Biodiversity, governance, defined contribution, data and the next healthcare crisis could be at the heart of your ESG conversations this year. Mark Dunne looks at what you need to know.
In 2021, the UK joined an exclusive club. It became only the 17th sovereign to issue a green bond when it raised £10bn to invest in making the country greener. The green gilt proved so popular that Rishi Sunak could have raised £100bn. So, within a month, he was back collecting a further £6bn from investors.
This came after the government stood firm against a group of MPs who tried to derail plans to ban new petrol cars on Britain’s roads from 2030. And towards the end of the year, eyes were fixed on Glasgow as world leaders appeared at the COP26 summit.
You could say that 2021 was the year of climate. But what will 2022 be known for in the ESG space? At the time of writing, we are still living with Covid. Any hopes that vaccines and lockdowns may have brought a return to normality have been dashed by a new variant sweeping the globe.
Yet despite the persistent disruption to our lives, the pandemic has a silver lining for those promoting responsible investing. It appears that the health crisis has highlighted the potential benefits of investing sustainably.
“The Covid-19 crisis has given an additional boost to the trends in ESG adoption already in place before the outbreak of the pandemic,” says Matthieu Guignard, global head of product development and capital markets at Amundi ETF, Indexing & Smart Beta.
His view is supported by figures from Bloomberg. “Inflows into ESG ETFs reached $107bn (£80.7bn) during the first nine months of 2021, compared to $92bn (£69.4bn) in 2020 overall and a meagre $32bn (£24.1bn) in 2019.”
Things to come
So, with the capital flowing into passive ESG funds more than trebling within two years, where will it be targeted in the year ahead?
Ian Burger, head of responsible investment at Newton Investment Management, does not expect to see a huge difference in approach to ESG at a high level this year. Yet he believes that an increasing sophistication in stakeholder understanding means that decision-makers should be prepared for a greater depth of conversation when managing portfolios.
“Individuals are better armed to understand what the potential implications of their actions could be and there is a greater level of intent in what clients are expecting from their investment managers,” Burger says. “COP26 was a big driver.”
The formation of the International Sustainability Standards Board was announced at the conference, while the take up of net-zero initiatives has been huge and there is more understanding of the just transition and what climate finance looks like. “The market has significantly matured over the past 12 months, which will, I expect, continue during 2022,” Burger says.
For Gabrielle Kinder, an investment specialist and environmental analyst at BNP Paribas Asset Management, ESG will continue to evolve in 2022. “People are becoming more critical of ESG and that’s not a bad thing,” she says. “It is a sign that the market is maturing.
“ESG has become so influential that not only is it a positive screen to identify alpha, but it also helps avoid risk,” she adds. “It is becoming a powerful tool and huge amounts of capital are being moved on the basis of it.
“With that amount of power comes a lot of scrutiny. People are asking, how good is it? How can we apply it more effectively? How can we make sure that the data behind it has the integrity needed to be an investment tool? They are starting to de-compartmentalise it to understand the individual constituents. They are essentially delving into ESG to a greater extent than they were before.
“Our clients are pushing beyond ESG or becoming more critical of it,” Kinder says. “They are looking at impact and how it ties into ESG, or assessing which parts of the E, S or the G are most important to them.”
Yet as stakeholder understanding of sustainable issues improves, could we be on the verge of a new era? When considering what the future holds for ESG, 2022 could set the scene for years to come, says John Mulligan, director and climate change lead at the World Gold Council. “Whatever gains momentum in ESG next year is likely to gain momentum for the decade,” he adds.
This is largely due to ESG being a collection of long-term issues that “cannot be addressed overnight”. “Investment strategies need to move beyond the short term if sustainable objectives are going to be addressed.
“We are talking about 2022, but we are really talking about a decade or more of trend momentum, which could have beneficial impacts,” Mulligan says.
November’s COP26 conference will influence sustainable conversations and strategies in the year ahead, believes Peter Mennie, global head of ESG integration and research at Manulife Investment Management. “We are in the post-COP26 era, so in 2022 we expect to see the start of implementing what was agreed in Glasgow on top of what was agreed in Paris,” he says. “We’ve seen alignment with the 1.5oC goal. Now there needs to be agreement on the pathways and targets for sectors and understand how regional differences will play out in order to meet that goal.
“This is supported by the financial sector, judging by its involvement in Glasgow,” Mennie adds. “The private sector sees the importance of being engaged and doing this in the right way.”
He puts the “incredibly strong” demand for sustainable-labelled products, such as green bonds and the other variants, down to the rising number of corporates and investors adopting clear sustainable objectives.
“Typically, there are higher levels of oversubscription for those types of bonds than for vanilla products,” he adds. “We expect that to continue and this will also support the secondary markets, which means that the private sector can play its part.”
The other two
Climate has been embraced as core to institutional investment strategies in the past few years, but going forward there will be more interest in other ESG factors when pension schemes select funds, believes Caroline Ramscar, head of sustainability solutions at Legal & General Investment Management (LGIM). “From the flurry of funds being launched, ESG in general is being much more explicitly baked into funds,” she says.
In 2022, this will include more of a focus on the S in ESG, which Ramscar believes has been encouraged by the Department for Work and Pensions [DWP] launching a consultation on the how schemes should consider social factors in their decision making.
“People are starting to understand the S and the G a lot more,” Ramscar says. “What people forget, is that the G is one of the most critical components in ESG. We have gone heavy on climate because we know there is a problem and if we do not realign our financing to help solve it, we are going to have much bigger problems.
“If you do not focus on the G you will not have a company to invest in,” she adds. “With the DWP focusing on that, people will be thinking more heavily around this in the coming year.” There is a greater interest in how staff are being treated as well as those working in the supply chain. “This was happening anyway, but Covid definitely sharpened it,” Ramscar says. “A societal shift is coming.”
She points out that the issue of general corporate behaviour will be a much broader story this year. Mulligan also expects the social aspects of ESG to be given more prevalence. “Employee welfare, health and safety, and diversity and inclusion have already been getting attention, but they are now getting more attention from institutional investors than ever before.”
So, it is not only the S in ESG that is important. Investors should not forget to consider issues surrounding the G, too. “We will see increased attention paid to boards being t for purpose,” Mulligan says. “We are already seeing closer scrutiny by investors here.
“It is interesting that a few years ago, when we formulated the responsible gold mining principles, we started with governance. The idea is that you need good governance to be a precursor or prerequisite if other ESG performance standards are going to flourish,” he adds.
Ramscar sees diversity and inclusion having greater influence over how people will think about their investments in the coming months. “It is now part of every conversation,” she adds. “Obviously, the interest in climate has been amplified this year, but it will be important for asset managers to consider diversity and inclusion within the investment process.”
Gender diversity has been a focal point for LGIM’s decision-making for years but they will now also vote against a chair’s re-election if there is not appropriate ethnic representation on the board. “That is going to be much more pointed in 2022,” she adds. “People want to see some teeth behind these conversations.”
Regulation focused on disclosure and governance has been a big part of the UK’s evolving ESG landscape for around three years now, but Tim Manuel, co-head of responsible investment at Aon, expects to see trustees pushed further into the public eye in the year ahead.
“In 2022, we will see more of a focus on investment decision-making processes, in particular, addressing the lack of diversity across trustee boards,” Manuel says.
He is still seeing trustee boards with limited diverse representation amongst decision-makers, despite ‘doing things differently’ being a big part of responsible investing. “We are confronted with challenges and a future that is bound to be different,” Manuel says, “so it is important to have a range of viewpoints and life experiences to tackle that.
“It is the elephant in the room,” he adds. “A lot of problems are framed in ways that connect to the symptom rather than the underlying cause. A lack of diversity is a fundamental challenge that needs addressing.”
There is one factor that could speed up progress in these areas and one asset manager would not be surprised if it happened sooner rather than later.
“I suspect that where regulation has gone on the climate side, it will only be a matter of time before this is reflected on the S and G,” Ramscar says.
This is a big theme in the sustainable investing world. Amundi’s Guignard believes that rising ESG demand leads to rising requirements in terms of data, reporting standards, regulation and the creation of voluntary industry initiatives, such as the Net Zero Coalition. “In our view, these trends will help to unmask the areas of inefficiency by filling the gaps of data availability and lead to adjustments in market prices as they start to incorporate these new pieces of information, therefore, generating a positive feedback loop.
“We anticipate an ESG regulatory “revolution” for 2022 and early 2023 with the implementation of taxonomy and Sustainable Finance Disclosure Regulation (SFDR) coupled with the introduction of ESG preference for investors with MiFID2… not forgetting the revision of BMR,” he adds.
Fighting the resistance
Covid has been an economic shock to the system, but there is another healthcare issue that investors need to start thinking about: antimicrobial resistance.
“It is estimated that about 750,000 people a year die due to drug resistant infections,” Mennie says. “Unless urgent action is taken that will rise.
“The reality is we assume we can currently treat people in hospitals because we have effective antibiotics, but even now we see from time-to-time wards shutting down and being deep cleaned because of antimicrobial resistance. It is a huge problem,” he adds.
The Access to Medicine Foundation has published a report on best practices and outlook to help investors focus on the issue and Manulife expects to see assessments of its economic impact in 2022 as well as improvements to structural incentives for investment in new antibiotics.
“We know this is a serious problem and when you put it in the context of Covid you can see why,” Mennie says. “Antimicrobial resistance is going to become an increasing focus for people in the ESG community.”
This is further proof that providing greater access to medical treatment does not just save lives or boost the profits of pharmaceutical companies. “Providing access to medicines is not just a social bene t but could also help to achieve long-term economic sustainability and viability,” Burger says.
Biodiversity will also be an area of focus this year following the creation of the Taskforce on Nature-related Financial Disclosures (TNFD) in June. “This shows that there is a clear consensus that biodiversity is an urgent issue, just like climate change,” Mennie says. “There is now a vast array of statistics that support this, we just need to accelerate action in the same way we’ve seen with climate.”
A review of the issue led by Professor Sir Partha Dasgupta will help. His research, which was published early in 2021, looked at the economic impact of biodiversity loss. “This is an important part of what we need as investors,” Mennie says. “We now understand that there is an economic impact from biodiversity loss as well as the moral argument. We expect there to be continued traction on biodiversity.”
LGIM understands the importance of biodiversity, integrating this into its investment process to meet demand. “Investors want to see how you are measuring such an impact,” Ramscar says. “People are looking to nancial players to consider this as part of their investment process.
“You need as an asset manager to be clear on how they are addressing, measuring and engaging on biodiversity. You cannot just lump it in with other key topics, you have to be much more explicit about it and introduce a voting policy linked to deforestation,” she adds.
It is being increasingly recognised that protecting the environment is not just about the climate. “Conversations around biodiversity and water – what we might call nature-conscious investment considerations – are going to extend,” Mulligan says.
“This will take time,” he adds. “It could be a trend we see in 2022, but the integration of where climate intersects with broader environmental impacts will become more prevalent.” He points to the TNFD gathering pace, EU regulation and water being “mentioned quite a lot” in Glasgow as drivers.
Going round in circles
Big threats to nature are pollution and waste. To help reduce the spread of Covid, more single-use items, such as disposable masks and cutlery, were sold around the world. Increasing urbanisation in parts of the developing world is also driving consumer demand, so making sure that less single-use products are made, or that they are recyclable, will help build a sustainable future.
“We also need to focus on those circular economy solutions if we are to ultimately be successful,” Mennie says. “We have a growing global and wealthier economy using more products, and one of the ways we can make that work is through circular solutions.
“There is going to be an increasing focus on challenging companies to make sure they have re-usable products,” he adds. “Having that transparency throughout the whole supply chain is going to become increasingly important. People are seeing that now and recognising that this is the challenge we need to address.”
The future of pension investing
The year ahead could also see the de ned contribution (DC) market come “under the spotlight”, Manuel says. He points to there being “fundamental structural issues” in the way the DC market has evolved that have created barriers to investing in long-term assets, which is where the sustainability challenges are most relevant.
“There are some quite deep-seated and fundamental structural problems in that market which will start to be resolved next year. It is a multi-year journey, but they will come much more to the fore in 2022.”
DC schemes investing through platforms, which are structured around daily liquidity, is one issue. Then there is the charge cap, which Manuel dismisses as a “red herring”.
“It is a market which is exceptionally cost conscious, where fees are everything,” he says. “Almost all decision-making is done with fees being the dominant factor, which puts a constraint on what can be done.”
Another problem in the DC world is the conflict of issues. The drive for flexibility and choice is a good objective in isolation but it is incompatible with putting capital to work long term in the real economy.
“You cannot give people the option to change their investments with a day’s notice, whilst at the same time asking them to commit to long-term projects which require capital to be tied up,” Manuel says. “So, there is a fundamental tension in that market which is not being discussed.”
The Americans are coming
The US could alter the landscape for ESG-led investors in 2022, Manuel believes. “The US is changing. Across the board it is waking up to responsible investment and on the demand side it is changing the picture dramatically.
“In the global marketplace, the UK and Europe are the minority customer base,” he adds. “If we see higher demand from the US, it will make a big difference to the availability of products in the market and the innovation driving those products.”
Amundi’s Guignard also predicts further penetration in this market. “Following recent growth, ESG adoption is now advanced in the institutional market, especially Europe. However, we believe that we are far from reaching a tipping point on ESG adoption, with growing interest from institutional investors in the US and Asia.”
For US institutional investors to turn more bullish on ESG, a significant hurdle will have to be overcome. A report by communication agency Edelman concluded that most institutional investors across the Atlantic do not trust ESG as it is reported and measured.
“We need to fully align investors and societal expectations if ESG is going to maintain momentum,” Mulligan says. “The investment community needs to establish trust in the ESG paradigm change if it is going to deliver in terms of climate and sustainable development.”
Data is one of biggest challenges for sustainable investors, and Manuel does not expect to see this change in the coming 12 months. “There are lots are people trying to improve it, but ESG represents many issues, which are different in nature. “Perhaps we will see data improve in those underlying themes but getting to a place where there is perfect ESG data covering all situations and across all asset classes does not feel like a realistic outcome to me,” he adds.
Some are optimistic that, although far from perfect, the quality of the underlying data is moving in the right direction. “The lack of consistency and quality of ESG data remains a concern for clients, but it is improving,” Ramscar says. “Increased regulation has led to greater transparency and more mandatory disclosures, but the lack of market-wide consistency can be challenging.
“There will hopefully be more guidance and regulation to surface, presented in a more consistent manner,” she adds. For Mulligan, the question he has about data is: “This is the data I have, but is it the data I need?”
He believes that ESG disclosures are too focused on the developed world and wants global information, which will only happen when emerging markets are brought into it. “The danger is that we will concentrate on what we can measure immediately, not what we need to measure going forward,” he says.
But for some, how the data is measured is another problem. Arriving at one number to represent aggregate risk across three pillars and 10s of constituent metrics for one company is potentially meaningless. “It does not tell you much about a company in terms of its ESG risk,” Kinder says.
“An average might obscure some important risks that a company is not managing, while it could be performing well in other areas.” BNP Paribas AM now sets its own ESG scores in response to some third-party rating providers having “a black box when it comes to the numbers they churn out”, Kinder says.
Setting their own scores gives BNP Paribas AM more control in collating the metrics to understand the data and its red flags. The move also expands the coverage to include emerging market countries, which can have the furthest to go in terms of managing environmental and social issues.
Standardisation between ESG data providers will be a big theme in 2022. “Given that they are influential for the allocation of a lot of capital, the correlation between the big providers is quite low – and this can be confusing,” Kinder says. “They are making improvements but they need to be more transparent with their data so clients can compare or adjust the weightings.”
The problem is that different providers make different conclusions about the same company. “One ESG agency might rank Shell as one of the best performing companies out there, while another says that as an oil and gas company it’s hurting communities and our environment,” Kinder says. “The impact element is built into some ratings but not others.
“There is a lot of subjectivity in the methodology,” she adds. “So, you can have consistency if you can see the assumptions behind the data.”
And this is the core issue. The data is there, but is it credible? “We have to have confidence as investors in public statements and accounts that are reported,” Burger says. “The reliance on data is becoming more and more evident and so we need quality.
“The growth in ESG data providers has been prolific over the past couple of years, so there is no shortage of information, but there are gaps.
As an industry, we have to be conscious of the methodologies data providers use and be aligned with that,” he adds. “And fundamentally, data providers will, maybe not next year but perhaps in future years, start getting increased regulatory attention as more and more capital is directed o the back of third-party ratings.”
This is why Newton does not rely solely on third-party ratings. Instead it focuses on the raw data, where it is available and accessible.
However, Kinder says that despite there being a long way to go, she is seeing evidence that correlations between different providers are improving and are becoming something akin to credit risk ratings.
“For ESG ratings we are seeing correlation co-efficiencies of around 0.5. That is a positive move and is a trend that will continue in 2022,” Kinder says.
Perhaps investors do not need companies to disclose their climate exposures. “There is lots of work from some interesting areas of academia on trying to figure out how we could get better data at the individual asset level,” Mennie says.
For example, the Spatial Finance group at Oxford led by Dr Ben Caldecott is using satellite image processing via machine learning to focus on identifying high-emitting locations such as a cement plants.
“You could overlay that information with hazard layers, such as it being close to high population centres, to assess the long-term viability of that asset,” he adds. “We hope to see more interesting and creative ways to get data that will enable us as investors to scrutinise and respond to what companies are telling us and make sure that we have a clear picture about the risks and opportunities of the future.”
Whatever shapes ESG discussions in 2022, asset managers are optimistic. “Regulatory pressures coming out of Europe and the UK, as well as proposed policy changes in the US, are providing a tailwind for ESG and sustainable strategies,” Burger says. “The number of sustainable fund launches over the last couple of years has been significant.
“My expectation is that the growth of assets into sustainable strategies globally will be proportionately greater than the number of companies that would be necessarily considered suitable for sustainable funds,” he adds.
The result will be that valuations of corporates will benefit from the rising demand. “Companies will trade above their norms off the back of their ESG credentials,” he adds.
But it is not just about backing companies with a strong sustainable profile. It will also be about making a difference with your capital.
“People considering the impact of their investment beyond financial returns came to the fore in 2021 and we expect that to start being more explicitly considered this year,” Ramscar says. The UN’s Sustainable Development Goals are one way of measuring investment impacts. “We are starting to see their explicit integration in the investment process,” she adds.
Coming of age
Many of the opinions expressed through this article are largely on topics we discussed in previous years: data, regulation, diversity and biodiversity. Not much is new. But what is clear is that all the professionals who shared their thoughts with us seem to point to ESG, as a debate, is maturing.
Investors, customers, regulators, taxpayers and corporate leaders all appear to have a better grasp of the themes and how to manage them, which can only be down to mainstream coverage, including, despite the main agreement being criticised as not having teeth, events such as COP26.
One point is certain: ESG is here to stay as an institutional investment strategy and we will be following it through the year to see how some of the insights discussed above play out. A final thought on how this debate is maturing comes from BNP Paribas AM’s Kinder.
“There is a departure sometimes between ESG and sustainability,” she says. “People used to equate them as the same thing, but now they are starting to understand that ESG is about whether a company is exposed to grave risks in its supply chain, in the boardroom, etc, which is not the same as sustainability. It is an enhancement and there are overlaps with sustainability, but it is not the same thing.”