESG investing that requires a response. There is a short-term question in terms of the tactical underperformance of a portfolio underweight in commodities, commodity-linked equities and defense stocks, which have been the key hedges in the recent crisis. But there’s also a more strategic question about the nature of long-run inflation protection and the best way to achieve it. This issue must be seen in the much broader context: that investors face a squeeze on real returns and reliable diversification. An ESG lens alone is insufficient. For example, Treasury Inflation-Protected Securities (TIPS) might provide inflation protection but at an exorbitant cost, and duration may not effectively hedge equity risk as inflation rises.

The list of good options is shrinking.

There’s something Hegelian in this linkage of ESG and inflation, an interaction that we think can be seen as a dialectic.1 Many typical inflation responses involve allocating to assets such as commodities, commodity-linked equities, crypto assets, such as Bitcoin, and private assets that have historically had less focus on ESG. ESG investing is a broad church with many flavors, but some established forms of ESG investing disavow investments like commodities and related equities.

In the Ukraine crisis, we could add defense stocks as a hedge, but that’s misaligned with many established ESG definitions. We think a synthesis is needed between inflation protection and ESG. In this tension we ground a call to action for the asset-management and asset owner communities to evolve and develop new return streams. This call is, in a sense, a provisional language for describing multi-asset portfolios in a world where investment management is synonymous with ESG, but within an inflationary macro landscape.

A common thread running through this note is that there are many ESG definitions, and that new challenges like those posed by the current environment will likely increase dispersion between different ESG approaches. We also think it will hasten the view that ESG policies need to be dynamic and contingent.

In this note, we will:

  1. Outline our claim that ESG is inflationary. In the near term, there’s an inevitable focus on the cost of the energy transition and what it means for prices. However, over strategic horizons we think this force will fade. The more persistent link will be what the “S” means for wages. (Section 1. Why ESG Is Inflationary)
  2. Show how many knee-jerk inflation responses in a portfolio are hard to align with restricted definitions of ESG investing. (Section 3. Are Inflation Protection and ESG Necessarily in Opposition?)
  3. Attempt to set out how ESG investing may change in response to a different environment and how new return streams are needed both to meet the economic challenge of the energy transition and to respond to the need for real assets that can offer inflation protection. (Section 4. A Synthesis Is Needed)
  4.  Discuss another macroeconomic linkage that’s not totally clear yet: Who bears the costs of ESG policies? (Section 5. Who Pays for a Shift to ESG-Friendly Policies?)

We’ll examine the portfolio implications of these four issues. For investors seeking inflation protection over long horizons, with the need to generate positive real returns, we think exposure to the delivery of renewable energy should increase. Allocations to specific natural resources—farmland and timberland—should also increase.

In the near term, we think these allocations could be funded from assets earmarked for illiquid assets, especially private equity. However, if investors manage to become less siloed, this shift should be viewed in the context of the overall portfolio—in a world of lower nominal returns and higher inflation, the funding could come from traditional fixed income.

Within public equities, we expect to see a greater distinction develop between passive approaches to ESG that rely on screening and exclusion versus ESG investing using active integration and engagement, with asset owners saving active fees for these more dynamic ESG approaches.

1.  Why ESG Is Inflationary

The investment world is (rightly) fixated by inflation at the moment. In the near term, we are still grappling with the inflationary impact of the supply and demand mismatch coming out of the pandemic. On top of that is an independent inflationary impulse from the Russia-Ukraine war. Aside from the immediate impact on energy and food prices, we think this conflict strengthens and hastens the transition to a less globalized world—removing a major deflationary force of the past three decades.

Beyond this very public debate about inflation, we see explicit reasons why ESG is inflationary as a mode of investment, but even more so as a sociopolitical force. There are many rational reasons for a company to invest in ESG to give it a competitive advantage, and there are good economic and moral reasons for a society to adopt more responsible policies.

The rationality does not forestall the possibility that such policies are inflationary. Given the current near-hysteria about inflation, one perhaps needs to explicitly point out that labeling a policy as inflationary is in no way a negative statement—it’s inherently value-neutral. Indeed, to the extent that some of the underlying disinflationary forces of recent decades have fueled social concern about the precarity of labor and the economic concern of deflation, the inflationary aspect of ESG could be seen in an overtly positive light.

There are multiple inflationary and deflationary forces at work over a medium- to long-term horizon that we’ve detailed in Assessing the Inflation Trajectory—and Portfolio Responses. In broad terms, we see medium- and long-term inflationary forces from: tight labor markets as the labor supply shrinks; the likely greater use of fiscal policy to cushion economies in future downturns; the possibility that developed economies might implicitly or explicitly favor higher inflation as a route to reducing record public debt; and the inflationary impetus of a less globalized world (hastened by the Russia-Ukraine war). Against these inflationary forces are potential deflationary forces: automation and the possibility that savings rates may have to rise if the real return on savings is lower.

We lay these forces out to offer the broader strategic context. In this note, we focus on the case for ESG as another inflationary force, both as an investment theme and a social force, driven by three distinct trends:

  1. Customers say they’re willing to pay more for ESG-friendly products. For example, one of the largest studies to date, a 2021 effort by Simon-Kucher & Partners, covered 17 countries and more than 10,000 respondents. It found that 34% of consumers reported that they’re willing to pay more for sustainability.2 That willingness was most pronounced among younger generations, Generation Z (39%) and millennials (42%), who will command a growing share of consumption in coming years.

  2.  Lower investment in the upstream extraction of commodities implies tighter supply and higher commodity prices. The Global Energy sector capex-to-depreciation ratio is back to historical lows (Display 1). For Metals & Mining, the ratio has inched upward over the past five years but remains just below the historical average, with capex and supply dynamics varying greatly across commodities. 

    The AB Bernstein Research energy team believes that the combination of deflationary shale technology, stranded-asset risk and the global climate change agenda will lead to a structurally lower level of global oil and gas capex. They expect global upstream capex to grow by only 3% annualized through 2025 (Display 2), significantly below historical levels. They see capital being rapidly reallocated toward downstream renewables, buybacks and increased dividend payouts faster than the demand-side energy transition, leading to persistent undersupply.3

    Changing management incentives across North American exploration and production companies since 2015 offer strong support for this case. According to the Bernstein Research team, compensation incentives linked to cash generation increased strongly from 2015 to 2020 (Display 3), while growth- and production-related metrics declined. This shift from growth-related metrics to cash-generation metrics provides a strong incentive for capital discipline going forward.

  3. There’s a bigger-picture link between ESG and inflation. If the adoption of ESG considerations broadens beyond investment rules to become more of an established sociopolitical force (which seems likely), the “S” component implies that labor bargaining power should rise and so should wages. This is distinct from, and potentially much faster than, the demographic force of a shrinking supply of working-age people that could also drive up wages..4


Much of the focus on ESG’s inflationary nature stems from the impact on energy prices, but it could be argued that this is a “temporary” phenomenon (if a process that lasts for up to a decade can be deemed temporary in investment discussions). When the transition to new energy sources is more advanced, there is more focus on energy conservation and population growth slows, then one could make the case for downward pressure on energy prices in the longer term.

That’s why we think the social component, with its profound wage implications, could be more strategically important. We believe that this will be a core force in shifting the balance of power between capital and labor in wage negotiations, reversing the trend of recent decades. One tentative sign is the slight uptick in union membership and favorability in the US (Display 4). It’s only a small move, but it could mark the beginning of a broader trend for developed markets. This shift would imply that the current wage increases, driven by supply and demand constraints in certain economic sectors, would become more broad-based.

The war in Ukraine could extend this “S” component even further. ESG has tended to focus on single issuers, but there’s a macro ESG angle too. Investors could look at the historical inclusion of Russia in ESG indices and wonder whether such investment approaches, for example in passive indices, should adopt a harder line on certain forms of government in a more forward-looking way. Should other autocracies be penalized in an ESG approach? It’s a difficult question, because it’s not clear where such a normative-based approach leads—though it’s likely to lead to more disagreements. The elephant in the room from such a line of reasoning is China and its role in portfolios—a topic we’ll return to in future research.

2. The Active Investing Industry Will Soon Be Synonymous with ESG Investing

In our view, the active investing industry will soon become essentially dominated by ESG investing. This progression has long been in motion in Europe but is now rapidly becoming the norm in the US and elsewhere. Indeed, a casual glance at industry commentary in recent years, such as that in the Financial Times, would imply that active investing has become synonymous with ESG investing. The share of non-ESG active investing fell below 50% in the second half of 2021 (Display 5), a decline that’s projected to continue, pointing to a future where ESG and non-ESG funds give way to ESG integration in investing processes.

The pandemic experience is informative.

We’ve long wondered if investors have been lured into a false sense of security by decades of rising markets—assuming they can afford ESG as a supplementary goal alongside traditional risk/return goals. If they used that experience as a basis, we think it’s dangerous. First, people wouldn’t agree on non-return-based goals, setting the scene for a clash. Second, it implies that investors would be shocked by a capital loss into possibly abandoning ESG investing.

However, preliminary evidence from the pandemic shows that this hasn’t happened. The initial stages of COVID-19 saw equity investors suffer a sizable capital loss, yet our sample of active ESG equity funds only saw two weeks of net outflows (Display 6) in contrast with nearly US$70 billion of net outflows from active equity funds overall from March through December 2020. We take this as prima facie evidence that investors view ESG investing as a path to achieve return-risk targets, not as an unrelated goal. This is admittedly a limited data set based on the reaction to one event, but as a provisional conclusion it could be a sign of a robust ESG bandwagon.

However, inflation could pose a bigger challenge to ESG investing. The early development of ESG investing has benefited from a period of persistent negative inflation surprises, with strategic inflation hedging lower on investors’ lists of concerns. Some clients have asked us recently whether inflation “breaks” ESG as an investment concept. We strongly reject that notion. ESG is too firmly ingrained and here to stay, driven, for example, by leaders of US asset-management companies and influential asset owners, such as those in Europe.

But the current environment is a new challenge to ESG investing—one that must be overcome by both stakeholders. Part of the challenge is tactical, related to short-term performance. It’s not too controversial a notion that if a subset of assets is excluded it will lead to short-term underperformance in certain periods. And we’ve seen recent tactical underperformance from some types of ESG investing.

This isn’t a simple story about the war in Ukraine. There’s also a link to bond yields, and much of the recent underperformance relates to bond-yield increases before the war, indicating a longer duration for many ESG investing approaches. Lower allocations to commodity-linked equities and defense have also impaired performance in the wake of the war (Display 7). Short-lived tactical underperformance is presumably not too much of a problem for asset owners focused on the long horizon. However, the strategic questions, which we cover in the next section, are the key ones. 

In other research, we’ve shown that active managers are better able to generate idiosyncratic alpha in an ESG context—a critical point, because we view idiosyncratic alpha as the core of active approaches. 5

In terms of simple excess returns, both ESG and non-ESG funds have underperformed recently (Display 8, left). While the idiosyncratic alpha of ESG funds has fallen in the most recent period, they maintain their advantage over non-ESG funds based on trailing three-year returns (Display 8, right). (Please see our Alphalytics research for more details).

For a US-only version of this analysis, we can again show that ESG funds have delivered higher idiosyncratic alpha than non-ESG funds (Display 9). 

3.  Are Inflation Protection and ESG Necessarily in Opposition?

In previous research, we noted that commodities and commodity-linked equities, as well as private real assets, are some of the best hedges in a high-inflation environment, especially if an economy tips into stagflation.6 With recent Consumer Price Index (CPI) releases at their highest since the 1970s, and with the war in Ukraine making the inflation peak higher and later, these assets have gained rapid interest and inflows from investors.

However, the knee-jerk reallocation into such assets in response to current inflationary pressures clashes with many precepts of certain definitions of ESG investing. Broad commodity indices have historically fared best in a moderately high inflation environment of 2%–4% (Display 10). But they’ve also been a hedge in very high inflationary environments that exceed 5%. Oil has historically performed best when inflation has been 2%–3%, but also delivered strong returns in inflation regimes above 5%.


From an ESG perspective, some commodities, such as copper, aluminum and nickel, play a critical role in the transition to net-zero carbon emissions. But others, such as oil, coal and steel, are clearly at odds with the current climate agenda and will have to be replaced over time by renewable resources. Energy- and mining-linked equities have also tended to outperform in moderate-inflation environments of 2%–3%, but also hedged effectively in periods of very high inflation.

Tactical underperformance in certain episodes, or at a specific point in the cycle, might not be too much of a problem for long-horizon investors. However, there are strategic questions too. If the inflation path is higher for a sustained period, what are the protection options? Likewise, if a particular ESG definition excludes any defense companies, does it miss the bigger picture need for defense in exchange for protecting broader social interests? And if this is the case, are there other avenues for inflation protection?

Real Estate: Real estate can help protect against inflation. Public real estate investment trusts (REITs) tend to perform best in the moderate-inflation range of 3%–4%, but they also post high returns in high-inflation environments, when inflation is above 4%. Private real estate, proxied by the Case-Shiller US National Home Price Index, has historically delivered a similar pattern.

Real estate is very established as an inflation hedge, both empirically and theoretically. The empirical data show an ability to deliver robust real returns in times of higher inflation. From a fundamental perspective, this makes sense given the way rental incomes stem from the real economy. There are potential short-term problems from rapid inflation changes and the slower response of rental incomes, but over longer horizons, we’re comfortable with real estate as a way to better enable portfolios to deliver positive long-term real returns when inflation is elevated.

There are relatively few overall constraints on real estate investing right now from an ESG perspective, in principle. There’s a focus on the “E” part of ESG and the potential for new buildings to be more efficient, which is all well and good. But we think that a more holistic view reveals challenges—investors need to be more aware of the “S” part of ESG. In September 2021, Berlin voters backed a referendum to force large corporate landlords to sell housing they own in the city, which could affect a quarter of a million apartments. The vote is non-binding, and arguably the high incidence of renting in Berlin makes the city different from others in developed markets, but it could presage a broader question around ESG considerations.  

A similar backlash is forming in Spain where, according to the Financial Times, Blackstone is now the country’s biggest landlord.7 At the end of last year, Spain’s government approved a draft bill aimed at landlords with more than 10 properties. The measure could introduce rent caps in certain areas where rents have risen much faster than inflation and might also ban the sale of social housing to investment funds. Similar pressures are apparent in other countries.

Seen in this light, the role of institutionally owned residential real estate is bound up with broader questions of inequality and social fairness. We think a shift to permanently higher inflation will drive up institutional demand for real estate. In the world of real assets, real estate is the only asset class that could be sizable enough to rival the capacity of equity markets. There have been constraints to this point on how much of the real estate market is investable, but large strides have been made to open more of it up to investors. The potential of tokenization could better enable investors to access a larger share of real estate markets—by making fractionalized ownership easier, for example.

However, there are dangers and limits. We expect a growing social and possibly political backlash against the financialization of real estate, particularly residential. In some cases, in Berlin for example, this opposition might limit investors’ ability to own such assets at scale. That might be an extreme example, but more broadly it could directly limit the ability of real estate income to rise with inflation as it has historically. The potential for rent controls to limit real estate’s ability to hedge inflation might have to be included when modeling returns. However, this also raises questions about the interaction of rent controls and the supply of real estate, given insufficient residential construction in many key markets..8

Cryptocurrencies: There is currently no empirical evidence of cryptocurrencies providing inflation protection. Bitcoin, for example, has dramatically failed as an inflation hedge—or a hedge for anything—over the past year. The day Russia invaded Ukraine saw gold and Bitcoin move in opposite directions: gold worked, and Bitcoin didn’t. The return history of cryptocurrencies is simply too short, and prices too volatile, to demonstrate any meaningful inflation hedging properties.

Nevertheless, we would note that if one treats this asset as “digital gold” because it is a zero-duration non-fiat asset with a programmatically limited supply, a case could be made that it should act as an inflation hedge, particularly when the money supply is expanding rapidly. It could be most useful in an environment where moderately elevated inflation was a policy goal to reduce public debt—debasing fiat currencies. The likelihood that such a shift in policy, either explicit or implicit, could occur has increased. Our view is that the pandemic marked a critical moment in the transition between monetary and fiscal policy as the key cushion for economies in times of stress. The fiscal genie is out of the bottle and there will be popular pressure to reach for it again in future downturns. A fiscal response to the elevated energy and food prices brought about by the Ukraine crisis could further entrench such a view.

The energy consumption required to mine some cryptocurrencies, most notably Bitcoin, is strongly at odds with the environmental principles of ESG. Some of these issues could be alleviated if more renewable energy sources are used for future mining, but that point is open to debate. A move to proof-of-stake could also blunt this ESG concern in some cases. However, the use of Bitcoin and other cryptocurrencies in money laundering and other illicit activities is highly problematic from a social perspective. To be fair, there is a positive offset to this downside, as crypto enables banking access to those shut out of traditional banking systems, while also making it cheaper and easier to repatriate money to poorer countries. 

Private Assets: There’s nothing inherently anti-ESG about private equity (PE) assets—unless one wants to argue that, from a policy point of view, direct access to these return streams is biased toward the wealthy. But private assets have historically not been subjected to the same kind of ESG constraints as active equity funds have. This disparity is being addressed but it will likely take time before it’s reflected in the majority of assets.

We’re seeing growing scrutiny of PE firm investments that are filling the financing gap in oil, gas and coal project funding left by public firms.9 The New York Times cites a report by the Private Equity Stakeholder Project showing that about 80% of the top 10 PE firms’ current holdings are in oil, gas and coal sectors. Because PE firms’ disclosure requirements are much less stringent than their public counterparts, it’s harder to evaluate their ESG practices, resulting in less pressure and fewer incentives to reduce emissions or divest non-ESG assets.

4.  A Synthesis Is Needed

We’ve laid out the case for ESG driving inflation and the tension between inflation hedging a portfolio while complying with some of the traditional constraints of ESG investing (e.g., simple approaches based on screening and exclusion). We think that this macro trend of inflation and the industry trend of an increasing focus on ESG will persist. Returning to our comment on seeing this as a dialectic, a synthesis is required, part of which is an evolution of what ESG investing really means. But critically, this also requires developing new return sources.

ESG, or responsible investing, is a very broad field. Answering the question we posed up front—how to address inflation responsibly—requires the recognition of the broad spectrum of ESG investment approaches. Historically, relying heavily on screening or identifying certain segments of the economy as “good” or “bad” has been a dominant approach. This can take the form of either excluding “sin” stocks from broad market indices or using “best-in-class” indices of companies that score highly on ESG metrics. Much of this form of investing has gone under the label of socially responsible investing.

When we think about the spectrum of ESG approaches, screening and exclusion still have a role to play, but represent a more passive approach, in our view: they should be considered akin to rules that determine broad market indices or “smart beta” simple factor tilts.

We argue that an active ESG approach should employ active engagement with the underlying issuers and investments, with the intent to gain insight, foster corporate change or promote certain outcomes. As a first step, it should acknowledge that ESG rules are dynamic and contingent, not static and absolute. This allows active ESG approaches to adapt rather than waiting for the deliberations of index providers. As a case in point, the war in Ukraine raises questions as to whether excluding defense companies is a sustainable approach. At the very least, the role of defense companies in enabling democratic societies to take a stance against existential threats deserves a discussion.

We also believe that active ESG needs to go further by fully integrating ESG into the financial considerations of buying or selling an asset, without necessarily imposing any exclusions. In this way, the financial materiality of ESG becomes an important element of any investment decision, implicitly placing a coefficient on an ESG input alongside other financial considerations.

A further extension of this active approach incorporates specific ESG-related outcomes in addition to integrating ESG into financial analysis—we’d include impact and sustainable funds in this category. Given their more thematic bias, some of these strategies could be susceptible to underperforming in certain phases of the cycle when specific themes aren’t in favor. However, the fund buyer would presumably have signed up explicitly for that tactical risk when making an allocation. As we showed earlier in the note, a broad sample of ESG funds has managed to achieve more idiosyncratic alpha than non-ESG funds in recent years—an important pillar of the case for an active approach to ESG.

Another route for a definitively active approach to investing under the aegis of ESG is engagement. We think this could become the core of what it means to be an active investor. From a purely commercial perspective, such an approach has advantages, would be much harder to create through passive strategies and could make it possible to defend fees. There are three other crucial benefits of an active engagement approach:

  1. Extending the time horizons of investments: If asset owners care about ESG in the form of engagement, they’re more likely to stick around to see the fruits of that engagement. This then becomes important not only for E, S or G reasons but also benefits the asset owner, making them less likely to incur an excessive churn cost from bad fund-selection decisions. It also becomes important for asset managers, enabling them to have longer investment horizons.
  2. Generating idiosyncratic alpha: In a world where smart beta is becoming free, we think the only kind of return that managers can charge a fee for is idiosyncratic returns.10 Engaging with companies and bringing about corporate change is at least a candidate for generating idiosyncratic returns.
  3. Competing with private equity: Engagement blurs the distinction between private and public equity managers. The most egregious differences in fee spreads across the industry aren't between active and passive managers but between active public equity managers and private equity managers. By encouraging active engagement and bringing about positive governance changes, active public funds would be bringing about the kind of returns that private equity managers aim to deliver, assuming that such ESG engagements lead to positive returns. So, if used correctly, engagement can be a strong element in narrowing the fee spread between public and private equity managers. Ultimately, this would benefit asset owners, too, in our view.

We think engagement-driven ESG is a key part of the active/passive debate. One line of reasoning sometimes used holds that because passive managers can’t decide to sell a given security in an index, they care more about engaging on ESG than active managers who have the option to sell. This leads to another view that many companies view passive managers as long-term investors because their capital allocation is stable—in a survey we conducted, corporations told us that they saw this attribute of passive managers as being a key attraction.11

We think both views are misguided. Not being able to sell an asset raises questions about the degree of power (other than voting power, which all owners have). It also presumes that one knows the right questions to ask or points of engagement to push. Moreover, thinking of passive investors as long-term investors is to conflate frequency of capital reallocations with the time horizon of investment. Tracking a broad-market index is necessarily a backward-looking exercise, not an endorsement of the future.

In our experience, asset owners might like this line of reasoning, but we also hear pushback. Surely, some argue, if ESG is to carry any moral or intellectual force, it must exclude certain types of economic activities altogether. Given these attitudes, we believe that there’s a need for other ESG approaches, rather than relying on engagement alone, to provide asset owners with new kinds of return streams—including renewable power, timberland and farmland.

Delivery of renewable power: This seems like a highly attractive option that neatly meets sustainability requirements and has a natural inflation-hedging property. In fact, as renewable power offsets older power sources, it can be thought of as naturally replacing part of a portfolio’s commodities exposure. Because it addresses the same “real” need in the economy for energy consumption, green-energy delivery should have a similar return profile in inflationary environments. Moreover, it helps address many ESG goals, so the asset class should enjoy the support of significant and sustained investment inflows from ESG-oriented investors and the public sector in the coming years.

In Display 11, we gauge the possible range of renewable investment in coming years—this analysis was completed before the Ukraine war, which will accelerate some of these goals. The exhibit shows the annual global renewables investment required under three different scenarios considered by the International Energy Agency. The Stated Policies scenario reflects the spending forecast under current stated climate policies. The more ambitious Sustainable Development scenario reflects the spending needs to meet the goals set by the Paris Agreement, with countries reaching net-zero emissions between 2050 and 2070. The most ambitious scenario aims for net-zero emissions by 2050 and is consistent with limiting the global temperature rise to 1.5°C.

To put the scale of spending into context, global gross domestic product (GDP) was nearly US$85 trillion at the end of 2020. Under the Sustainable Development scenario, the required investment would be nearly 0.7% of 2020 GDP for the next 10 years, and nearly 0.8% of GDP thereafter. For the Net Zero scenario, investment would be 1.2% of 2020 GDP for the next decade, and 1.3% thereafter.

These numbers are relatively modest compared with prior investment booms, when changing technology caused huge, society-altering investment in infrastructure. One historical comparison that seems relevant is the capital investment in UK railways from the mid-1830s to 1860. Railway investment averaged 2.1% of GDP, or 1.6% if we exclude the peak “railway mania” years of the mid-1840s. At the peak build-out of the US interstate highway system in the late 1950s and early 1960s, the US was spending around 3% of GDP on transport and water infrastructure.12

Meanwhile, BloombergNEF analysis of different net-zero scenarios, which is broader in scope and covers renewables, energy storage, electric vehicles, carbon capture and sustainable materials, suggests higher required investment.13 For 2022 to 2025, the analysis projects an average of US$2 trillion of energy-transition investment annually, and nearly US$4.2 trillion annually for 2026–2030. These amount to 2.4% and 4.9% of global GDP, respectively.

Farmland and timberland: These are long-established alternative asset classes, yet they have been considered niche investments for the past century. While the institutional assets under management in these asset classes is still low compared with private equity or real estate, they’re gaining renewed interest and importance in the current macro environment. According to recent academic studies, global institutional investments in timberland have grown to nearly US$100 billion.14  

Data on institutional investors’ exposure to farmland are harder to come by. According to the United States Department of Agriculture, only about 2% of total farmland ownership in the US is held by non-family-owned farms, which includes corporations and institutional investors.16 However, the growing market value of the widely followed NCREIF Farmland Index from less than US$4 billion 10 years ago to nearly US$14 billion at the end of 2021 suggests increasing institutional interest. 15

Both timberland and farmland have attractive inflation hedging properties, as suggested by the close long-run link between US CPI and timberland[6] prices (Display 12) as well as farmland prices (Display 13). Also, timber is a major component in housing construction, while farmland prices are tied to the price of agricultural commodities, so they should provide a natural hedge against rising real estate prices and food-price inflation.

Since the 1970s (Display 14), both farmland and timberland have, on average, delivered strongly positive real returns in periods of moderate and high inflation. We define periods of moderate inflation as those where the US 10-year breakeven rate was between 2% and 4%, while defining high inflation as a breakeven rate above 4%.

In addition to the specific role these assets play in protecting investors from inflation, they also offer strong strategic “fundamentals” in the form of a growing population, changing consumer preferences in protein sources and a rising demand for agrofuels and carbon sinks. 

Both timberland and farmland are also increasingly important from an ESG perspective. Forests play a crucial role in climate regulation, and their role as carbon sinks is attracting more interest from institutional and corporate investors looking to invest in growing forests for carbon sequestration—an aid to achieving net-zero emission goals. Meanwhile, farmland plays a crucial role in achieving United Nations Sustainable Development Goals, such as zero hunger.

Given this backdrop, farmland and timberland could offer a very desirable overlap between protecting investors against inflation and fulfilling ESG objectives. However, fulfilling that promise requires that the management of these assets incorporates a significant focus on sustainable goals. Given this required slant, it’s probably not enough for these exposures to be passive-only, so there should be dispersion in the demand for different types of farmland assets. Not all farmland exposure will be equal.

Taking the US as an example, farmland productivity is highly skewed. Large-scale family farms and industrial non-family farms account for only 4.8% of farms but 57.4% of production in dollars, and there’s a succession issue, with 28% of farmers between the ages of 55 and 64.18 This leaves open the possibility of a need for capital, which could leave a useful role for institutional investors.

The focus of ESG-minded investors in this area will likely be on sustainability and the “E” of ESG in the first instance. We should note that, as with the debate about the social impact of the financialization of residential real estate, there may be a parallel challenge emerging to the role of institutional investors in farmland and converting more of it into a financial asset. This will likely manifest both at the local level, in terms of the impact on communities, and at a global level, from the perspective of the commons and the status of food in society.19

Tokenization: The tokenization of real assets currently presents very few examples of meaningful investment capacity outside of real estate. However, World Economic Forum projections show immense future potential for growth (Display 15). In our view, the key benefit of tokenization is that it enables access for retail investors and small institutions to real asset classes previously inaccessible to them, such as private real estate, farmland and collectables via fractional ownership. 


Overall Allocation and Sizing

In the context of protecting against inflation and complying with ESG rules, we suggest that investors seeking inflation protection over long horizons, and therefore needing positive real returns, increase allocations to renewable power delivery. These allocations will likely be limited by capacity in the near term but will scale up as projects are developed. We also think allocations to private natural resources—such as farmland and timberland—should increase. Real estate exposure should stay or rise, but these decisions should be made within a long-term strategic view that considers emerging risks from the “S” of ESG.

What allocations can be reduced to fund these return sources?

Many investors are siloed by their governance structure or allocation methodology. So, we suspect near-term funding would come from existing alternatives or illiquid positions—possibly at the expense of private equity, or at least at the expense of new allocations into private equity. In time, we think this decision should be viewed in the context of the whole book and sources of real return. As long as risk constraints allow, a world of lower nominal returns and higher inflation implies that more of these allocations should come at the expense of traditional fixed income.

We’re mindful of the risk implications, but this must be viewed in the context of a bigger risk (i.e., that of a hardship outcome for end beneficiaries). We would argue that should be the primary risk that agents entrusted with managing assets are focused on. We are fully aware that risk is usually measured as trailing realized volatility. That might have been excusable in an environment when major asset classes delivered strong positive real return, however we think that for a long-horizon investor, it is myopic to focus on realized volatility as the principal measure of risk in the current environment. This is a huge topic in its own right, but one that is a common thread through much of our research. Within public market allocations, we expect an evolution in distinguishing between cheap, passive approaches to ESG, based on exclusion and screening, and engagement-based approaches as a destination for active fees.

There’s an open question as to how to size allocations to these newer return streams.

The usual approach would be to assess their long-run real return potential, ability to hedge inflation and volatility to arrive at an allocation. But this is complicated with newer return streams. An alternative approach considers the potential scale of the return source in the economy. Such an approach would have been ineffective in recent decades when financial assets strongly outpaced real assets and the real economy, but we expect that performance gap to be much narrower in the future. Thus, approximating the sizing of assets in the real economy might be an effective path to generating real returns. This, we note, is a much more general question than the specific issue of ESG and inflation.

We discussed earlier how investment in the energy transition could account for 1%–2% of GDP for an extended period. This would leave renewable power sources occupying a similar place in the economy to that of fuel commodities today, potentially performing a similar role in investment portfolios as well. Fossil fuel costs currently account for around 6% of GDP. Adding metals and mining, the share rises to nearly 14%.20 However, many metals, such as copper, aluminum and lithium, will still be needed in the future and are keys to the green transition—and neither gold nor silver will be replaced, so that higher number might not be a relevant comparison.


5. Who Pays for a Shift to ESG-Friendly Policies?

Not directly related to the portfolio question of inflation protection is the issue of who will pay for a sociopolitical shift in favor of ESG-friendly policies. Perhaps the most obvious cost is the investment required for the energy transition, a need now rendered much more acute by the war in Ukraine. However, the shift is a much broader question encompassing the cost of a rebalancing of power between labor and capital that results in higher wages.

We claim that consumers cannot bear this cost. Yes, consumers may say they’re happy to pay more for sustainable products, but we think the burden will fall more heavily elsewhere—namely on companies and governments. Corporates should be expected to take a large share of the cost because margins are at historical highs. The profit share of GDP for US corporations is currently 12.6%, well above the 9.7% average since 1950. Commodity inflation raises input prices, but also important is that the messaging of the “S” in ESG involves wages and labor bargaining power.

We expect governments to take a large share of this cost. In the post-pandemic world, the ability to deploy fiscal policy to address investment requirements has plausibly changed. There will always be a debate on this point, but policymakers have had to become comfortable with much higher levels of debt/GDP than were deemed acceptable before. Moreover, if investment is labeled as “green infrastructure,” it is more likely to be deemed politically palatable.

One implication of the ESG bill coming due is that investors should expect a downward drift in corporate margins in the years ahead. However, there is room for this to happen with equities still generating positive real returns.21 The other consequence would be an expected continuation of the unprecedented high debt levels across the Organisation for Economic Co-operation and Development; at the margin, this implies a lower endpoint to any run of interest-rate increases. There will be a policymaking desire to keep the interest rate below the growth rate of economies as a route to manage debt.

We’ll touch on the question of who pays and who owns the drivers of growth in a forthcoming essay.

6.  Conclusion

ESG, both as a mode of investing and broader sociopolitical force, is here to stay—representing a secular force in investment and society. We’ve argued in this note that this force is profoundly inflationary and adds to other inflationary forces to cement our view that the post-pandemic future is one where inflation is above the pre-pandemic equilibrium. However, there are balancing deflationary forces, so this should not lead to unanchored inflation.

Thousands of notes have been written on what kind of assets are compliant with an ESG portfolio or with an ESG investment ethos. Here, we’ve focused on the specific question of ESG and inflation. We’ve done so not only because inflation protection is the question of the day, but also because we think the question of how to address inflation responsibly will be a key question for the investment industry to grapple with for years to come. ESG is a cause of inflation, but certain ESG definitions hinder some of the knee-jerk responses to inflation. At the same time, investing responsibly and protecting investments from inflation are two of the biggest issues investors need to deal with. The synthesis of these forces will be strategically important for the investment industry.

We’ve made the case that ESG investing is far from monolithic; there’s in fact a wide spectrum of approaches. What’s more, the resurgence of persistent inflation for the first time since ESG has become a material force for change raises a new challenge for this mode of investing. The corollary is that inflation causes a wider dispersion between different kinds of ESG investing (for example, favoring an active engagement approach and/or integration over a more passive screening or exclusion approach). It also provides extra impetus to develop return streams that are both ESG-compatible and potentially effective as inflation protection.

Any mode of investing must continually evolve as it encounters the vagaries of the investment landscape and changing investor preferences. This is true of style-based modes of investment (for example, the way value strategies have overcome a long period of disfavor) and for active investing overall (with more of that happening in illiquid alts than in public equities). ESG is no different, and we think a sustained resurgence of inflation will bring changes in people’s definitions of ESG. One thing seems certain: ESG investing is here to stay.

The Hegelian dialectic seems like an apt lens through which to view this topic. For those who are rusty on the concept of the dialectic, the idea is that an initial thesis (be it an intellectual movement or an investment approach) will eventually be shown to be inadequate or insufficient. This gives rise to an antithesis, which in turn will prove to be inadequate. These two movements must be brought together to address what is insufficient in both, which is called a synthesis. All dialectical movements lead to a synthesis of some form. Here we see the evolution of ESG investing as the thesis, which has become established over the past decade. However, the abrupt need to seek inflation protection in the post-pandemic world raises new questions that ESG has not had to face before. The urgency of the need to address the inflation question gives rise to an antithesis. However, classical approaches to inflation protection are insufficient, as they do not adequately address the needs of responsible investing. Therefore, the synthesis lies in the resolution to the question: How to address inflation responsibly? See, for example, Peter Singer, Hegel: A Very Short Introduction (Oxford, England: Oxford University Press, 1983).

2 “Global Sustainability Study 2021: Consumers are key players for a sustainable future,” Simon-Kucher & Partners, October 2021,

For more details, please see Bernstein E&Ps: The Green Wolf at the Door—Oil is transitioning to a new (and bullish) paradigm and we upgrade the sector, June 21, 2021.

See our discussion of this and our review of books on this topic in our black book Inflation and the Shape of Portfolios: A Changed Policy Environment, the Market and Factor Outlook, and the Changing Needs of Asset Owners.

See Alphalytics: The Elusive ESG Alpha Question, September 4, 2020.

See What the War in Ukraine Means for Asset Allocations.

“Spain takes on private equity landlords as cost of housing soars,” Financial Times, November 13, 2021,

For example, see Prasanna Rajasekaran, Mark Treskon and Solomon Greene, Rent Control: What Does the Research Tell Us about the Effectiveness of Local Action?, Urban Institute, January 16, 2019,

“Private Equity Funds, Sensing Profit in Tumult, Are Propping Up Oil,” New York Times, October 13, 2021,

10 See Alpha, Beta and Inflation: An Outlook for Asset Owners.

11 See Fund Management Strategy: Management incentives, buybacks and the failure of ESG, Bernstein Research, March 21, 2019.

12  “Public Spending on Transportation and Water Infrastructure, 1956 to 2014,” Congress of the United States Congressional Budget Office, March 2015,

13  “Energy Transition Investment Trends 2022: Tracking Global Investment in the Low-Carbon Energy Transition,” BloombergNEF, January 2022,

14 R.P. Chudy and F.W. Cubbage, “Research trends: Forest investments as a financial asset class,” Forest Policy and Economics 119 (October 2020),

15 “Farm Structure and Contracting” Economic Research Service, US Department of Agriculture, updated March 8, 2022,,the%20value%20of%20agricultural%20output.

16 “NCREIF Farmland Property Index Released,” National Council of Real Estate Investment Fiduciaries,

17 Forestry Investment Total Return index is based on: Colm Fitzgerald, “The Forestry Investment Total Return (FITR) Index,” The Journal of Alternative Investments 23, no. 4 (Spring 2021): 131–150,

18 “U.S. Food System Factsheet,” Center for Sustainable Systems, University of Michigan, 2021,

19 See, for example, Stefan Ouma, “This can(’t) be an asset class: The world of money management, ‘society’, and the contested morality of farmland investments,” Environment and Planning A: Economy and Space 52, no. 1 (August 2018): 66–87,

20 Please see Global Metals & Mining: The world has never paid more for the stuff we pull out of the ground [in two charts], Bernstein Research, October 25, 2021.

21 See An Equity Outlook: Are Stocks the Biggest Real Asset Out There?

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