ESG is not a passing fad. Institutional investors today are just as, if not more, committed to building sustainable portfolios that generate a positive impact on the natural world and promote equality than they were a decade ago. No longer seen as niche, such strategies are increasingly becoming a cornerstone of institutional portfolios.
Climate change has typically been the priority here, but other issues have emerged, such as providing access to fresh drinking water as well as adequate healthcare, housing and education. Then there is protecting our ecosystem, building resilient communities, ensuring that companies are well behaved and treat their employees with dignity and respect.
Building a sustainable and fairer world is a big job. Therefore, it is not surprising that new themes emerge in conversations between pension schemes and their investment managers.
Each year, portfolio institutional surveys the opinion of the members of its ESG Club to discover what they believe will be the big themes in the year ahead.
One of those people is Laura Brown, who is head of client and sustainability solutions at Legal & General Investment Management (LGIM). She expects ESG-led investing to mature in 2024, in that there is likely to be increasing focus on real-world impacts and the outcomes investors are creating through their actions.
With this in mind, LGIM launched an engagement-led strategy in 2023 focusing on companies that traditional net-zero strategies would tilt away from. “It is focused on the subset of companies where we can identify that they are currently climate laggards but have the potential to become leaders and unlock shareholder value in the process. A detailed, pro-active engagement programme with very specific actions and KPIs aims to move them along that journey over time,” Brown adds.
The disclosure regime will also be a big part of investment conversations in 2024, believes Nico Aspinall, a sustainability advocate at Newton Investment Management.
The final rules of the Sustainability Disclosure Requirements (SDR) were confirmed in November and will have a big impact on sustainable strategies. “We will spend a lot of next year working out which products will meet those rules and presumably creating new ones,” he says. “That for me is huge.”
“We are supportive of the SDR regime as it aligns with many things we do and how we think about sustainability.
How investment management firms think about ESG is pretty foundational, so that could start to move things around next year,” Aspinall adds.
SDR is not the only reporting disclosure that investment managers will need to get to grips with in the coming year. The Carbon Border Adjustment Mechanism will be implemented in the EU in 2026, but its reporting phase comes into force from January 2024 targeting iron, steel, aluminum, fertilisers, electricity, cement and hydrogen imported into the bloc.
The mechanism is being introduced to “prevent carbon leakage from their own carbon standards”, says Abbie Llewellyn-Waters, an investment manager for global sustainable equities at Jupiter Asset Management.
“So at the point of importation, the carbon content of the product sold within those initial seven categories will now be initially measured, [and] ultimately priced,” she adds.
The international response to this initiative has been expedited with several carbon-based initiatives being developed.
The US, for example, has initially responded with The Prove It Act – provide reliable objective verifiable emissions intensity targets – which requires the Department of Energy to study and compare the emissions of carbon-intensive sectors.
Other global mechanisms have developed, notably in China and Australia; with the former developing a carbon footprint management system for 50 products by 2025, introducing national level accounting rules.
The UK is also working on its own version. “So it is logical to assume that over the next two to three years, we will have established mechanisms that internalise the price of carbon on a direct basis,” Llewellyn-Waters says.
“From our perspective, what we look to in our capital allocation process, is those companies that are well positioned for when markets better reflect the climate-related financial risk and ultimately the valuation of the companies that we are investing in,” she adds.
Those companies, Jupiter believes, are ready for this transition, in that they can “respond to those regulatory developments”, which gives them a competitive advantage.
Llewellyn-Waters uses cement as an example. “If you want a tonne of cement, and you receive two quotes of the same quality that can be delivered on the day you want it, then you are probably going to go with the cheaper option.
“Companies with less carbon to price in their products therefore have a competitive advantage,” she says. “For us, companies who understand the direction of travel and have sought to decarbonise their businesses to prepare for a low-carbon transition are much better positioned than those who have not.”
So Llewellyn-Waters believes that this mechanism has the potential to make “a significant difference” in the transition to a 1.5-degree climate scenario.
“And the mechanisms that will come into force, will accelerate internalisation of climate-related financial risks, with the valuation of equities better reflecting their transition strategy,” she adds.
Rage against the machine
But the new year could see a pushback against the rules. “I’m going to call it a rebellion against regulation,” says Tim Manuel, Aon’s head of responsible investment.
A raft of ESG-related regulation has been introduced in the past few years emphasizing policy, process and disclosure. In short, it requires investors to collect more data to prove they have considered the environmental risks of their investments. “It has done a great job of putting climate on the agenda and getting the issue firmly in the minds of investors,” Manuel says. “But the issue is that regulation hasn’t created an impetus for action.
“Many investors have recognised the importance of the issue, and they want to do something about it, but their resources are being drained by what regulation is continuingly asking them to do, which is more disclosure, more data.
“That is taking energy and attention away from what investors know they need to do, which is to start investing differently,” he adds.
So Manuel expects to see some pushback here. It could start with the consultation looking at what the Sustainable Finance Disclosure Regulation should look like in future, which some are questioning if we should rip it up and start again. “I wouldn’t be surprised if there is a high degree of support for that,” he says.
“At the end of the day, change is not going to happen on the basis of nice disclosures. It is going to happen if people start behaving and investing differently.”
The regulatory focus on transparency is making some people too cautious about the accuracy of the data they are disclosing, Manuel believes, which is acting like a barrier to action.
There are instances, he says, where it is doing more harm than good. “In most cases, we are going to be judged on action at the end of the day, not glossy disclosures. So I’d like to think that a theme in 2024 will be a focus on what is meaningful, rather than what is accurate,” Manuel says.
ESG has dominated investment conversations for many years, but if you asked five people what it means, you could receive five different answers. Indeed, an asset owner once told me that ESG is “three random letters that have been thrown together which we have to work with”.
Such confusion could cause problems. “ESG is a term that has been prodded and twisted out of shape over the past year or two,” Manuel says. “If ESG as a label is not used well it could cause more confusion than clarity.
“It is important for people operating in this space to be more conscious about language, to speak accurately and precisely about what they are trying to achieve.
“Sometimes ESG is used out of laziness: ‘I know there is something that I should be talking about, but I’m just going to substitute it with “ESG” and hope that the person who is listening understands what I mean’,” Manuel says.
He uses water as an example. It is a finite natural resource that supports life on Earth and which all businesses need a clean, constant and secure supply of. Semi-conductor makers, for example, are massive consumers of water.
So not only is it a sustainability issue, but it is a financial risk for investors. “Why not just talk about water being a business risk and an investment risk, rather than about it being an ESG risk,” Manuel says. “There is often no need to label things as ESG. Using the term in a lazy way can sow confusion.
“A trend will be everyone starting to talk more precisely about what they mean in this space,” he adds.
30 by 30
Biodiversity has become part of investment conversations for a couple of years now, and in 2024 the theme will continue to evolve, says Peter Mennie, chief sustainable investment officer of public markets at Manulife Investment Management.
“It has been a year since we were in chilly Montreal for COP15,” he adds. “One of the key outcomes from that was the 30 by 30 target, which gives us evidence of where public policy is going and the angle we need to take when engaging with companies to promote nature-positive action.”
In the year ahead, Mennie expects the 30 by 30 target to be a priority that drives decision-making on engagement targets alongside Nature Action 100 and the PRI’s Spring initiative. “When we talk to asset owners, they are thinking about their dependencies and impacts on nature,” he adds. “So we are expecting to see an increase in reporting on nature.”
So 2024 is the year that will see asset owners beginning to work towards putting that into practice, says Eric Nietsch, head of sustainable investing for Asia at Manulife Investment Management. “There are other pieces of regulation and pledges that are being made, which will come up next year at COP16, which is the first time that countries will begin to show their progress.”
He adds that there are things happening on the regulatory side in Malaysia, the Philippines, Indonesia and Vietnam, while changes in Europe will also have an effect on Asia, specifically the EU Deforestation Regulation.
“It comes into effect at the end of 2024 and covers supply chains, so that any product that goes on a shelf in Europe will have to show that it has not contributed to deforestation. Palm oil, for example, has been heavily scrutinised,” Nietsch says.
“Deforestation related to palm oil has decreased by about 80% over the last 10 years, but this new regulation will also cover rubber, coffee, cocoa cattle, wood and soy. We expect a lot of companies to be working on that through their supply chain next year,” he adds. “If everything has to be clear by the end of December, then that means they have to do the work in 2024. That is just another example of regulation off the back of COP15.”
Mennie says that nature and biodiversity should matter to everyone. A third of the world’s medicine comes from nature, a third of our food supply is dependent on pollinators and with studies showing the potential job creation linked to addressing biodiversity loss, this is something we should all care about. As we move towards COP16 we are expecting to see a real focus on how we address it.
“The 30 by 30 target provides a framework and focal point for everyone to work towards: but we need to make sure it works and we need to harness the power of the markets and set the right incentives to make sure that targets are met,” he adds.
Moving out of the shadows
It is becoming widely understood that climate change and bio-diversity are linked. “If we just build an economy that doesn’t emit carbon dioxide, there is a big risk that we will still destroy the planet,” Newton’s Aspinall warns. “Indeed, a good way to absorb carbon dioxide is to maintain our forests and oceans.
“Biodiversity has become a topic on its own,” he adds. “The Taskforce on Nature-related Financial Disclosures (TCFD) is fresh out and clients are name checking it more and more, so there is definitely an increasing client awareness of the topic.”
Aspinall expects more and more of Newton’s clients to be discussing natural capital going forward, as they try to understand how this systemic risk might affect returns.
“More of the investment process will be dedicated to natural capital as more and more people are thinking about these risks and more data is becoming available,” he says.
Aspinall explains that when it comes to biodiversity, the investment world is not at the same stage as it is with climate change, but collectively responsible investment teams are pushing that agenda and there could soon be change. “In 2024, we could see positive change in internal philosophies around biodiversity,” he says.
Many of the trustees Manuel speaks with are more engaged with nature risk than climate. “You can’t take the person out of the decision-maker,” he says. “People are more deeply affected at a personal level by issues connected with nature than they are with issues connected with the climate.”
You look up at the sky and know there are emissions up there because scientists tell you that they are, but you can’t see them. The destruction and abuse of the natural world is more tangible and visceral. “There is a personal drive that sits behind the decision-maker to want to do something about it, because there is something they can do,” says Manuel.
The development in biodiversity during 2024 will be, Manuel believes, the realisation that if you think climate is complicated, then nature is a whole another level. “Not least because with climate there is a generality to it,” he says. “Rising temperatures are a huge global problem, there is a similarity about it everywhere. The same solutions are going to solve that problem.
“But nature is location specific,” Manuel adds. “The nature issue in the UK is completely different than the nature issue in the Amazon, which is completely different to the nature issue in Southeast Asia. And the solutions to those issues are different, too.”
Nature risk is also a hot topic for LGIM. “Over the last few months, we have received a big increase in questions about what it all means for investors,” Brown says, who puts a lot of this down to The Taskforce on Nature-related Financial Disclosures (TNFD) coming onto the agenda for institutions.
“It’s not an obligation, but having experienced TCFD, I guess people would like to get ahead of the game,” she adds.
To helps its clients get ahead of the game, LGIM has been adapting its ESG scoring frameworks to incorporate nature-related metrics and are looking at strategies in this space, such as, for example, debt-for-nature swaps where it has experienced a jump in enquiries.
Biodiversity has a connection to climate change and so the firm is making sure that strategies evolve to account for nature risks. “I expect to see more and more interesting discussions on that side of things,” Brown says.
To include it in their frameworks, LGIM have broken the issue down into its underlying component parts. Deforestation and water management are the two areas they have decided to start with, given that there is data available. “I would expect to see more and more in that space as more data is available,” Brown says.
All that gas
Finally, governments are working to achieve the Paris agreement through investing in renewables and scaling up decarbonisation technologies, but there are other issues they need to tackle.
“We hope there will be more action on methane next year,” Mennie says. “There seems to be an increasing alignment on action on methane and potentially more countries joining the Global Methane Pledge.”
Methane is a potent greenhouse gas, which has a warming potential 84 to 87 times that of C02 over a 20-year period. The IEA identifies cutting levels of this gas as a crucial part of hitting the 1.5-degree target.
“The next 20 years are a critical time for addressing climate change,” Nietsch says. “Watching what happens out of the next COP will be interesting.”
COP will certainly influence institutional investment portfolios in the coming year, with making a positive impact on the natural world and fighting climate change high on the agenda in what promises to be a year where ESG continues to evolve.