Swathes of regulation, a slew of net-zero commitments, progress on reporting standards and an unprecedented turn-out at the COP26 climate conference – from any angle, 2021 was a landmark year for the environmental, social and governance (ESG) sector. What comes next? Euromoney asks experts from across the industry about their forecasts for the year ahead.
Net zero
For many, one of the most important developments of the next 12 months will be finding out what pledges by banks, corporates, asset managers and more to reach net zero greenhouse-gas emissions by 2050 actually mean in practice.
“What I really look forward to this year, particularly around energy transition,” says Elree Winnett Seelig, head of ESG for markets and securities services at Citi, “is getting more detail, understanding what the strategies are and what the horizon is, and starting to see that execution.”
Peter Reali, managing director of responsible investing at Nuveen, says investors will be watching particularly closely.
“They will want to see companies move beyond goal setting and start to set out details on their KPIs [key performance indicators], what progress they are making towards those, and how they will report on them,” he says.
Whether or not companies will be able to do all that remains to be seen. As Reali notes, methodologies for calculating and disclosing Scope 1, 2 and 3 greenhouse-gas emissions are still being finalized.
Richard Mattison, head of S&P Global’s Sustainable1 division, says there will be a lot of scrutiny of what constitutes a “good” transition plan.
“At the moment, we have a very blurry pathway to a 2050 goal,” he says. “We need very sharp focus on exactly what we’re going to do before 2025 and probably out to 2030 because of the scale and size of industrial change that needs to happen.”
We need very sharp focus on exactly what we’re going to do before 2025 and probably out to 2030 because of the scale and size of industrial change that needs to happen
Richard Mattison, Sustainable1
Pressure on firms to flesh out their net-zero strategies – and start implementing them – will likely be heightened by concerns over reputational risk.
“Obviously, given the fact that the announcements of the goals were so splashy, there will be a lot of eyes on them,” says Reali. “People are increasingly sceptical about greenwashing and they want to see progress.”
Collaboration
An interesting feature of the net-zero drive is the fact that it will require an unprecedented degree of cooperation both within the financial sector and beyond.
As Mattison notes: “A bank cannot pull together its own transition plan, it has to work with its clients. Asset managers have to work with the companies that they invest in.
“This is an unusual scale of collaboration. Investors don’t usually get involved in setting company strategy. But this situation is different because everyone is back-to-backing with targets, so it requires collaboration. That is going to be a really interesting space to look at this year.”
An obvious vehicle for cooperation will be the Glasgow Financial Alliance for Net Zero (GFANZ), which, by the time of the UN climate conference in November, had signed up more than 450 banks, insurers, asset managers and other financial players, representing around $130 trillion of capital.
Collaboration across the industry will greatly increase our ability to push companies to act
Hannah Simons, Schroders
National governments and regulators may also play a role. As part of the UK government’s drive to create “the world’s first net zero-aligned financial centre” announced at COP26, asset managers, regulated asset owners and listed companies will be required to publish transition plans.
Collaboration between the private and public sectors is also flagged as a key theme for the coming months.
Calls have been growing recently for the public sector, including both governments and multilateral development banks (MDBs), to encourage private-sector climate finance by creating attractive investment opportunities.
Winnett Seelig says the role of MDBs will be pivotal this year.
“For sustainable energy transition, we’re going to be leaning heavily on our public-sector colleagues to help us deploy capital and de-risk investments,” she says.
At the same time, she warns that this will need to be done “in an equitable way for the MDBs” that doesn’t involve them merely taking all the risk.
Experts also expect more collaboration between investors to push companies to act on sustainability issues.
“What we already saw last year – and I believe we will see much more of – is investors engaging in collective engagement initiatives such as Climate Action 100+ to make their voices heard in company boardrooms,” says Maximilian Horster, head of ISS ESG.
Hannah Simons, head of sustainability strategy at Schroders, agrees. “Collaboration across the industry will greatly increase our ability to push companies to act,” she says.
Engagement
At the same time, Horster notes, there is a growing recognition among sustainability-minded investors that years of focused engagement have not always produced the desired results. As a result, “more and more equity investors are making use of their vote as a means of escalation”, he adds.
Traditionally, the accepted way of forcing companies to act in areas such as climate has been via single-issue shareholder proposals.
Plenty of these are expected during this year’s proxy voting season, particularly following a recent relaxation of Securities and Exchange Commission (SEC) guidelines that will make it easier to file ESG-related proposals.
“Now those barriers have started to decline, we can expect a very active proxy season from a shareholder proposal perspective, with the focus moving beyond transparency to accountability,” says Reali. “Proposals will not just ask companies to disclose their carbon emissions but to present a plan for Paris alignment or report according to TCFD [the Taskforce for Climate-Related Financial disclosures].”
He predicts an increasing focus on executive pay.
“Many companies have already taken it upon themselves to include more E and S metrics into compensation practices,” he says. “We expect to see shareholder resolutions asking companies to do more of that.”
Investors are escalating their concerns by voting on regular ballot items, such as the reelection of directors, based on companies’ climate strategies
Maximilian Horster, ISS
Investors are also expected to make more use of voting in other areas to push the sustainability agenda, particularly when it comes to energy transition.
That strategy shot to prominence last year when tiny activist investor Engine No. 1 persuaded shareholders in Exxon Mobil to vote out three members of the oil firm’s board and replace them with the hedge fund’s own nominees.
“Investors are escalating their concerns by voting on regular ballot items, such as the reelection of directors, based on companies’ climate strategies,” says Horster. “That is a part of the investor’s toolbox that we will see increasingly used in in 2022.”
Reali agrees: “Given the push to hold companies to account and to really accelerate the pace of change, I think we’re going to see a lot more focus this year on directors.”
Regulation
Unsurprisingly, regulation is expected to loom large again for all ESG practitioners in 2022.
In the European Union, the year started with further wrangling over the sustainable finance taxonomy after draft legislation sent to key bodies for review on New Year’s eve – with a January 12 deadline for comment – controversially included both gas and nuclear power.
Also on the EU’s agenda for this year is finalization of the Corporate Sustainability Reporting Directive (CSRD). The first set of standards is expected to be published by the summer and will include reporting on the percentage of activities aligned with the taxonomy.
Implementation, however, is still a way off. If all of this can be agreed in time by the various EU bodies, larger corporates will be required to start reporting according to CSRD rules in 2024 for the previous financial year.
In the meantime, asset managers in Europe are still struggling to work out how to fulfil the requirements of the Sustainable Finance Disclosure Regulation (SFDR) – which came into force in March 2021 – to categorize the ESG credentials of their funds without the underlying information on which it is based.
Last year, regulators increasingly realized that ESG is a lot harder to codify than they thought
My-Linh Ngo, BlueBay Asset Management
Anastasia Petraki, sustainability investment director at Schroders, put it succinctly in an end of year note: “As of January 2022, asset managers still have to show a number for their products’ alignment to an EU taxonomy that is not complete, using company taxonomy-alignment data that does not exist.”
My-Linh Ngo, head of ESG investment at BlueBay Asset Management, says these delays and controversies speak to fundamental concerns around the definition of sustainability.
“Last year, regulators increasingly realized that ESG is a lot harder to codify than they thought,” she says. “This means we will continue to have a lot of pain points in terms of implementation, definitions and reporting.”
Again, the need for clarity is all the more urgent, given the increasing focus – by regulators and other stakeholders – on greenwashing and the mislabelling of ESG funds.
Market participants are acutely aware of the problem.
“We need to disentangle precisely how we define ESG and what is an ESG-appropriate way of looking at sustainability for the investment community in particular,” says Mattison. “Otherwise, your average investor in an ESG-labelled ETF [exchange-traded fund] may expect to be doing a lot of good for the world and in fact, what they’re doing is driving better financial performance. I think there will be quite a lot of scrutiny around that this year.”
Beyond Europe, the US is tipped to be the focus of regulatory interest this year, following various announcements by the SEC last year that pointed to plans for the development of a regime to standardize ESG disclosure at US companies.
“This matters because, unlike in most European countries, the average person in the US is an investor, not a saver,” says Horster. “So if ESG regulation is introduced there, it will propel the topic into the public domain even more strongly than we have seen here.”
He notes that the same applies to China, which has a large middle-class investor base and where ESG regulation is developing rapidly.
Elsewhere in Asia, market participants will be watching progress on a joint framework for green investment in the Association of Southeast Asian Nations, which established an Asean Taxonomy board in March 2021.
Standardization
Surprisingly, calls for global standardization of ESG reporting and disclosures are much more muted than a year ago.
This seems to be partly due to a growing acceptance that discrepancies between regions and countries are inevitable, and partly to high hopes for the International Sustainability Standards Board (ISSB).
Formally launched at COP26 by the IFRS Foundation, the ISSB combines several existing and competing ESG reporting frameworks, and there are widespread hopes across the industry that the board will prove as influential for sustainability disclosures as its parent was for traditional accounting.
“The ISSB marks a useful step forward in addressing the alphabet soup of ESG,” says Luke Sussams, head of EMEA ESG and sustainable finance at Jefferies. “The draft proposals it will publish this year will be hugely significant, because we expect those frameworks to become the minimum standards for corporate ESG-related disclosures internationally.”
The ISSB marks a useful step forward in addressing the alphabet soup of ESG
Luke Sussams, Jefferies
For some market participants, this is setting the bar low. Unlike the Global Reporting Initiative (GRI), currently the most widely used sustainability reporting framework, the ISSB’s remit will be limited – at least initially – to financially material information.
“From what we have seen so far, the framework will be quite simplistic,” says Sussams. “The recommended disclosures will cover things like energy consumption and Scope 1, 2 and 3 emissions, and there are some social and human rights indicators.”
As he notes, these are the sort of metrics that are already mandated and most companies listed on OECD stock exchanges already disclose.
“The marginal impact, the scope for improvement will therefore be greatest in emerging markets, where ESG disclosures are somewhat patchy and opaque,” Sussams says. “It will take time, but we believe the ISSB will become the new benchmark for ESG disclosures in those markets.”
Jarek Olszowka, head of sustainable finance at Nomura, agrees.
“The ISSB may not be completely revolutionary in Europe, where there is already a lot of regulatory focus on sustainable disclosures, but for many parts of the world, where at the moment there is very little ESG disclosure, it will be a big step forward,” he says.
Green bubble
On another positive note, experts expect to see a continued increase this year in the number of investors looking for upside opportunities in ESG investment rather than relying on the exclusionary or risk-based strategies that have previously dominated the market.
“Across multiple markets, there has been a shift from seeing ESG as a tax and a limit on portfolio choice to seeing it as a way of achieving out-performance by identifying winners and losers,” says Winnett Seelig.
Combined with the rising desire among European investors in particular to see positive impact from their investments, this is expected to spur a surge in demand for the highest-graded ESG funds. In the EU, this means those designated as Article 9 – defined as “a fund that has sustainable investment … or a reduction in carbon emissions as its objective”.
“The SFDR has been very useful in driving behaviour change and innovation,” says S&P’s Mattison. “A lot of funds are saying, actually, we want an Article 9 fund because we know that that will be popular, because we know that will drive capital.”
The question is whether there will be sufficient assets to meet this demand. The range of assets that can be counted as ‘dark green’ under the SFDR is extremely limited.
“The danger is if you don’t have enough assets and you have a lot of capital trying to chase them, you could end up with a sustainable investment bubble,” says Ngo. “Certainly, within Europe it could be something to watch for as the taxonomy plays out.”
Sussams agrees that there are growing incentives in European capital markets for money to move towards dark green equities.
“We see demand for things like pure play renewable and electric vehicle charging stocks becoming ever more positive into 2022,” he says. “Asset owners want it and regulators want it, because there’s no sense of greenwashing, and asset managers are feeling that pressure already.”
Yet while this may enhance valuations for certain stocks and sectors, Sussams sees it as benign.
“The possibility for a ‘greenium’ is noteworthy but I don’t think there’s a danger of a green bubble,” he says. “The discussion was prevalent 18, 24 months ago, when the valuations of household names of the energy transition such as Vestas and Orsted were looking somewhat eye-watering.
“Since the start of the pandemic, due to supply-side constraints and inflationary drivers, the valuations of those stocks have come down significantly.”
Green inflation
A more worrying prospect raised by some sustainable finance experts is that of green inflation.
“I see energy transition and ESG as potentially being inflationary in certain sectors and certain markets,” says Winnett Seelig. “We already see volatility and inflation increasing alongside the increasing focus on ESG.
“Changing food production, switching of corn and bean oil into biofuels, achieving responsible retirement of carbon-intensive assets, introducing carbon taxes – those are all things that can drive up costs.”
The EU’s decarbonization agenda… is based on making the dirtier stuff more expensive rather than the clean stuff cheaper, which is inherently inflationary
Luke Sussams, Jefferies
As she notes, this is a highly contentious view among sustainable finance professionals – but Sussams, at least, is supportive.
“Green inflation is something we’re tracking,” he says. “The EU’s decarbonization agenda, and in particular the Fit for 55 initiative, is based on making the dirtier stuff more expensive rather than the clean stuff cheaper, which is inherently inflationary.
“The impact is as yet uncertain because we’re already in quite an inflationary market, but it’s something we will be watching closely over the next 12 to 24 months. It will test the willingness of consumers to pay for green solutions and we don’t yet know which way that will go.”
Bond concerns
Sustainability is expected to be a key theme in fixed income again this year as issuance of ESG-labelled bonds continues to smash records.
According to Crédit Agricole, sales of sustainable instruments – comprising traditional green and social bonds as well as newer sustainability-linked structures – had reached €780 billion by mid November 2021, nearly 90% up on the same period the year before. The French group tips issuance from the sector to top €1.2 trillion this year.
At the same time, ESG regulation is proving a challenge for bond bankers and investors, particularly in the EU. As Ngo notes, the SFDR has some notable gaps when it comes to fixed income.
“The EU’s requirements for corporate disclosure on ESG have a cut-off in terms of size, and with fixed income we’ve obviously got quite a few small private companies in the high-yield space, or investments in emerging-market companies that wouldn’t be caught by that,” she says.
“Efforts also fail to appreciate investors have exposure to non-corporates, with sovereigns being almost an afterthought in the regulation.”
[Mandatory standards for green bonds] could kill off a big chunk of the market
Jarek Olszowka, Nomura
Another area that will be closely watched this year is the EU’s new green-bond standard, which so far has raised more questions than it has answered.
Under the standard, which is due to be implemented this year, bonds will have to be fully aligned with the EU taxonomy – in other words, the proceeds should contribute to one of the taxonomy’s environmental objectives and cause no ‘significant harm’ to the other five.
In theory, projects that will become taxonomy-aligned within a set timeframe – five or 10 years has been mooted – can also be eligible, although it is unclear how that would work in practice, not least given the continuing uncertainty around the taxonomy.
Attempts to allow for further changes in the taxonomy – by giving issuers time to make sure eligible assets satisfy the updated criteria – are also seen as problematic.
“For heads of funding and CFOs, this introduces a level of risk because they don’t know how the taxonomy will evolve,” says Olszowka. “They can’t predict what will be the requirement for, say, gas in three or five years, and suddenly they might be in a situation where they don’t have eligible assets.
“The concern is that would lead to loss of the green-bond label, which would prompt a rush of divestment by investors and reputational risk. This could have the perverse effect of promoting borrowers to issue shorter-dated bonds to mitigate the risk of change.”
A bigger concern is that the standards will be made mandatory for green bonds issued in the EU, as both the European Central Bank (ECB) and EU parliament have recommended.
Olszowka says this would have far-reaching implications for euro-denominated green-bond issuance, which last year accounted for half of the global total.
“It could kill off a big chunk of the market,” he says. “There are just not enough taxonomy-aligned assets out there.”
Product focus
In terms of products, sustainability-linked bonds are expected to continue their rise this year. The structure accounted for around 10% of total ESG-labelled supply in 2021, and Crédit Agricole forecasts this proportion to double in the next 12 months.
Market participants say issuance will still largely be limited to corporates, given the challenges faced by other borrowers with the format.
For banks, the main barriers are regulators’ reluctance to allow step-up coupons in capital products, which comprise the majority of issuance from the sector, and investors’ preference for climate-related targets. Most firms are still working out how to calculate their greenhouse-gas emissions.
Sovereigns and supranationals also struggle with identifying suitable performance metrics.
As Olszowka notes: “Setting KPIs for a country is obviously challenging.”
Ngo is more optimistic.
“You could have a sovereign issuing a green bond or a sustainability-linked bond that’s linked to their NDC commitments on climate or on deforestation targets,” she says. “That’s a way you can invest to drive that accountability.”
Public-sector issuers are also expected to be the key players in the rapidly growing market for climate adaptation and resilience bonds.
The European Bank for Reconstruction and Development (EBRD) issued the first dedicated climate resilience bond in September, while the Netherlands, UK and France have included climate adaptation components in their green bonds.
The other area that is tipped for strong growth this year is private credit markets – part of a broader trend of ESG gaining traction in private markets.
“There is a lot of focus at the moment on how to integrate ESG and private credit markets, which have previously been lagging in this area,” says Olszowka. “When we speak to some big investors, they are not asking us to purely originate more green bonds, they want to also know if we have any private assets which have a strong sustainable angle to show them.”
Biodiversity
Nature is again tipped to be one of the key themes for this year, particularly if the much-delayed UN biodiversity conference finally gets underway in Kunming in April.
Experts say it is rapidly moving up the agenda for investors.
“A year ago, maybe 10% of my client conversations had biodiversity in them,” says Winnett Seelig. “Now 40% do. And it is not because I’ve brought it up. It is because clients are starting to expand the ‘environment’ aperture to include biodiversity.”
Proponents argue that biodiversity is key to addressing the climate crisis. Mattison, who is a member of the Taskforce for Nature-Related Financial Disclosures (TNFD), says it is not possible to have a credible climate transition plan without consideration of nature issues.
A year ago, maybe 10% of my client conversations had biodiversity in them. Now 40% do
Elree Winnett Seelig, Citi
“If we focus on man-made interventions that will drive down emissions, but don’t also think about how that connects to the world we live in and the ecosystems we rely on, we will fail on many fronts,” he says. “We will have a perceived success pathway towards reducing climate risk, but we will introduce other risks, or climate risk will appear in different ways.”
Whether or not growing interest in nature will translate into investment flows in the near term remains to be seen. Sussams says some in the capital markets still have doubts about the relevance of biodiversity.
“The direction of travel on nature and biodiversity is clear,” he says. “There is a greater focus on both as big thematic issues, largely driven by the TNFD and everything that brings. But speaking to our clients, the financial materiality of those issues is for some still in question.”
This is exacerbated by a lack of data, metrics and accepted targets for biodiversity.
As Sussams notes: “Assessing the impact of nature on enterprise value is objectively more difficult than with carbon because we have a carbon price.”
This is the problem the TNFD is hoping to solve. Given the complexities of the issue, some have been sceptical of promises of rapid progress. Mattison, however, insists that this is possible.
“We are being very ambitious and we’re on a very accelerated pathway,” he says. “Unlike some task forces that I might have worked with in the past, people are really rolling their sleeves up.”
Perhaps the most obvious way in which biodiversity could become more relevant is through nature-based solutions in voluntary carbon markets.
Winnett Seelig sees this as a big growth area.
“Voluntary carbon markets are going to take centre stage this year as a way to accelerate transition, which is great because they are effectively a form of green self-taxation,” she says.
“They increase the return that’s required to hit your hurdle. We now have enough of a framework to really start building out the market, but there are still questions about how to create high-enough quality offsets and what type of transactions they can be put against.”
