The Green Tea Guide to ESG in Capital Markets: From Theory to Practice
In today’s post, we have a Q&A-style post to discuss a variety of ESG topics, trends, and impacts that are influencing the ESG landscape.
Today, we are shaking things up a little by interviewing each other on the state of ESG in 2023. We talk about themes like how investors are integrating ESG into their investment process, criticisms & skepticism of the ESG movement, broader industry trends and developments, the regulatory and legal landscape, and what we think the future holds for ESG investing.
Setting the Stage
Let’s start off by defining ESG and discussing how we would each explain ESG to someone who is unfamiliar.
AH: ESG stands for Environmental, Social and Governance and it is an acronym used to describe a movement the capital markets of investors using data & information related to companies’ non-financial risks and opportunities to inform investment decision-making.
MV: To build up what Addy said, I think ESG is another lens of framework to assess a company’s performance outside of the typical financial assessment which includes looking at a company’s fundamentals like their profitability or growth profile. This falls under the broader sustainability umbrella but where sustainability focuses more on how the company is making an impact through internal investments and operational changes, ESG is focused on capturing specific environmental, social, and governance data that stakeholders can use to assess risk profiles.
ESG in the Investment Process
Why do investors incorporate ESG factors into their investment decision-making process?
AH: There are a number of reasons that investors incorporate ESG factors, including (1) Enhancing risk-adjusted return potential by reducing investment risk, (2) Optimizing the risk-return characteristics of their portfolio, (3) Belief that companies are more likely to succeed and deliver strong returns if they create value for all their stakeholders, including the environment, employees, customers, and suppliers, (4) Meeting the growing investor interest in ESG factors, reflecting the view that environmental, social, and corporate governance issues are important, (5) Compliance with regulatory requirements.
MV: We are seeing the adoption of ESG for several reasons, but I think encompassing them all is that ESG risks can have financial consequences for a company alongside of reputational risk. For example, if a company isn’t adhering to environmental regulations this can come with a heavy tax or fine. Or if the company is prone to regions that are increasingly being affected by severe weather this could affect their assets or suppliers. This, along with a wider set of factors, could help an investor make a better investment decision on the potential success of the company and the possible challenges the company may face.
How have investor attitudes towards ESG changed in recent years?
AH: To understand how investor (and company) attitudes have changed towards ESG, I tend to think back all the way to 2018, when I was just beginning my career as an Analyst on the Strategic Capital Intelligence team at Nasdaq. I hadn’t moved to Chicago yet, so this would’ve had to be in my first week – but I remember receiving a training on Larry Fink’s letter, specifically as it pertained to ESG. This letter in 2018 emphasized the importance of a company articulating its purpose in order to financially prosper while benefiting all stakeholders. He also mentioned the following ESG themes: The demand for ESG is going to transform all investing, the importance of ESG metrics, and the need for companies to focus on long-term value creation rather than short-term gains. This was my first exposure to the concept of “ESG Investing”. Since then, I have seen the boom of “non-fundamental” or “non-financial” data in capital markets. The boom of non-financial data in capital markets reflects a growing recognition that financial performance is not the only measure of a company's success, and that non-financial factors (such as environmental, social, and governance issues) can have a significant impact on a company's long-term prospects. While ESG investing started in the Nordics, it has since permeated capital markets in the US and globally. ESG investing has matured to the point where it can no longer be considered a niche strategy, but rather a mainstream approach to investing. In recent years, it feels like adoption has been exponential. The percentage of institutional investors implementing ESG has risen by 18%, climbing from 61% to 72% between 2019 and 2021 (Link). More investors are supporting ESG initiatives despite headwinds. Attitudes toward ESG risks and opportunities have become more positive, with 79% of respondents agreeing that ESG risks are an important factor in investment decision-making (Link). It seems to me that most investors view ESG as a permanent and pre-eminent part of the investment landscape.
MV: Investors are continuing to be more accepting of ESG partially due to the standardization coming to fruition. We have seen the consolidation of frameworks and the emergence of prominent frameworks now being integrated both here in the US and internationally into regulations. When I think back to 2018 when I first started at Nasdaq, a lot of my clients were just starting to get ESG-related questions from their investors. Many of them didn’t issue ESG reports and didn’t understand the potential opportunity it posed to attract more capital to the stock. In the next couple of years, due to investor pressure, many began publishing inaugural reports to meet these expectations. While that was on the public side, we see ESG influencing the private markets as well. There was a survey conducted by Private Equity International, and they asked hundreds of investors to what extent do you agree that GPs are taking the risk of climate change seriously enough in their own investment policies and practices. In 2021, 6% strongly disagreed while 41% either somewhat agreed or strongly agreed. In 2023, that same question was asked and none of the investors strongly disagreed and 49% somewhat agreed or strongly agreed.
What role does ESG play in today's capital markets?
AH: It seems that investor consensus is that ESG investing is here to stay - it's not just a passing trend. Only about 13% of investors around the world think it's a fad, which tells you that most investors think it's a permanent fixture in the investment world (Link). Investors are getting more sophisticated about how they incorporate ESG into their strategies, moving beyond basic checklists to more nuanced approaches. Trust in sustainable investing is also growing - fewer people are suspecting companies of "greenwashing" (pretending to be more environmentally friendly than they actually are), and fewer think that ESG is just a PR move. There are still challenges, though. The biggest one is lack of good data. To overcome these issues, investors want standardized tools and data, consistent information from asset managers, and more automation in analyzing ESG data. But not everyone's on board. There's an anti-ESG movement, mainly among conservatives, that argues ESG is a threat to profits, promotes liberal values, and has shoddy metrics. This crowd also thinks ESG limits diversification and breaks the trust (fiduciary duty) between investors and companies. It's not totally clear whether this movement is just speaking to a small, sophisticated audience or trying to win over a broader crowd. Despite these criticisms, the bottom line is that ESG investing can be flexible and effective without hurting performance. Ignoring ESG can actually create risks and hurt a company's financial health, while taking it into account can build trust and create long-term value. It can align investors' values with their financial goals, and the metrics are becoming more reliable and don't limit investment options or increase risk.
MV: As mentioned by Addy earlier, there has been a growth in the number of ESG products and broader sustainability offerings in today's market. On the public side, there are funds that specifically focus on ESG or certain thematic investments, screening out companies that fail to meet specific ESG thresholds. Additionally, sustainability-related products have emerged in the bond market, such as Sustainability-Linked Bonds (SBLs). SBLs are a type of bond instrument where the financial and structural characteristics can vary based on whether the issuer achieves predetermined environmental, social, and governance (ESG) goals and targets. Unlike "use of proceeds" green bonds or sustainable bonds, the proceeds from SBLs are not limited to green or sustainable purposes. The coupon rate of the bond is tied to the issuer's ability to meet its sustainability targets, and adjustments can be made in both directions. Additionally, ESG integration has become prevalent in the credit market and insurance. This is all to say, I don’t think ESG in the capital markets is going away.
What do you believe are the implications of not considering ESG factors for long-term investment success?
MV: To keep this brief, I think not including EGS factors into the due diligence or investment decision process doesn’t provide a holistic assessment of a company and any potential risk factors or even value-creating factors could be missed.
AH: Ignoring Environmental, Social, and Governance (ESG) factors in long-term investment planning can lead to bigger risks, such as environmental mishaps or governance scandals, which can harm a company's financials and future. This oversight could also mean missing valuable opportunities like investing in sustainable practices, which attracts more investors, employees, and customers. There's a chance of reduced returns too, as companies with strong ESG performance often do better financially. Asset managers ignoring ESG may not be fully honoring their duty to maximize returns for clients and could risk losing clients to competitors. Lastly, they could also miss out on potential cost of capital benefits, and face reputation risks and customer backlash.
Criticisms and Skepticism
Some people are skeptical about the impact of ESG investing, often termed the "anti-ESG movement". Let’s now discuss the main criticisms of ESG investing and our thoughts on them.
AH: There are a few criticisms I want to call out here.
ESG considerations are a distraction from companies' primary goal of generating profit. Some argue that businesses should focus solely on maximizing profits and shareholder value, rather than diverting attention and resources to environmental, social, and governance concerns. Critics of ESG investing suggest it doesn't definitively lead to better financial performance and may even be costlier due to extensive research required.
I believe that ESG factors and financial performance are connected, and that ESG can help manage risks and increase the value of investments. In fact, there are studies that support this idea. Additionally, having an ESG program in place may end up being essential for companies to maintain their social license.
ESG investing is "anti-capitalist" and promotes "liberal values." According to some critics, ESG investing is part of a larger "anti-woke" and anti-sustainability effort, and is a proxy for opposition to the spread of "liberal values" in civil society.
A relevant counterargument to the "woke capitalism" argument is that ESG investing can actually lead to better financial performance. Some ESG investing strategies aim to identify companies that are better positioned to manage risks related to issues such as climate change, labor practices, and diversity and inclusion, which could ultimately lead to better financial performance. Additionally, ESG investing can attract a wider range of investors who prioritize companies that align with their values, leading to increased demand for ESG-focused companies and potentially higher stock prices. Companies that prioritize ESG factors are more likely to generate long-term value for shareholders. While some industries may face challenges in the transition to a more sustainable economy, it is important to consider the long-term risks and opportunities.
ESG metrics are unreliable and not standardized. Critics argue that ESG metrics are subjective, difficult to measure, and not standardized across companies and industries. As a result, the critics believe that investors cannot accurately compare ESG performance across companies or make informed investment decisions based on ESG factors.
It is true that even though ESG ratings and standards have made strides, there's still no globally recognized framework to clearly define what counts as ESG. Systems that rate individual companies are out there, but they can be biased and rely on inconsistent data. A good example is Tesla, which nails the environmental part of ESG, but doesn't do so hot in the social and governance categories - hence why it was booted from the S&P 500 ESG Index. Ratings are a helpful tool, but they shouldn't be the only thing guiding investment decisions. Sustainability rating agencies are sizing up an increasing number of companies using ESG criteria, and there's a push to get these ESG metrics standardized across different companies and industries. Although these metrics aren't flawless, they're getting better and proving more valuable for investors.
ESG investing reduces diversification and increases risk. Some argue that ESG investing limits investment options and reduces diversification, leading to greater investment risk.
While this is not true as a universal statement, I believe it’s founded in the finding that some ESG funds underperformed in 2022 due to exclusion of energy companies / overweighting tech companies. In 2022, even the approach of funds using environmental, social, and governance (ESG) principles couldn't shield investors from the financial market downturn, with top ESG funds, including those of BlackRock and Vanguard, seeing substantial losses. Critics of ESG investing are quick to label this as evidence of the approach's failure, but it's more nuanced - not all ESG funds are the same and issues like greenwashing have raised eyebrows. Moreover, funds favoring large tech companies, which often score high on ESG scales but perform poorly during economic downturns, can be particularly vulnerable, helping to explain why some ESG funds have underperformed recently. However – not all ESG funds use screening as their method of construction. In fact, only 20% of investors claim to leverage negative screening according to sources like The Global Sustainable Investment Review 2022 by the Global Sustainable Investment Alliance, The 2022 ESG Investing Trends Report by PwC, The 2022 Impact Investing Trends Report by the GIIN.
MV: One of the biggest criticisms I am hearing today is that ESG is allocating money based on political agendas rather than focusing on earnings and returns for investors. One of the concerns voiced today revolves around the contention that ESG investments may prioritize political agendas over investor earnings and returns. A rising movement known as the Anti-ESG movement has gained traction, expressing opposition to corporations and investment firms that integrate environmental or social principles into their investment strategies. Florida's Board of Advisors implemented regulations to prohibit state fund managers from factoring in ESG considerations when investing state funds, particularly noteworthy being the state pension fund valued at $186 billion. Florida's governor notably emphasized the importance of "maximizing financial returns above all other considerations." While the anti-ESG movement may suggest an underlying ideological motive, it is crucial to take a broader perspective. For pension fund managers with a long-term investment outlook, disregarding ESG and climate-related factors could entail substantial risks, given the ultimate objective of maximizing financial returns. In a similar vein, Texas recently voiced opposition and pledged not to engage with firms that "boycott" fossil fuels, resulting in the identification and exclusion of approximately ten financial firms, potentially impacting state pension funds or local governments issuing municipal bonds, leading them to contemplate divestment.
Another crucial aspect to consider is the lack of consistency among the raters and data providers within the ESG landscape. In contrast to the credit markets, where Moody's, Fitch, and S&P—the primary credit agencies—yield broadly comparable outcomes, the same level of conformity is absent in the realm of ESG. Unlike credit ratings, where different agencies would not assign a AAA rating to one company and a single A rating to another, the ESG market exhibits a multitude of rating agencies, often assigning different ratings to the same company. This divergence among rating agencies poses a significant challenge to generating alpha. Moreover, the issue extends beyond differing definitions; it encompasses fundamental disagreements concerning the underlying data. According to a 2022 study (Link), the correlations between ESG ratings from six different raters ranged from 0.38 to 0.71. Such substantial variation underscores the complexities inherent in ESG ratings and further complicates the task of navigating the ESG landscape.
Industry Trends and Developments
Let’s discuss some of the key developments in green and sustainable finance.
AH: Green and sustainable finance has been a rapidly growing area in recent years, with many key developments. Some things that I’ve been keeping an eye on are:
Sustainable finance market growth: The sustainable finance market has been growing rapidly, with investors redirecting trillions of dollars towards sustainable activities. Sustainable finance involves making investment decisions that consider not only financial returns but also environmental, social, and governance factors. Specifically - Sustainability-linked bonds (SLBs) have grown rapidly as a means for companies to secure funding for sustainable projects, with an 80% annual growth rate since 2014. They offer an incentive for companies to improve their environmental, social, and governance (ESG) metrics. Despite certain challenges, SLBs can provide cost-effective financing for sustainable initiatives, benefiting companies, investors, and society. If you’re interested in learning more about SLBs, you can find a whole post about it here.
Low-carbon transition: The transition to a low-carbon economy, known as the low-carbon transition, poses substantial implications for capital markets, necessitating a new risk pricing logic that accounts for climate risks and opportunities. Financial institutions will need to manage climate risk, reallocate capital towards sustainable investments, and adapt their market products and practices, potentially accelerating the pricing of climate risks in securities.
European Green Deal: The European Green Deal is a comprehensive set of policies introduced by the European Commission, aiming to make the EU climate-neutral by 2050. This initiative, covering sectors like transport, energy, agriculture, and various industries, seeks to modify existing laws based on their climate impact, introduce new legislation focusing on circular economy, biodiversity, and pollution, and push for economic growth independent of resource use. A third of the €1.8 trillion investments from the NextGenerationEU Recovery Plan and the EU's seven-year budget will fund the Green Deal, further aiming to cut net greenhouse gas emissions by at least 55% by 2030 compared to 1990 levels.
MV: Green bonds are a form of sustainable fixed-income instruments that serve the purpose of raising funds for projects with positive environmental or climate benefits. These bonds play a crucial role in financing initiatives related to renewable energy or practices like sustainable water management, and other specific environmental objectives. According to Goldman Sachs, the market for green bonds has been experiencing remarkable expansion, with an average growth rate of approximately 90% per year from 2016 to 2021. [Link] This growth, coupled with the widening availability of mutual funds that offer exposure to green bonds, provides investors with the opportunity to incorporate these bonds into their fixed-income portfolios as a substitute for conventional bonds. Given the increasing momentum behind sustainable products and the escalating responses to climate change, it is anticipated that investors will continue to support the transition to a lower carbon economy by investing in these instruments. Speaking more broadly, as laws and legislations are created to increase the development of a low carbon society, there will need to be ways to finance the energy transition. The transition to a sustainable and low-carbon future entails significant investments in renewable energy infrastructure, energy efficiency measures, clean transportation systems, and other initiatives aimed at reducing greenhouse gas emissions and mitigating climate change impacts.
Which specific industries or sectors have shown the most significant ESG developments, and why?
MV: While at Nasdaq, I had the opportunity to work with all sectors in developing their ESG strategies from technology companies to biotechnology companies so when I think of specific sectors that are fueling the most significant ESG developments its energy, industries and technology. I think all three of these sectors in combination drive huge developments. For example, the digital advances made by technology can aid a variety of energy intensive sectors. Digital advancements, such as smart sensors, Internet of Things (IoT) devices, and artificial intelligence (AI), have immense potential to optimize energy consumption and improve efficiency within energy-intensive sectors. By leveraging these technological solutions, industries can make informed decisions, reduce resource wastage, and minimize environmental impact. Another sector which is making huge development is the transportation sector. The transportation sector relies on fossil fuels, primarily gasoline and diesel. The energy transition drives changes in this sector, promoting the adoption of electric vehicles (EVs), hydrogen-powered vehicles, and other alternative fuels. As governments and companies prioritize decarbonization, policies and investments are directed towards expanding EV charging infrastructure, developing advanced batteries, and supporting sustainable transportation solutions.
AH: I think ESG is interesting because it is relevant for all sectors. Some that I think have shown rapid development are:
Energy: As a primary contributor to global carbon emissions, the energy sector has seen substantial changes. Many companies, particularly in oil and gas, have committed to transitioning towards renewable energy, setting net-zero emission targets, and investing in clean technologies. This shift is driven by the realization of environmental risks and the regulatory pressure to mitigate climate change. In late 2022, we wrote about the energy sector and its role in the energy transition (link). A lot of the themes we noted have continued through this year.
Technology: The tech sector has made strides in improving its ESG practices, particularly in areas like energy efficiency, data privacy, and security. Many tech firms are making efforts to reduce their environmental footprint, such as by moving towards renewable energy for their data centers and committing to circular economy principles in their hardware manufacturing processes.
Real Estate: With buildings contributing significantly to global carbon emissions, real estate developers and managers have been adopting green building practices, improving energy efficiency, and promoting sustainability in their property portfolios.
Automotive: With the rise of electric vehicles (EVs), the automotive industry is also seeing significant ESG developments. Traditional automakers are investing heavily in EV technology, in response to regulatory pressures and changing consumer preferences towards more sustainable transportation.
Agriculture/Food: This sector has made significant strides in sustainable farming practices, reducing food waste, and promoting fair labor and animal welfare standards, driven by rising consumer awareness and demand for sustainably produced food. For more information on sustainable agriculture, please see our post about Fintech for Farmers.
Regulatory and Legal Landscape
How have recent economic and political events influenced the current ESG trends?
MV: Over the past year we have seen regulations specific to climate come to the forefront in the US. The first proposal that is one of the most prominent is the SECs Climate Proposal which essentially mandates companies align with the TCFD and report on climate-related risks and opportunities the transition to a lower carbon economy will provide. It also holds the company’s executives responsible for climate-related matters as the proposal mandates the board should have direct oversight and responsibility for the corporates environmental impact. Outside of this proposal, you have state-level regulations that are being enacted like the Regional Greenhouse Gas Initiatives (RGGI). This regulation is specific to the Northeastern and Mid-Atlantic states to reduce greenhouse gas emissions from power plants. Under RGGI, power plants must obtain allowances for their emissions, and these allowances can be traded among participants. Or in New York, have the state enacting its own climate action plan called the New York State Climate Leadership and Community Protection Act (CLCPA). Under the plan, the state set its own targets including incepting renewables, provisions for energy-efficient buildings, and clean transportation.
AH: There are a few trends that I want to call out here that have influenced ESG trends.
Regulatory changes: Regulators across the globe are busy writing and implementing new regulations that focus on ESG issues. For example, new legislation relating to ESG in the U.S., the U.K., and Europe was introduced and proposed in 2022.
Political events: Political events have also influenced ESG trends. For instance, in the run-up to the November 2022 midterms, many Republican Governors attacked BlackRock and decided to boycott the firm by pulling out their money. However, the tone among investors expanding into ESG strategies has shifted in response to political events.
ESG data: ESG data is evolving, and this is influencing ESG trends. For example, researchers at Columbia University and London School of Economics found that ESG funds don't seem to deliver better ESG performance
Economic performance: Economic performance has also influenced ESG trends. For example, Russia's invasion of Ukraine has significantly impacted ESG trends and performance in the first six months of 2022, with some viewing the effects as a setback for the ESG movement
What role do international agreements (such as the Paris Agreement) play in the development of ESG in capital markets?
AH: International agreements, particularly the Paris Agreement, significantly influence the development and integration of ESG factors within capital markets. Here's how:
Climate Goals: The Paris Agreement aims to limit global warming to well below 2 degrees Celsius above pre-industrial levels and to pursue efforts to limit the temperature increase to 1.5 degrees Celsius. This goal amplifies the focus on environmental factors within ESG considerations in capital markets, guiding their investment and risk management strategies.
Regulatory Frameworks and Policy Alignment: International agreements influence national policies and regulations, often leading to policy alignment across countries, creating a more consistent regulatory environment for ESG investing. Countries' commitments translate into domestic laws, including disclosure requirements, emissions standards, and incentives for renewable energy, affecting companies' ESG profiles and valuation in the capital markets.
Directing Capital Flows: The Paris Agreement promotes investment shifts towards sustainable and low-carbon sectors. Article 2.1c aims to make financial flows consistent with a low greenhouse gas emissions and climate-resilient development, thus encouraging financial institutions to invest in businesses that align with these goals.
Increasing Investor Demand: These agreements foster growing investor demand for ESG-compliant investments, largely due to the amplified focus on climate change and sustainability.
Transparency and Disclosure: International agreements often advocate for improved transparency in reporting environmental impacts, propelling ESG disclosure by companies. Better disclosure practices enable market participants to make more informed decisions and inspire companies to bolster their ESG performance.
Enhancing Corporate Reputation: Compliance with international agreements can boost a company's reputation among stakeholders, including investors, consumers, and employees, influencing its market valuation and its ability to attract capital.
Guidance for Policy Makers: International organizations like the OECD provide guidance to strengthen ESG investing and finance climate transition through the use of ESG ratings and financial market products.
MV: Overall, I think that having international standards increases how countries and investors can collaborate while having a set standard. For example, the OECD, The Organization for Economic Co-operation and Development, works with governments, policymakers, and corporates to set the standards for a range of social, economic, and environmental challenges they may be facing. The organization sets standards for a variety of different industries including employment, corporate governance, sustainable development, tax, and corruption, all of which are elements that can be found layered into ESG reports. In addition, you have frameworks, like the GRI, that specifically look at the OECD to provide companies guidance on what is considered best practices when reporting. Specifically thinking about the Paris Agreement, this led to a global consensus of 180+ countries to collectively agree they need to do something to address climate change. With the agreement came the Nationally Determined Contributions (NDCs) which allowed countries to establish a framework on how they are going to reduce their own emissions, adopt any targets, and set their own goals. With countries setting goals or targets, this is eventually going to trickle down to corporates as they feel pressure to meet either state goals or investor pressure to meet certain climate-related goals.
Are there any global regions leading the way in ESG development, and why?
AH: I’ll start by breaking out the different regions are key ESG developments for each.
Europe: Both Northern Europe and the UK lead the world in ESG practices, due in part to their advanced regulatory frameworks and ambitious climate targets. Directives such as the Sustainable Finance Disclosure Regulation (SFDR) and the Non-Financial Reporting Directive (NFRD) have mandated greater transparency and disclosure from companies and financial market participants. Furthermore, the European Green Deal's goal for climate neutrality by 2050 continues to drive significant ESG-focused activity. In the UK, rising regulations designed to protect the environment are exerting considerable pressure on companies to reach their ESG goals.
North America: While historically behind Europe in terms of regulatory focus on ESG, the United States has seen a significant rise in ESG investing recently. This surge can be attributed to growing awareness and demand for ESG investment products among both institutional and retail investors, as well as an increasing emphasis on ESG considerations by financial market regulators like the Securities and Exchange Commission (SEC).
Asia-Pacific: China, Singapore, and Hong Kong are defining the ESG regulatory landscape in the Asia-Pacific region. These nations have made significant strides in developing ESG metrics, taxonomies, and disclosure practices for companies, in addition to launching carbon trading markets. Asia-Pacific also boasts the fastest percentage growth in ESG assets under management, with ESG products expected to more than triple, reaching $3.3tn in 2026. Notably, Japan has emerged as a regional leader due to strong governmental and industry initiatives promoting ESG integration. Additionally, China's commitment to achieving carbon neutrality by 2060 is prompting significant ESG considerations within its vast economy.
Future of ESG Investing
Are there any emerging trends in ESG that you think our readers should know about?
MV: The past two years have witnessed an accelerated pace of change in the realm of ESG, thanks in part to the pandemic and prevailing societal issues. However, while there might be a slight cooling off in the ESG space, I firmly believe that investors will continue to prioritize it. Incorporating ESG factors into due diligence processes and investment screening models will likely remain a key focus for investors and LPs. In fact, private companies can anticipate sustained expectations and pressure to enhance transparency regarding their ESG activities and performance. Additionally, there is a notable trend of investors retracting their Net Zero commitments. Despite the previous surge in companies making such commitments, it becomes apparent upon closer examination that many sectors lack the readiness and infrastructure required to achieve Net Zero goals. Meeting these objectives demands substantial transformations in supply chain logistics, market policies, innovations, and even the environmental impact of manufacturing processes. Moreover, constructing the innovative infrastructure necessary to support a low carbon economy will entail significant amounts of concrete and steel, which generate CO2 as a by-product. Not to mention the additional challenges posed by population growth, which increases the need for housing and buildings. All in all, investors like Vanguard recognize that their portfolio companies have a substantial amount of work ahead of them.
AH: There are four key trends that I think are insightful to callout here.
The first is an increased importance of ESG oversight: In 2023, board members had to prepare for an incoming wave of ESG-related proxy voting and assume responsibility for ESG issues. Executives, on the other hand, began to anticipate their compensation being influenced by ESG factors, and they should set concrete ESG targets and publicly track progress towards them.
Expanding focus on natural capital: The MSCI ESG Trends to Watch for 2023 report highlights the critical role of natural capital in ESG investing (Link). This means that companies are increasingly focusing on the conservation and sustainable use of natural resources.
More attention on diversity, equity, and inclusion (DE&I): DE&I is another important ESG factor that is gaining traction. Companies that are committed to DE&I are more likely to attract and retain top talent, and they are also more likely to be successful in the long run.
Growing importance of cybersecurity: Cybersecurity is a critical issue for businesses of all sizes. As the world becomes increasingly interconnected, businesses are at greater risk of cyberattacks. Companies that are not taking steps to protect their data and systems are at risk of financial losses, reputational damage, and even legal liability.
What's your perspective on the future of ESG investing? How do you think it will shape the capital markets over the next 5-10 years?
AH: In my view, the future of ESG investing is promising. I think that it will continue to grow and shape the capital markets over the next 5-10 years. Key factors driving this growth include investor demand, regulatory changes, institutional adoption, public awareness, and technological advances. Investor demand for sustainable and responsible investments is increasing, driven by factors such as climate change awareness, social responsibility, and the demand for transparency and accountability from companies. Governments and regulators are implementing stricter regulations and disclosure requirements, embedding ESG considerations into the financial system. Institutional investors are recognizing the financial materiality of ESG factors and aligning their investments with societal goals. Public awareness and concern for issues like climate change and social inequality are also driving the demand for ESG investments. Technological advances enable better analysis and reporting of ESG data, facilitating the integration of ESG factors into investment decisions. Looking ahead, ESG investing is expected to have significant implications for capital markets. Capital reallocation is likely as investors prioritize companies that perform well on ESG factors, potentially leading to a re-rating of these companies. The increased focus on ESG factors could also influence corporate behavior, encouraging companies to improve their ESG performance. Moreover, there will be continued innovation in financial products and services, including green bonds and sustainability-linked loans, to meet the growing demand for ESG investments. Greater transparency is expected as companies strive to meet investor demands for ESG information, enabling more informed investment decisions.
MV: I think ESG is here to stay due to the support that ESG is linked to shareholder value, which is one of the key considerations during the investment decision process. In a report by Bloomberg, they estimate that ESG assets will hit $50 trillion by 2025 and this growth is driven by investors. There are a variety of studies out there that showcase ESG funds tend to have lower volatility during market uncertainty and provide additional insight into a company’s risk profile. This is to say, ESG is widely adopted by the investor community and the noise of some against ESG won’t prevent it from prevailing.
Taking a step back and looking more broadly, I also think the energy transition will help in creating new opportunities. With the IRA providing billions of dollars in incentives, grants, and loans, capital and investments will be flowing into clean energy or sustainable development projects.
Lastly, what are your predictions for ESG in capital markets for the rest of 2023 and beyond?
AH: Investors should brace for mandated climate-related disclosures as a global framework emerges for more consistent disclosure. Both the SEC & EU FCA will continue to identify and act against greenwashing, so investors must be prepared to support ESG-related claims with empirical data. It's crucial that they also formulate a strategy for discussing ESG topics with Limited Partners (LPs). Bankers should be ready for ESG factors to influence Mergers & Acquisitions (M&A) and be aware of changes in capital access. There will likely be an increase in sustainability-linked debt issuances, and ESG factors will continue to influence Initial Public Offerings (IPOs).
MV: If the SEC proposal actually goes through this year this will be a huge undertaking for American companies but it will force companies to be more transparent and accountable for their environmental impact. the proposal was also modeled off of one of the most influential climate reporting frameworks, TCFD, which looks to understand a company’s governance structure to manage climate risks, risks, and opportunities arising from climate and the transition to a low carbon society, as well as emissions reporting. In general, I feel the proposal brings with it a ton of challenges that may not have been considered whether it’s the increase in lawsuits that may arise from disclosure (specifically for scope 3), another deterrent and requirement for public companies or even just the reallocation of resources to report. This is to say, with laws being constructed to incorporate environmental and social factors, I don’t suspect that ESG is going away.