The effects of the pandemic, war, persistent environmental degradation, and inequality mean that the role of sustainability in business and investment has never been higher profile. In addition, Environmental Social Governance (ESG) and sustainable investment found themselves the subject of healthy debate too.
Against this backdrop, Lloyd McAllister, head of sustainable investment at Carmignac outlines seven themes that he predicts are likely to dominate the sustainable investment discourse over the next year.
A shift from climate commitments to delivery
A lack of progress on global emissions reductions will move the climate discussion from long-term targets to delivery and a focus on innovation and technology solutions. Delivery was given a shot in the arm thanks to the Ukraine war highlighting the weakness of energy systems vulnerable to geopolitical risks. As a result, emphasis will turn to scalable technology that can support the transition and renewables growth will continue to outpace expectations.
We expect the rush of long-term emission reduction targets to slow and become caveated with dependencies on regulators setting explicit rules and consumers buying lower emissions products and services, as the reality of delivery becomes clear. We also expect brown-to-green transitions to face greater scrutiny but will ultimately become more accepted as the duration and complexity of the energy transition become better understood by asset owners.
The uncapped tax incentives within the Inflation Reduction Act in the US will drive faster adoption of clean tech in the US and we expect further regulation and activity from central banks and EU regulators, in particular highlighting the EU’s Carbon Border Adjustment Mechanism.
We expect a shift in expectations from long and medium-term “talking” metrics such as science-based decarbonization targets to a focus on capital and operational expenditure that enables the delivery of these targets. With much green tech still nascent and unproven, financial incentives can provide a catalyst for companies to invest in laggard transition sectors such as cement, steel, aviation, shipping and food.
The resulting innovation in climate technologies will provide opportunities for investors looking to align portfolios with the energy transition.
Long tech, short oil won’t cut the mustard anymore
It was easy to appear sustainable in the post-crisis era of easy money which generously rewarded growth. This led to the typical long-tech short-energy portfolio becoming the blueprint for sustainability due to its low level of easily measurable negative externalities such as carbon emissions, alongside positive exposure to cutting-edge technology that was improving people’s lives. We believe this somewhat superficial approach will cease to work going forwards, due to higher asset owner expectations, regulation and a different market environment.
We expect portfolios marketed as having sustainable characteristics to clearly demonstrate what client-alignment, additionality or outcomes they are delivering and the extent to which ESG is considered from a financial and non-financial perspective.
In addition, we expect the need to show positive engagement outcomes will become a base requirement, rather than a nice to have.
Definitions under the microscope
Sustainable investment became a regulatory quagmire over the past couple of years with the introduction of the EU’s Sustainable Finance Disclosure Requirements (SFDR) and the Sustainable Finance taxonomy. This trend of regulators trying to untangle the interaction between financial, environmental, and social systems and different investment objectives will move from getting the basics in place to scrutinizing how asset managers have interpreted the small print of the regulation.
Regulation will evolve to focus on refining the definition of sustainable investment and we expect that there will be enhanced scrutiny and further definition guidance on Article 8 funds under the SFDR.
Evolving expectations of fiduciary duty and materiality
There is a growing shift in defining fiduciary duty from shareholder wealth to shareholder welfare accompanied by the rise of stakeholder capitalism. This means asset owners are increasingly expecting asset managers to consider the concept of double materiality whereby both the consequences of environmental and social issues on a company’s performance, as well as the company’s impact on the environment and society, are considered material.
We should expect clients and regulators to talk about ESG issues that appear less relevant to a company’s valuation in the short term but are material to long-term asset owner decision making.
Politicisation of ESG
ESG has been attacked in the US by politicians from both sides of the aisle. For the right, ESG represents a political cabal that is distorting markets and dangerously removing finance from crucial industries such as energy and defence. For the left, ESG is the latest game cooked up by Wall Street to extract higher fees using greenwashing. While the arguments often misrepresent, oversimplify or are overly reductionist, the critique of ESG as it becomes more mainstream will force higher quality approaches and transparency, which we view as positive.
While political noise often misrepresents ESG, we expect these arguments will remain a source of news flow, thereby creating confusion for clients, thus asset managers must be clear regarding their investment philosophy and approach.
We hope that there will be a growing recognition that individual or groups of asset managers have some, but not unlimited ability to deliver system-wide ESG goals and that regulators need to step up.
The resurgence of the de-growth narrative
The two dominant economic theories in sustainability either focus on degrowth or green growth. Green growth believes that it is possible to grow traditional metrics like GDP while reaching acceptable global pollution and living standards. De-growth believes that resource consumption needs to fall to enable society to live within an ecologic ceiling. Throughout 2022 the de-growth narrative became more prominent due to the perceived ineffectiveness of green growth.
Unless absolute global pollution begins to trend down, which we view as unlikely, the de-growth narrative will likely begin to slowly permeate into broader economic debate and government policymaking. Companies with high exposure to commonly perceived “over-consumption” issues i.e. fast fashion and single-use plastic, can expect to draw increased attention from regulators, consumers and clients.
To date, governments have focused policy on the need for companies to quantify their emissions but wider acceptance of the de-growth theory could result in a more interventionist stance. This could have a profound effect on the long-term financial outlook of the most in-focus sectors.
A broadening of the agenda
ESG has been dominated by climate and financial market regulation in 2022. We believe that the focus will now shift to broader topics of biodiversity, considering planetary boundaries rather than specific environmental metrics and social issues such as food security, anti-microbial resistance and monopoly.
We expect that asset managers will need to demonstrate their performance against natural capital limits or budgets, rather than as absolute performance metrics. This is already happening to some extent through initiatives like the EU carbon budgets for funds and the Taskforce on Nature-Related Financial Disclosures, but we expect it to accelerate.
The focus on broader social topics will force difficult conversations where there are less “win-win-wins” for financial, natural and social capital, but instead where trade-offs will exist that require careful navigation.